The Essentials: investment strategy - Where the smart money goes

A charity with money to invest needs to balance many variables, including how much cash it needs and how much risk it is prepared to take. Patrick McCurry outlines six steps towards getting investment right.

With the days of booming stock markets a fading memory, investing charitable funds wisely to get the best return is more important than ever. Trustees of charities with surplus funds may decide to use them to generate extra income for future activities.

The choice of investment products available to charities is extremely wide, ranging from equities and bonds to commercial property and hedge funds. Last year, for example, a charity leaving its cash on deposit would have made a return of less than 5 per cent, while the FTSE All-Share Index returned 12.8 per cent and UK commercial property 19 per cent.

The key to good investment decisions is an appropriate investment strategy - one that describes the broad approach the charity wants to take and includes the level of income it seeks, how much risk it is prepared to take and any ethical restrictions. The strategy will take into account the particular needs of the charity and balance current commitments with future spending. Having developed a strategy, trustees are then able to hold their investment managers to account or use it as a guide when making their own decisions. A charity should also review its investment strategy regularly, and if it has appointed fund managers it should review their performance every three years or so.

Although the Charity Commission gives detailed guidance on investment matters, not all trustee boards are taking it seriously. According to research by financial consultancy Watson Wyatt, many trustees do not accept the commission's view that their job is to get the best return possible.

The survey also found that nearly a third of trustees with financial qualifications believed their portfolios should be invested only in UK assets, which arguably goes against the commission's guidance that portfolios be held in a diverse range of investments.

This step-by-step guide describes the process of drawing up an investment strategy and some of the key issues to be tackled.

1. DISTINGUISH BETWEEN SHORT AND LONGER-TERM FUNDS

All organisations will need funds they can access at short notice, and a high-interest account is the obvious place. For medium-term funds, which the charity has no immediate plans to use, a deposit account may be appropriate. For charities with longer-term funds, which they do not expect to need in the next five years, it often makes sense to invest in securities (either income or capital growth) that offer a higher return than a bank or building society account.

It is important to check the charity's founding documents to find out if there are any ethical restrictions. Trustees will need to check whether the organisation comes under the Trustee Act 2000, the main legislation covering investment, because it does not apply to unincorporated charities.

2. TAKE ADVICE

The Charity Commission's main guidance to trustees when it comes to investment is that they must take a prudent approach. Although the Trustee Act 2000 gives trustees significant freedom in how they invest, they are required to get advice from a suitably qualified person (who may be a trustee), unless the fund is so small that this would not be cost-effective.

"Trustees or the charity's staff may have investment expertise themselves," says Ruth Murphy, director of charities business development at investment manager Newton. "These are the first ones to be involved in the debate, but others can be brought in to give advice and can include various types of investment advisers." She adds that many trustee bodies now specifically seek trustees with investment knowledge so that the charity itself can have a strong input.

Advice can also be sought from investment managers or consultants. Henry Buckmaster of investment manager Investec says consultants can be useful, but come with a cost. "It's up to the charity whether it thinks the cost of the consultant will be offset by the benefit gained," he says.

3. DECIDE ON POOLED OR SEGREGATED INVESTMENT

A charity will need to work out whether it wants to hold a portfolio of individual stocks and shares that is professionally managed or wants to pool its investment with hundreds of thousands of others in unit trusts, common investment funds and other such vehicles.

The main benefits of a segregated fund are that the portfolio is tailored to the charity's needs and it is easier to exclude investments on ethical grounds. Pooled funds, on the other hand, enable a charity to invest in a wide range of areas even if it has only a small sum to invest - and they are generally more cost-effective.

Fund managers will usually want to deal only with large portfolios of several million pounds or more on a segregated basis. "Although some houses have lower limits, we wouldn't deal with less than £15m on a segregated basis because of the cost of setting it up and running it," says Buckmaster.

A fund can be actively or passively managed. In active management the fund manager seeks to outperform the market average by choosing good investments.

A passive manager seeks to reflect the general movements of the stock market.

Among the most popular pooled investments for charities are common investment funds. These are similar to unit trusts but are specifically for charities and carry some tax benefits. They cover a range of investments from bonds to equities and property.

