Planning for the unexpected
Richard Maitland suggests how charities and other not-for-profit organisations might make their medium-term capital work in a continuous climate of low interest rates and bond yields
In the current economic conditions there is a constant and very real concern for many charities: how to handle ‘unexpected’ events. One of the conundrums faced by many charities at present is the ultra-low interest rates available on cash deposits. Is it right to hold cash when the returns are so paltry?
One, if not, the golden rule of investment, is the importance of managing one’s assets in such a manner that volatile and illiquid investments can be left intact during periods when they have fallen in value (equities) or when they can only be sold at fire-sale prices (property).
For many operational charities or endowment funds, where occasionally trustees might choose to spend over and above their sustainable spending rates (such as now, during a period of economic and social stress) it is good practice to hold significant cash deposits. Such short-term reserves act as a sensible cushion and they complement the long-term investment portfolios.
The main problem is that with interest rates and bond yields at such incredibly low levels, as well as beneath the prevailing rate of inflation, there is a ‘real’ cost to holding too much cash for too long. With inflation running at just 2.5% a year, charities could expect a capital erosion in real terms of some 12% after just 5 years. Moreover, for many charities, while it is right to plan for the unexpected, these ‘unknown’ events never actually materialise. Holding too much cash over many years results in a significant opportunity cost: the cash deposits slowly lose their spending power and might have produced better returns if invested in other assets.
While some reserves and investment policies allocate monies to just two ‘pots’, at Sarasin & Partners, we introduced the concept of a third ‘pot’ when we launched the Alpha CIF for Income & Reserves back in late 2005. Our aim was to offer trustees a medium-term investment programme that could supplement short-term reserves (which we continue to suggest should only be held in liquid and safe cash deposits) and that would sit between their short-term and truly long-term investments.
The Alpha Common Investment Fund for Income & Reserves is invested in a combination of government bonds (35%), corporate bonds (40%) equities (20%) and cash (5%). It has an income yield of 4.5% and has produced an annualised total return of 4.8% since 31st December 2005. As a Common Investment Fund, it has charitable status and adopts a socially responsible investment policy that is closely aligned to the Church of England's ethical criteria.
It is worth re-iterating, this is not an appropriate investment for monies required within the next twelve months. Although the precise asset allocation and stock selection are managed actively depending on the prevailing market conditions, such a fund should be expected to produce an occasional short-term capital loss. So, despite the very low interest rates, we would always recommend that monies for immediate spending should remain on deposit. With these reserves, to quote Mark Twain, ‘I am more concerned about the return of my money than the return on my money.'
However, a defensively invested medium-term reserves fund allows trustees, perhaps, to hold a little less on deposit while still having the confidence to continue to invest their genuinely long-term reserves in higher return-seeking investments such as equities, property and alternative investments (hedge funds, private equity, infrastructure, commodities).
As Nicholas Cottam noted in his interview with Melanie Roberts, the Cathedral finance team are now working through a belt-tightening phase to re-build their short-term reserves. Nonetheless, astute financial planning meant that in a year when both planned and unplanned events caused a significant reduction to their income stream – and markets were once again volatile - there has been no need to panic and this extraordinary centre of worship and one of London’s leading tourist attractions can plan for the future with renewed confidence that their finances remain in good order.
David Vickers, fund manager of the Alpha CIF Income & Reserves Fund comments:
“How to generate sufficient levels of income without putting ones capital at risk is one of the major challenges facing our clients. Our aim with this Fund is to generate above average levels of immediate income by active management and sensible diversification across the fixed interest spectrum. Additionally, a relatively small percentage invested in equities should help to preserve the capital in real terms.
"Within the Fund, we remain underwhelmed by government bonds, which are near the most expensive they have been for 50 years and in many cases offer negative yields. Many companies are in better shape financially than most governments and as a result we have been comfortable retaining our overweight positioning in corporate credit (including additional European holdings where valuations and yields post the ECB support plan are attractive). Meanwhile we continue to see value in defensive, cash flow rich global equities, with a focus not just on high income stocks, but also on sustainable income growth over the longer term.”
This article first appeared in Sarasin & Partners House Report, Quarter 4, 2012.
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Richard Maitland is a partner and Head of Charities at Sarasin and Partners.
Richard has more than 22 years of investment experience and joined Sarasin & Partners in 1992. In addition to UK equity research, Richard has led the firm’s third party funds research team, analysing specialist equity funds and alternative assets while managing portfolios for a range of charities, pension funds and unit trusts. He now focuses on managing diversified multi-asset portfolios for charities and assists in setting the firm's long-term strategic asset allocation. He is author of the Sarasin & Partners Compendium of Investment. Richard has a degree from Newcastle University and is a member of the St Paul’s Cathedral Investments Committee. He has been a visiting lecturer on investment and endowment management at the Judge Business School and the Universities of Stellenbosch and Vienna.Read more articles by this author