The author of this article, an investment manager, looks at different facets of risk as they apply for charities.

The following article from Melanie Robert, head of charities at Sarasin & Partners, takes a risk management approach to the way charities operate their investments and outgoings. The editors are pleased to share these thoughts on this important topic and invite readers to respond. Remember, these articles are designed to stimulate conversation and debate. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com and amanda.cheesley@clearviewpublishing.com

At its core, “risk” relates to the probability, severity and frequency of an adverse outcome or event occurring. The management of risk is therefore centred on the reduction of related uncertainty and the creation of an environment where it can be adopted and harnessed in a controlled manner. One of the fundamental tenets of investing is the notion that taking measured and calculated risk is a necessary function of generating attractive investment returns.

Risk takes different forms for different organisations and every charity will naturally have its specific areas of focus. The risks most charities will encompass are inflation risk, reputational risk, investment risk and spending/withdrawal risk. While common risk metrics often provide useful historical context and are a helpful guide, we tend to view investment risk through two distinct lenses. The first is absolute risk, the risk of a decline in values in absolute terms resulting in absolute loss of capital in extremis. Secondly, relative risk, which is a measure of the variability of returns when compared with a composite benchmark and/or a peer group comparator.

Absolute risk
Industry established measures of investment risk include volatility, maximum annual drawdown, and value at risk. While instructive, these are inherently backward looking. Caution is needed when extrapolating historic trends into the future, as the next economic or market crisis could be different. 

Similarly, while it is necessary to understand an organisation’s capacity to tolerate variability in capital values, these risks are only brought into relief if they are crystallised through forced asset sales at the worst possible moment. When taking on investment risk, the best protection against loss in absolute terms is through robust strategic planning: investments must be managed in keeping with liabilities, expected future cashflows and spending requirements.

At a more granular level, absolute loss can encompass the loss of capital in a single individual investment – a very real risk when managing investment capital. A charity investor’s greatest protection in this regard is to scrutinise an investment manager’s process. Their track record, security selection process, depth of resource and ex-ante risk controls should be sought.

Liquidity risk is especially important in this context, particularly if an investment manager is seeking to invest in smaller companies or less liquid markets. Attention should be paid to position sizing in these sorts of investments. Experienced managers will likely have self-imposed ownership limits in smaller companies and collective investments such as investment trusts, where liquidity can become constrained in periods of market stress.

Businesses that display “quality” characteristics typically create more enduring and sustainable value for shareholders. These characteristics include higher returns on invested capital, sustained competitive advantages expressed through higher and more persistent margins, competent management teams with strong and transparent governance, coupled with lower, or well understood, ESG risks.

Conversely, we recognise the threats posed by uncertainty and opacity. Businesses that are overly exposed to the business cycle, exogenous factors such as commodity prices or government funding streams, or those which are especially sensitive to interest rates, all represent potentially more uncertain and therefore higher risk investments. 

Relative risk
Most charity investors, regardless of experience, suffer to a greater or lesser extent from “loss aversion.” For this reason, absolute risk is often the overriding focus. However, given the increasing sophistication of many charity investment committees, relative risk is increasingly under scrutiny. Put another way, trustees will assess the opportunity cost that occurs as the result of an investment manager’s decisions and actions.

Over the long term, most charitable organisations with investment reserves are concerned with achieving a “real” return objective. This is typically to fund charitable expenditure or operations, while growing the capital base to maintain the spending power of the assets. However, we encourage clients to measure their investment performance over a wide range of time periods against a composite index-based benchmark and an appropriate peer-group comparator.

The measurement and assessment of relative risk, when compared with an index-based composite benchmark can be fraught with complexity. For example, measuring global equity performance against the MSCI World Index, which excludes emerging markets, as opposed to the MSCI All Countries World Index which includes them, would have yielded different results over the past decade. Understanding the reasons behind a disparity in the performance of comparable indices is crucial.

Moreover, the composition of modern stock markets and the level of concentration risk inherent within them have their own complexities. Concentration is not a new phenomenon, but the recent size and dominance of US technology businesses has resulted in a challenging backdrop for global investors used to relying on global indices for diversification.

Advocates of US exceptionalism would point to recent headlines underscoring the exodus of UK businesses from domestic stock markets in favour of the US. According to the London Stock Exchange Group, in 2024 alone, a total of 88 companies delisted or transferred their primary listing from London’s main market with only 18 new listings taking their place. With the US market acting as such a powerful pull for global business, it could be argued that geography, based on a company’s listing, is losing its effectiveness as a measure of diversification.

One solution for sceptics could be to focus attention on equally weighted indices, which normalise the size of these behemoths. However, this could significantly impact returns. Similarly, country listings are increasingly becoming an inefficient way of building and diversifying standalone portfolios.

The skewing of geographies and the sectoral imbalances in certain stock markets call for a more holistic approach to diversification and risk management. While many institutional investment managers focus on factor risks, we still believe that taking a thematic approach to investing ensures that portfolios are well exposed to the trends that are likely to generate superior returns over the medium to long term.