Investment management: The Ivy League Solution

Wary of further stock market slumps, grant-making charities are being urged to follow the lead of bodies such as Yale University by investing in alternative asset classes. Julie Pybus reports.

The shock waves from the stock market slump of 1999 to 2002 are still reverberating around the voluntary sector. If returns from investment fall, then foundations' grant making abilities usually suffer.

According to research from the Charities Aid Foundation, grant making by the UK's largest trusts has declined by nearly 10 per cent, from £242m in 2001/2 to £218m in 2002/3. CAF's research team is also predicting that figures for 2003/4 will show further declines in grant making when they become available.

This has prompted some trustees of grant making organisations to reconsider their investment strategies to try to ensure grant making isn't hit in the future.

One of the most talked-about subjects over recent months has been the potential of alternative asset classes - such as hedge funds, property and private equity - for charities with big investments. Having had their fingers burned by the equity markets, charity investors are becoming increasingly receptive to the idea of alternative asset classes. The Trustee Act 2000 and recent guidance from the Charity Commission have also led to a more flexible attitude.

A report released earlier this year by Goldman Sachs Asset Management (GSAM) set out a radical suggestion for charities with long-term investment needs, such as charitable foundations. UK Charities: Bridging the Gap, argues that foundations should follow the lead of US not-for-profit organisations, such as Yale University, and invest up to half of their portfolios in alternative asset classes.

GSAM also argues that foundations should follow a total return investment strategy. Traditionally, foundations have spent their investment income on grant making and used capital gains to maintain the real value of their capital.

GSAM believes that investment income is unlikely to be able to support the expenditure that foundations want to achieve, and capital returns are likely to be lower that those seen during the 1980s and 1990s. A total return policy means that charities' investment returns are not viewed separately as capital and income; instead, the overall return of the investments is the main focus. As a result, spending is not limited by falling investment income and long-term spending policies should not be threatened by short-term fluctuations in capital gains.

Danny Truell, managing director and co-head of GSAM's Global Investment Strategies, says: "Charities need to think in a more scientific way about how they manage their assets to give themselves the best chance of meeting their objectives."

Amna Karim, head of charities, endowments and foundations at GSAM, adds: "Traditionally, many charities' investment portfolios have been structured like pension funds - but their aims are different."

To illustrate this argument, GSAM constructed a hypothetical endowment fund called Spend4life and invested 50 per cent in equities and 50 per cent in bonds. The investment portfolio was £100m, and the hypothetical body was to make grants of £5m a year, which would grow in line with inflation.

Spend4life's trustees decided on a spending policy planned over 10 years - it wanted to be confident that in 80 per cent of outcomes, the real level of its assets would be maintained over that decade. Using modelling tools, GSAM predicted that with these investments Spend4life's spending would have to be cut by 26 per cent to £3.7m a year.

Instead of cutting expenditure, GSAM felt Spend4life should adopt a total return approach and diversify its investment portfolio, cutting its equity weighting from 50 per cent to 40 per cent, and reducing bonds from 50 per cent to 10 per cent. Property then became 10 per cent of the investment portfolio, private equity 20 per cent and hedge funds a further 20 per cent. According to GSAM's model, this portfolio would allow Spend4life to maintain real spending of £5m a year, with 80 per cent confidence that the assets would maintain their real value over the next 10 years.

Truell says: "In some cases I think investors have been wary of alternative assets because they are new and therefore seen as more risky. In the past few years, we have seen that the volatility of equities can produce unacceptable risk, whereas alternative asset classes can diversify the portfolio and reduce risk."

Models cannot predict the future, as Truell admits: "None of us has a crystal ball, but we do know that a well diversified portfolio has a better chance than one that places all of its eggs in one basket."

Not everyone accepts that these alternative asset classes are suitable for the UK's charitable investors, however.

Hedge funds are part of a range of investments known as 'absolute return strategy funds'. These are designed to seek positive returns for investors at all times, instead of aiming to outperform a benchmark. If the market is struggling, the fund managers take advantage of a wide array of financial instruments and techniques to get these positive returns.

Such funds have come under fire for their lack of transparency. In March this year, students from Yale and other US universities demanded disclosure of the social and environmental impact of their universities' hedge fund investments.

Hedge funds are sometimes deemed too risky for charities, with sceptics quoting the 1998 collapse of the highly speculative Long Term Capital Management fund in the US - it had to be bailed out with $3.75bn (£2bn) of banks' money.

Some fund managers argue that as take-up of hedge funds has widened, transparency and accountability have improved and risk has fallen. In 2002, Cazenove launched the first hedge fund common investment fund for charities, the Absolute Return Trust for Charities. John Gordon, head of charity client service, says his company aims for transparency. "If our hedge fund managers don't give us the information we need, we don't invest in them," he says.