4. PRIORITISE INCOME AND GROWTH

Charities have to decide if they need a specific income from their investments to meet their spending needs, or whether they feel able to invest their funds for capital growth. However, many charities will want both income and growth from their portfolios and will thus balance the two in their investment strategies.

A charity that is highly dependent on income will frequently invest more in gilts, corporate bonds and fixed-interest securities, whereas an organisation seeking capital growth is likely to look more to equities.

Mark Powell, senior charity investment manager at stockbroker JM Finn and Co, says the balance between income and capital growth should be based entirely on the charity's requirements.

"A charity raising funds for a building project would require a different approach from one that requires funds to meet everyday running expenses," he says. "Our experience shows that many charities seek an income return of higher than 3.5 per cent, often above 4.5 per cent, with some growth if possible."

Powell adds that the more ambitious the capital growth requirements are, the more risk a charity is taking on.

5. ALLOCATE ASSETS

Once a charity has worked out its income or growth needs and its attitude to risk, it will need to decide, perhaps in discussion with an investment manager, how to achieve them - this is where asset allocation comes in.

Asset allocation is the term used to describe how an organisation splits its investment funds between equities, bonds, cash and so on. The way in which a portfolio is allocated will have a huge influence on the returns achieved and the level of risk.

A key part of asset allocation is working out what level of risk is acceptable and whether the investment portfolio is sufficiently diversified. The Charity Commission stresses that trustees must have a "suitably diversified portfolio". In simplified terms, this means the charity should not hold all its eggs in one basket, such as the stock market, but should instead attempt to spread its risk by investing in a number of asset classes.

Alternative investments, such as derivatives and hedge funds, have become more common because they can provide returns that don't depend on the usual market.

"Traditionally, equities have provided most of the capital growth," says Nick Rickard, head of investment at the Charities Aid Foundation. "Although they're not forecast to do as well in the future as in the past 20 years, they're still a better long-term option than bonds or cash. But given some of the alternative investments that are emerging, there are now many more options."

6. CONSIDER ETHICAL OR SOCIALLY RESPONSIBLE INVESTMENT (SRI)

Trustees have a general obligation to get the best return possible from charitable funds. But this requirement is flexible if certain investments could conflict with the charity's objectives - think of a cancer charity investing in tobacco stocks - or if the charity believes some investments would alienate supporters.

Of course, regardless of such situations, trustees can choose ethical investments so long as they are not likely to perform worse than other investments.

Traditional ethical investment involves excluding particular sections of the stock market (such as tobacco, alcohol and the oil industry), whereas SRI focuses on influencing companies to behave more responsibly through shareholder activism.

Smaller charities with ethical considerations can seek to invest in pooled funds that exclude certain sectors or focus on supporting companies of whose activities they approve. Larger charities with their own specific fund managers can draw up tailored solutions to their ethical investment needs.

For charities with pooled funds, it is trickier because they are not in control of the investment parameters, unlike a segregated fund investor.

But there are various ethical and SRI pooled funds in which charities can invest to achieve their aims.

- For more details on SRI, see the feature on page 33

INVESTMENT: THE RULES

Under Charity Commission guidance, trustees must act to certain standards when managing a charity's investments

- The general duty of care: a higher level of care and skill is expected of a trustee who claims to be knowledgeable in investments or who is paid

- Trustees must be convinced that any proposed investment is right for their charity after considering a range of investment options

- Trustees must consider the need for diversification to reduce the risk of losses

- Trustees must periodically review the charity's investments, striking a balance between chopping and changing investments too frequently and leaving investment policy unexamined so that opportunities are missed

- Trustees must get proper advice, unless the funds are so small that this would not be cost-effective

The Charity Commission publications CC14: Investment of Charitable Funds and Guidance on Common Investment Funds provide help on investment. See www.charity-commission.gov.uk

FURTHER INFORMATION

The Charities Aid Foundation produces a glossary of investment terms that can help you understand the jargon www.cafonline.org/ccs/glossary.cfm

- CAF also publishes a guide called Understanding Charitable Investments www.cafonline.org/charity

- NCVO's Ask NCVO microsite has a range of helpful information on various aspects of investment www.askncvo.org.uk

- Investment manager Sarasin Chiswell produces an annual Compendium of Investment for Charities www.sarasin.co.uk

- The Charity Finance Directors' Group runs investment training for trustees www.cfdg.org.uk.

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