This article continues our exploration of Strategic Investment Framework for Charities, a series of articles for charity trustees and executives that we develop in collaboration with Robert Hayes, a senior consultant to PMCL Consulting.
In our last two papers we discussed objectives and risks in terms of ‘what’s the money for?’ and ‘what are you trying to avoid?’ – the key points being that charity investments need to be aligned with their commitments and that risk needs to be broadly defined to cover a range of financial and nonfinancial items. For a large number of charities however the requirements are pretty broad and there are not many constraints. The question therefore becomes ‘how much return can we generate and what might be the implications?’.
In this note we therefore develop the concept of risk and return and propose some rules of thumb for thinking about it.
The ‘least risk asset’ – a useful starting point
If you wanted to take the minimum amount of risk possible – how might you invest?

So it seems logical to think that if you are going to take some risk with your investments you need to get a return that ‘rewards’ you for that risk and which is greater than you can get from your ‘default’ or ‘least risk’ option.
Likewise it makes sense to measure the risk relative to that option – so the concept of ‘relative risk’ is crucial. A 'return number' without reference to a 'risk number' is therefore not very useful.
Annual returns, annualised returns, risk and a bit of maths
A very typical conversation we will hear between a charity and their investment manager goes:
 ‘What is your expected return from equities?
 ‘Our strategy team are using 7% real with a risk of 15%’
 ‘ah so our target of 5% real is okay with a bit to spare’.
The problem is that the two sides of this conversation may not be talking about the same type of average – one may be ‘arithmetic’ and the other ‘geometric’. To give a quick example of how different they can be, think of two years the first where you double your money (+100% return) and the second where it halves ( 50% return).
‘Arithmetic average return' is +25% (100%  50% divided by 2)
'Geometric mean' or ‘cumulative’ return is actually zero as you end up back where you started.
Taking a real world example and using the London Business School database the very long run annual average real return from Global Equities is 6.5% with a risk of 17.4% (standard deviation). Cumulative average return is 5.0%. The difference between the two averages of 1.5% can be thought of as a ‘cost’ of the risk. The rule of thumb under various assumptions is that the difference between arithmetic and geometric returns is to take away half the square of the risk – in this case
So in our manager conversation in the beginning, the 7% and 5% may actually mean the same thing and for the charity there is not necessarily any ‘cushion of safety’ and no allowance for items like costs. This basic bit of maths also helps explain, regardless of anything else, why a lower return with a lower risk may actually be ‘worth more’ than a high return high risk approach.
Adding in costs and bringing it together
As we mentioned in passing above, when talking about expected market returns it is also normal to be using pre cost estimates. There is nothing wrong with managers using this approach since costs will be investor and strategy dependent – a huge fund investing passively will be paying less than a small active one. Also costs will vary by investment asset and strategy so for example it is normal to have higher costs for managing a property portfolio say as opposed to investing in Gilts. Obviously in the end it is the net of costs return that matters to a Charity.
So if we combine this with the concept of a ‘cost of risk’ and a ‘least risk asset’ we can conclude that a charity might want to focus on the following:
Try to maximise your net return above the least risk option per unit of risk up to a level of risk that you are comfortable with
What returns expectations are plausible?
In our example above we stated that the very long run (123 years) historic average real return from global equites was 5% per annum. The equivalent UK numbers for sterling cash (treasury bills) and Gilts are 0.9% and 1.4% per annum respectively. However, all three numbers have varied considerably over that period and there have been periods as long as 20 years when the returns have been zero or negative in real terms. At the time of writing the real yield on a UK inflation linked gilt is about 0.5%.
So if we assume say 0.5% for costs, this gives us a range of long run potential expected returns from zero up to about 4.5% from ‘safe’ index linked gilts at one end of the scale to ‘risky 100% equities’ at the other end.
Although the relationship is not linear you can see from this that a strategy of say 70% equities and 30% gilts might end up with a net of costs real return in the range of 33.5%.
Our Role in Supporting Your Investment Journey
This paper is intended as an introduction and we have simplified a number of concepts – this is the caveat which is meant to stop my maths master and various economists and fund managers writing me lots of critical letters!
However, we hope that it is useful in thinking about how to bring together your objectives with your risk appetite to think about the appropriate investment strategy.
There will inevitably be trade offs and decisions to make and, for example, your desired level of return may not be possible at an acceptable level of risk.
Our focus has also been on the ‘unconstrained’ charity without any immediate calls on their funds. As explained in our previous note an approach that splits assets into ‘low risk’ and ‘return seeking’ allocations may work well for situations where there are constraints to meet.
Should your charity require professional support in any aspect of this process, we are here to assist. Our team is ready to discuss your specific needs and explore how we can contribute to your charity’s financial success. You can view client testimonials on our website for examples of the impact we've made with other clients.
Stay tuned for upcoming insights
Our subsequent articles will delve deeper into key topics:
Developing the Plan: Transforming objectives and constraints into actionable policies
Getting into the NittyGritty: Practical implementation and ongoing policy management.
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