Generating investment returns for charities in periods of high inflation

With UK inflation exceeding 10% during last year to November 2022, and global equities losing more than 10% over the same period, a charity invested in global equities could have seen a real-terms reduction in its investments of more than 20%. This demonstrates that charities who aim to preserve the value of their endowments in real terms are being squeezed from both sides, with inflation eroding the ‘real’ value of assets faster than any time in the last 40 years and traditional growth assets falling in value.

In this blog, I consider the steps you can take to protect the value of your assets from high inflation.

First, a word of warning. Whilst it is important to consider the impact of current high inflation, we would caution against over-reacting. Be patient and have faith in your long-term investment strategy – many charities will have experienced falls in the value of their assets because of the current market environment. We would advise Charities to think very carefully before making large scale changes to the investment strategy at this point in time, as this could crystallise losses. Your investment strategy should be designed to produce the returns you need over the long term. Even a well-diversified strategy will likely suffer losses in tricky market environments, the key is to allow your portfolio the time to recover. If you do think that changes to the strategy are warranted, I hope that the thoughts set out in this blog provide some interesting ideas to enhance your current strategy.

Equities are typically the main driver of long-term returns in charity portfolios. Whilst they do provide inflation protection over long term periods, they tend to be particularly adversely affected by periods of high inflation in the short term.

We therefore recommend charities who feel they need greater protection against inflation consider diversification into other inflation-linked, income-generating assets. This may include:

Global infrastructure

Investment in assets such as toll roads, airports, water companies and energy companies. These assets typically provide a stable, inflation-linked income stream, which can help to protect the value of the charity’s assets in real terms.

UK property

Rental yields are often subject to inflationary uplifts. Caps within contracts and breaks in tenancy do mean that this asset class is not a perfect hedge but can provide good inflation linkage. UK charities also benefit from a stamp duty exemption if investing through one of the specific tax efficient charity property funds. Be aware that although property provides a good long-term match for inflation, this won’t necessarily apply over shorter term periods. For instance, although property held up well throughout most of 2022, the end of the year was more challenging, and we expect this may continue into 2023, particularly if interest rates continue to rise.

Global property

Similar to UK property, rent is often linked to inflation (albeit not necessarily UK inflation). Global property offers greater diversification than UK property, with access to new industrial sectors – like data storage – that are less prevalent in the UK.

Diversified private market funds

For smaller charities we believe it can be advantageous to choose a single, high-quality manager to oversee all your private market holdings – this reduces governance and is an efficient way of improving diversification. These funds can include substantial allocations to the three inflation linked asset classes above.

What else should charities consider?

Consider cashflow

In a volatile market environment, it is important not to be a forced seller of assets if at all possible (otherwise you could end up crystallising investment losses). Therefore, you should plan carefully for how you source the cash you need for day-to-day spending. As a first port of call, use income to meet cashflow needs; this avoids incurring the transaction costs associated with selling assets. If you do need to sell some assets, ensure that you have in place a strategic asset allocation, clearly setting out the target allocation to each asset class within your investment portfolio. Use sales for cashflow purposes to rebalance to the strategic asset allocation. This will naturally result in selling assets that have outperformed (crystallising profits) and should mostly leave alone assets that have underperformed (avoiding the crystallisation of losses). Your investment strategy should include a strategic allocation to lower risk, liquid assets that will be a reliable source of cash at times when your more risky, higher-returning assets (such as equities) have fallen in value.

Understand the investment risk you are running

Now more than ever it is important to understand, and be comfortable with, the level of investment risk within your investment portfolio. We use Value at Risk* (VaR) analysis and scenario testing to help Trustee boards to understand the scale of investment losses that they might expect in difficult market environments. We find that having this prior understanding makes the communication and management of downside risks much easier.

Consider the level of spending

Think carefully about the level of spending that the endowment can support at this time, especially if you have a target to maintain the endowment’s value in line with inflation. Many charities are seeing increased costs and demands for grant-giving as a result of inflation and the cost-of-living crisis so there will be pressure to increase investment drawdowns.

Having a spending policy in place and guardrails around that will give you a clear framework for deciding whether and how much regular spending can increase without compromising the long-term sustainability of the charitable reserves. For instance, some charities we advise have felt confident to apply an exceptional uplift to their ongoing spending on the basis of surplus from good returns in prior years. If returns in recent years have been lacklustre, this may require more careful consideration.

*A one-year VaR(90%) of £xm tells you that there is a 1 in 10 chance that the value of your investment portfolio will fall by at least £xm over a 12 month period.

Conclusion

There is certainly lots to think about for charities in today’s market environment. If you would like further information on any of the ideas in this blog, please do contact me, or any of the LCP charity investment team.