It is always critical to plan ahead for outcomes that might throw investment portfolios off course. Strategic defenses can be deployed well ahead of upsets, while tactical flexibility should help navigate specific market scenarios.
Be prepared: strategic defence
Match cash flows with liabilities. Identifying the purpose of a charity's capital and matching cash flows with known liabilities is the best way to avoid forced panic-selling during market volatility. Forward planning might involve dividing the capital pots between short-term (12 months) immediate needs and a long-term (five years plus) desire for real capital growth. If drawdowns are forecast, a medium-term reserve could be invested to generate returns better than cash, but with less volatility than would be acceptable with genuinely long-term monies.
Strong stewardship skills should steer us away from the worst mismanagement that might trigger individual corporate collapses – which often occur during wider market stress. Actively voting and engaging regularly with management boards are important defensive tools, while policy work with wider stakeholders can increase the likelihood of sustainable returns for all investors.
Diversify income streams. Over the past 20 years, our largest capital reallocations have been driven by the search for more diversified, sustainable income growth. UK-listed equities used to make up 50% of the Sarasin Endowments fund, but the percentage is now only 20%. Our broader, global opportunity helped protect charity investors when the UK banking sector slashed dividends in 2008/9 and BP subsequently suspended its dividend following the Macondo Well disaster.
Set appropriate spending levels. Whilst the majority (75% plus) of regular spending should be funded by income, adopting a total return approach can allow for greater diversification, both geographically and across asset classes. Instead of being permanently shoehorned into higher income stocks, charities can top up the natural income from the portfolio with a little capital. As the table below shows, there have been decades when prudent ‘income-only’ spenders should have reinvested some income.
Tracking a typical long-term endowment back to 1900 suggests that charities could have spent about 4.5% per annum after allowing for inflation and costs. Over the past five years, the equivalent figure has jumped to 7.8%. Charities may, therefore, have built up a useful ‘buffer’ (the so-called Unapplied Total Return), allowing them to spend a bit more capital over the next five years.
Be nimble: tactical defence
Managers with wider operating parameters can add value with tactical moves as market conditions change. We consider below some scenarios that might trigger volatility.
- A sharp, unexpected rise in inflation would drive up bond yields and almost certainly destabilise most asset prices. Managers holding more cash than usual in anticipation of a spike could buy into volatile assets at lower prices. Whilst fixed income prices would re-adjust downwards to a new higher yield reality, real assets with income streams linked to the economy would ultimately recover.
- As Brexit policies become clearer, opportunities could emerge to buy into over-sold UK equities. Sterling remains undervalued versus other major currencies; a positive outcome could see this reverse. Managers with the flexibility to alter currency allocations quickly could take advantage of shorter-term price fluctuations.
- Trade disputes have been worrying investors of late. Typically, there are no winners and such spats dent economic growth—which could ultimately drive dividend cuts. Focusing on more defensive industries and companies with strong, long-term thematic tailwinds may protect against dividend disappointments. Income targets must be realistic: don’t rely on ‘special’ dividends to be repeated every year and revisit income projections every six months to ensure they’re on track.
Finally, for charities permitted to use derivatives, a simple option overlay strategy could limit the downside of an agreed portion of the portfolio, whilst ‘giving up’ a little return.
Tales of the unexpected
Volatility may well return and we should expect to see ‘riskier’ assets fall back at some stage. Timing this is almost impossible, so known short-term liabilities must be identified and converted, where necessary, to cash or short-dated government bonds. We are erring on the side of caution and adopting a more conservative approach, combined with global diversification and a focus on stewardship skills in our selection process. We believe this could help us avoid any ‘tales of the unexpected’.