The value of investments and any income from them can fall and you may get back less than you invested.

What does risk mean to charities?

One of the key conversations we must have with our charity clients surrounds risk. Immediately, when considering risk from an investment perspective, investors often only think about the potential for capital loss and volatility. However, risk to capital and volatility only forms part of the discussion and we believe investors need to think about risk in a more comprehensive manner.

RISK TO CAPITAL AND INCOME

This is the risk that capital and / or income is permanently destroyed or lost. More often than not, this risk type is associated with a company failure (e.g. a company going bankrupt) and accordingly is largely connected to equity investments, although this risk can also occur with bond investments. We must remember that the value of an investment will rise and fall over time (volatility, discussed below) and clearly charities want to avoid the need to cash in an investment at a market low.

Warren Buffett, often heralded as the world’s most successful equity investor, has a solution to avoid risk to capital in his two main investment rules. Rule 1: Don’t lose money. Rule 2: Refer to Rule 1.

VOLATILITY

Volatility has long been associated with risk, with the central premise being that higher risk assets offer the potential for higher returns but will also be more volatile over the holding period. Accordingly, as volatility is measurable, and there is no simple way of capturing all the various types of risk, it is often used as a proxy for risk.

However, we must be mindful of solely looking at volatility as being the same thing as risk, as volatility is a consequence of a variety of risks and external factors, rather than a cause of risk. To better illustrate this point consider this example. The large amounts of volatility that we have witnessed in equity markets over the past 15 years would be supportive of the conclusion that a higher risk asset has higher levels of volatility. However, how do we quantify the large amounts of volatility witnessed in high grade government bonds over the last few months? Here is a low risk, some might even say risk free, asset which has been more volatile than equities during 2015.

Are government bonds now more risky than equities? We don’t believe so, there have merely been some external factors and heightened risk (such as inflation, interest rate, and liquidity factors, as well as political events) that has caused higher volatility in government bonds at present.

Therefore, we must accept that volatility can affect all assets, with the exception of cash, and be cognisant of the factors that will bring about higher levels of volatility. As investors in a variety of asset classes, we need to ask about the level of volatility that is comfortable and tolerable for our charity clients. The question trustees need to ask themselves is how concerned are you about the rises and falls in the value of the investments, even though the investments may be still be on track to deliver your required outcomes over a longer-term time horizon?

SHORTFALL RISK

What is the risk of the investment not meeting the underlying investment objective? What are the implications for an organisation that cannot fund their work as not enough capital growth or income has been generated? This isn’t necessarily associated with a loss of capital or income as described above. Often, shortfall risk occurs when not enough market risk has been taken on and the returns generated have not been sufficient, but it can also occur when too much risk has been taken on. Consider how much risk your charity needs to take on, remembering that risk cannot be avoided; the key is how it is managed.

INTEREST RATE RISK

This is the impact that rising or falling interest rates may have on investments. Although this risk type is more commonly associated with lower risk cash and fixed interest investments, we must remember that all asset valuations are dependent on interest rates. What are the risks of locking into current rates of interest?

INFLATION RISK

This is the risk that the purchasing power of the investment is eroded by inflation. Whilst many other risk types are tangible (i.e. we can see a fall in value) and visible over both a short and long-term time horizon, inflation risk is more covert. Inflation is particularly damaging over long time periods for lower-risk assets, such as cash and fixed interest, where we would expect the returns to be lower. It is therefore important to consider what the ‘real return’ – the return after inflation - is likely to be. Inflation risk is a significant issue for charities, most of whom have very long time horizons. A careful balance must be struck when dividing assets between ‘lower risk, lower return’ investments and ‘higher risk, higher return’ investments, taking into account that equities have traditionally provided the best long-term returns ahead of inflation.

LIQUIDITY RISK

This is the risk of being unable to access the money invested. Liquidity risk has two components: will you need access to the capital; and then how quickly will you need the capital? Clearly, cash is the most liquid investment available, with investment into direct property probably being the most illiquid. However, there can be occasions (usually around times of market stress) where it may be difficult to sell equity or fixed interest investment, particularly in the less liquid or smaller parts of the markets.

REPUTATIONAL RISK

Whilst much of the debate about risk focuses upon the technical elements of risk, key in everything a charity undertakes is the preservation of its reputation. Aside from the internal governance issue of maintaining and reviewing a risk register, the investment criteria (including risk appetite) set out in the IPS are a useful way of highlighting the plans made by the Trustees and how they are in the interests of beneficiaries. How many of us have heard the view that charities should not invest, rather spend all their funds, as soon as they come in? (This can be dealt with by a conversation on the importance of reserves for survival). The annual report is then the place where a summary of the IPS serves as a useful summary of the reasons the charity is investing and some key points from the IPS, set out for all the stakeholders to see and review, if necessary.

THE REGULATORY PERSPECTIVE

In their comprehensive guidance on risk for charities (CC26), the Charity Commission for England and Wales reiterates the point about being conscious of the risks faced by the charity and highlight some specific ones relating to investment (in the Financial Risks section). They also highlight both the potential impact of each kind of risk and some of the steps Trustees can take to mitigate them. Amongst them are included loss through inappropriate investment, lack of investment advice, lack of diversification and the lack of income streams to fund beneficiary activities. In mitigation, much of the guidance centres on having the right IPS, talking advice and prudence on the part of Trustees.

STRIKING THE RIGHT BALANCE

In debating the range of risks, there can be a conflict between them. For example, if you require a strong total return, you cannot also make a policy statement that you wish to be a low-risk investor, given the volatility and other risks you need to absorb in order to gain those returns over the long term. In these instances, compromises have to be made and the investor must be aware and accepting of potential consequences. The answer for charities lies in having an appropriate balance being struck between all the types of risk described in order to achieve their objective. Taking advice when required, and reviewing both the policy and investment outcomes, enables trustees to fulfil their duties and adapt over time.

CONCLUSION

So what should be the thought process and Trustee conversation about risk? Firstly, you need to consider whether your charity can take on risk, which type and how much. What is your charity’s ability to absorb either a loss in the capital value of its investments or a reduction in the income generated from investments?

Thereafter, we need to establish whether you are willing to take on risks that you are reasonably able to absorb. Are you comfortable with the aforementioned risks and accepting of potential volatility? In addition, and in keeping with ‘shortfall risk’, you should consider how much risk you need to take on in order to achieve your desired investment objective.

Ruth Murphy Head of Charities

The value of investments can fall and you may get back less than you invested.

Past performance is not a guide to future performance.

This information is for illustrative purposes only and is not intended as investment advice. Any opinions expressed are not necessarily those of Brewin Dolphin Ltd.

 

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