Charities, endowments and foundations have greater freedom to act than many other institutional investors. Making use of it requires governance built around their own objectives rather than conventional portfolio constraints.
Charities, endowments and foundations (CFEs) typically have one significant advantage over many other institutional investors: freedom.
Pension schemes can find their investment decisions constrained by funding levels, while insurers must consider solvency requirements. By contrast, CEFs generally face neither constraint, potentially giving them the freedom to invest counter-cyclically when markets become stressed.
However, Alan Brown, a trustee and member of multiple investment committees, told delegates at Longview Networks’ CEF Investment Forum that many institutions fail to exploit their advantage.
He cites an example from his time as the investment committee chair of the Wellcome Trust, which in 2018 issued £750m of 100-year bonds at a coupon of just over 2.5%. Brown described it as the most counter-cyclical transaction with which he had been associated.
Locking in very cheap long-term financing gave the endowment additional capital to deploy at considerably higher prospective returns. At the time UK equities yielded more than 4%.
The wider lesson, he argued, is that endowments should recognise the advantages inherent in their structure rather than adopting investment approaches developed for institutions facing very different constraints.
Starting point
That criticism extends to strategic asset allocation itself. Brown described the conventional model as “intellectually bankrupt”, arguing that investors spend too much time constructing an asset allocation every three to five years and subsequently managing risk against the resulting benchmark.
The problem, he said, is that the risk between the portfolio and its benchmark can be relatively small compared with the risk that the benchmark itself fails to deliver what the organisation ultimately requires.
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He suggested a total portfolio approach should replace this process. Rather than beginning with allocations to individual asset classes, Brown argued that an institution should first ask whether the portfolio is achieving its required outcome – for example, inflation plus a specified return – before considering how effectively it is exploiting the available investment opportunity set.
For CEFs, this can be increasingly material as portfolios become more complex. Private markets, impact investments and other less conventional strategies need not be considered simply as allocations to be fitted within predetermined buckets. Rather, each investment can be considered in terms of what it contributes towards the organisation’s overall objectives.
Shared understanding
Greater investment freedom also places greater demands on those ultimately responsible for the portfolio.
Gail Cunningham, independent consultant and author of the Charity Investment Governance Principles, highlighted the challenge during an interactive session examining how charities govern their investments.
The delegates revealed significant differences in practice. Relatively few confirmed that trustees were routinely given an understanding of the charity’s purposes and how its investments furthered them as part of their induction or board discussions.
Similarly limited responses followed questions about whether all trustees were directed towards Charity Commission investment guidance and whether organisations had formally considered their need for investment advice.
The informal survey illustrated a wider problem that Cunningham has identified: investment expertise and understanding of an organisation’s purpose do not necessarily reside in the same people.
Investment specialists co-opted onto committees may have considerable financial expertise but relatively little knowledge of the charity’s mission. Trustees, meanwhile, can understand that mission intimately while having much less investment experience.
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The solution, she suggested, is to ensure both groups possess sufficient understanding of the others’ domain to make decisions together.
Brown described how this issue was solved at Wellcome. Its governing body included considerably more scientific than financial expertise, even though the trustee governors retained ultimate responsibility for the endowment.
Wellcome therefore offered what Brown described as an ‘investment 101’ class for governors without financial backgrounds. Almost all attended, improving their ability to understand and challenge the recommendations put before them.
Staying the course
Good governance also matters when markets put long-term investment beliefs under pressure.
Matt Hurshman, associate partner at Aon, and Guy Davies, director at Yoke and Company, argued that portfolio construction should begin with what an organisation needs its investments to accomplish.
That includes understanding spending requirements and separating assets needed in the near term from those that can genuinely be invested over long horizons. Cash required over the following year, for example, has a fundamentally different purpose from assets intended to support an organisation in future decades.
Davies illustrated the consequences of that distinction breaking down with the example of a charity that, concerned by geopolitical events and the bombing of Iran in February, sold the entire risk portfolio and moved into cash. Markets subsequently recovered, leaving the charity facing the difficult decision of when to reinvest.
Hurshman pointed to the other side of investment risk. Losing money matters, but so does failing to generate sufficient returns. Moving into cash can replace market risk with the danger that investors remain on the sidelines while asset prices recover.
For institutions capable of investing over decades, such decisions can squander one of their greatest advantages. Effective governance allows CEFs to use the freedoms their structure gives them – establishing what their capital needs to achieve, allocating accordingly and maintaining their positions when market conditions become uncomfortable.