Private equity - investments in companies that have not listed their stock on a public exchange - is another alternative investment that is gaining favour with UK charities. Although many investment managers think they are a good idea, some trustees are concerned about illiquidity because it can take many years for a company to develop to the extent that investors get the returns they are anticipating. Lack of transparency can also be a worry. GSAM suggests that an indirect approach - investing through a 'fund of funds' - can offer diversification and more predictable returns.

It could be argued that property isn't a true 'alternative' investment because it has formed the basis of many foundations' investments for hundreds of years. However, the fear of illiquidity has meant that only 3 or 4 per cent of charities' investments have been in property.

Two property common investment funds are now available to charities.

As they are unitised investments, these are easier to buy or sell than a directly owned building. Property can provide a stable, predictable income stream. It can also be a useful portfolio diversifier because it is negatively correlated to bonds and equities - if bonds and equities are doing badly, it is likely that property is doing well.

Despite all this debate about the benefits of alternative assets, John Hildebrand, head of charities at Investec Asset Management, argues that equities should remain the "bedrock" of foundations' investment portfolios, making up about three-quarters of the investment portfolio. "Historically, equities have made up a very strong asset class," he says. "And there is a rising income stream."

He argues that charities with a long-term horizon, such as grant making foundations, can afford to tolerate the volatility of this asset class, so low returns over a short period of time shouldn't have a devastating effect on long-term spending plans. He does point out, however, that some diversification into other asset classes is necessary in order to reduce exposure to risk.

The latest results from the WM Company's charity fund survey demonstrate that things are looking up for equities. The average charity fund (which is still primarily invested in equities) posted a return of 2.4 per cent for the third quarter of 2004. Returns for the past three years are now at 3.2 per cent.

George Urquhart, a consultant at the WM Company, says: "The positive third-quarter returns will come as a breath of fresh air to charity funds in the UK. In particular, the three-year return is now back in positive territory for the first time since the beginning of 2002, which should ease the worries of many charities."

Perhaps this positive news will ensure that many trustees remain in their comfort zone and keep hold of their equity-heavy portfolios. However, it is clear that forward-thinking institutions, such as Yale, are seeing strong returns from their innovative investment strategies. Charity trustees would be well advised to bring themselves up to date with the latest thinking in the investment management world to ensure that they can make the best decisions for their charities.


Yale has led the way into alternative investments for US not-for-profit organisations. A return of 19.4 per cent on its endowment for the year ending June 2004 has taken its total assets to $13bn (£6.8bn) and made it one of the strongest performing institutional investors in the US.

According to the university, its success is down to "Yale's disciplined and diversified asset allocation policies, combined with strong active management".

Back in 1988, nearly 75 per cent of the endowment was committed to US stocks, bonds and cash. Over the past 15 years, Yale has moved into alternative asset classes after being attracted to their "return potential and diversifying power".

Asset allocation at June 2003 saw less than half the portfolio in 'traditional' investments, with domestic equity at 15 per cent, foreign equity 15 per cent, bonds 7 per cent and cash 2 per cent.

The remaining assets were devoted to alternative investments: private equity 15 per cent; absolute return funds (including hedge funds) 25 per cent; and 'real assets', such as property, oil, gas, and forestry, 21 per cent.

The success of the investments means that spending from the endowment this year will be 11 per cent more than it was the previous year. The endowment's contribution provides about 32 per cent of the university's revenues - more than twice what it provided a decade ago.


Until the stock market slump, the King's Fund had a fairly traditional equity-based investment portfolio. Having lost a lot of money when the markets fell, the investment committee carried out a review of the investment strategy.

The trustees studied the success of Yale's investments and decided to move some of the King's Fund endowment into alternative investments. The new asset allocation is still equity-heavy, with 72.5 per cent of the total £100m investment in UK and overseas equities. But the charity is dipping its toe in the water of alternative investments, with 5 per cent in property, 5 per cent in hedge funds and 5 per cent in private equity.

The remaining 12.5 per cent is in bonds and cash.

Frank Jackson, the King's Fund head of resources and deputy director, explains that the property investments are in indirect property funds to gain exposure to a diversified portfolio of assets. The hedge fund investment is in two US-based 'fund of funds'.

Jackson says: "We feel we are being cautious in going into fund of funds and cautious in establishing contact with two very well known and established funds." He points out that the private equity investment is cautious too: "We have gone into private equity through a very traditional vehicle."

In future, he sees the King's Fund moving towards the Yale model. "Yale has been terrifically successful," he says. "The future direction of the King's Fund will be more towards alternative assets rather than conventional assets. But that decision will only be made when we have got a lot more experience, and we are mindful of the liquidity problems that come with alternative investments."

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