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What investment risks do your trustees need to consider?

The Charity Commission recognises that the purpose of a financial investment is to deliver a good return by taking an acceptable level of risk as these returns will help charities to achieve their stated aims.
Andrew Impey, portfolio manager at OLIM offers a guide to charity trustees for reviewing risk.

All investments carry risk. There is no such thing as a risk-free investment. For example safe investments like cash or short-to-medium dated government bonds offer very low interest rates. Even worse, after adjusting for the impact of inflation, these rates of return are in fact negative. The real value of your safe investment is gradually eroded by inflation. Charity trustees must be vigilant and an investment policy should take all reasonable steps to mitigate risks. Charities have a broad range of obligations when adopting an investment strategy. Most importantly, they must be able to explain and justify their decisions to their various stakeholders, including the level of risk they have chosen to assume.

Identifying and managing investment risk

Trustees have a wider responsibility to identify all risks to the charity, but need to go one level deeper to understand the investment risks that could impact their portfolio, and any relevant legislative restrictions. Trustees must be very clear on the reasons for investing, the expected benefits, their risk appetite and how they want to manage and monitor their investments.

Shortfall risk and diversification

The two main investment risks a trustee should consider are loss of capital, followed by loss of income. If capital is destroyed it is harder for investments to generate income, so the two go hand-in-hand. Realistic income targets need to be set; currently, the market yield on UK equity investments is around four per cent, so a strategy which requires an eight per cent yield could be extremely risky. Trustees should ask their investment managers about forecasted income and how confident they are of dividends not only being paid, but also growing at a sustainable rate. This is especially important in an endowed charity where it is harder to withdraw capital. Shortfall risk can be managed by having a diversified portfolio, which avoids having all of your eggs – or assets – in one basket. Trustees must assess the range of asset classes available for investment – equities, fixed income, property, alternatives, currencies, cash – and decide upon their asset allocation. Geographical diversification can add an extra layer of protection by providing exposure to different markets and economies. This can be achieved by investing directly in the shares of foreign companies, or indirectly by owning UK quoted companies with significant overseas operations.

A well-diversified portfolio should not have too large a proportion in any one asset class, sub-asset class, sector or stock. Charities need to be aware of unintentional concentration if they are invested in collective funds managed by external managers. A number of funds could, for example, have significant percentages invested in one company, so there is the possibility of owning a large amount of one stock without realising it. Holdings should also be diversified across industries so there is not too much exposure to one sector.

A diverse portfolio ensures the risk from a loss on a single investment or type of investment is reduced. Diversification also reduces volatility through the combination of less correlated asset classes. It is rare for all asset classes to experience dramatic swings at the same time, except when a major market event, such as a crash, occurs. Even then, when correlation increases, the risks to a well-diversified portfolio should be less. Liquidity and interest rate risk Liquidity risk is the risk that charities won’t have sufficient cash to meet their obligations. Certain types of investment are less liquid, or realisable, than others. Property is a prime example of an illiquid investment, as seen following the announcement of the Brexit referendum result, when property funds could not sell their underlying assets fast enough to generate the cash sought by investors demanding their holdings back. Fixed income investments, particularly government bonds, tend to be more liquid. As a result, many trustees will hold an appropriate portion of their portfolio in bonds or cash.

Currency and interest rate risk

A UK charity with all its costs in Sterling could have a significant portion of its portfolio invested directly or indirectly in assets whose income is derived in foreign currency. Such charities are susceptible to movements in exchange rates and need to be aware of their effects when considering how their assets match their liabilities.

Trustees invested in bonds face interest rate risk. If a charity owns a bond delivering a three per cent return, but interest rates rise to seven per cent, the charity’s bond will be unattractive relative to new bonds and lose its value. Equally, bonds can rise in value when interest rates fall, so trustees need to be aware of their impact.

Inflation risk

Investments such as bonds – which provide a fixed return – also face inflation risk as their return will be eroded. To mitigate against inflation, portfolios should include exposure to real assets such as equities or property, which have the potential to grow their profits and dividends ahead of inflation.

Valuation risk

Trustees must be aware of valuation risk, especially in relation to illiquid assets. It is easy to value BP, Shell or other large quoted companies because the price is being tested all the time as investors buy and sell. In more esoteric markets or less liquid stocks, companies are not as frequently priced, introducing the risk that valuations may be more volatile. Property is another example of an asset class where valuations can fluctuate widely given the diversity of underlying assets. Trustees must familiarise themselves with the factors impacting fair value.

Reputational risk

Reputational risk is often related to ethical, social and governance (ESG) factors. Charities may wish to adopt an ethical investment policy but should resist a piecemeal approach. An unrealistic policy will set expectations too high and could dramatically limit the scope of investments. Fundamentally, a charity’s investment policy should avoid assets that are at odds with the charity’s purpose and values. As the case of Wonga and the Church of England shows, such conflicts can command disproportionate media attention.

Investment style

The quality of investments is important. Charities need to be conscious of a fund manager’s style; if a manager is cautious he may focus on factors such as strong balance sheets and cash flow, and companies that are more likely to ride out a difficult operating, or market, environment. If the manager is overweight volatile, variable sectors like technology, gambling or mining, quality of cash flow may be far more uncertain.

Trustees need to be happy that the style of any external managers they use matches their requirements and fits with their risk appetite. A charity may use more than one external manager and hold 80 per cent of its assets in liquid, robust investments, deciding to invest the remainder in higher risk areas of the market. This approach is reasonable, so long as the charity’s trustees appreciate the risks they are taking and the allocation is proportionate and does not damage the operation of the charity.

Style is particularly relevant when considering horizon timeframe risk – the charity’s assets must be appropriate to match its liabilities. For example, an endowed charity is likely to be an extremely long-term investor, making investment in real assets more given their long-term return potential. Conversely, if a charity identifies a future liability such as needing £5m to sponsor a project, trustees should set the money aside in a liquid, short-term asset that meets that horizon. Bonds or cash would be most relevant, while equities could be risky should the market collapse at a time when the funds are needed, forcing the charity to sell its assets low.


Trustees are responsible for the ultimate operation of a charity, including exposure to investment risk. It is therefore vital that trustees can demonstrate they have taken all reasonable steps to mitigate the risks that their portfolios are likely to face, and have a clear and rational investment policy, which identifies an appropriate level of risk in line with the charity’s objectives.

This article appeared in Civil Society Magazine January 2018

Charity Finance wishes to thank OLIM for its support with this article – See more at: