UK charities have enjoyed bumper returns on their investments over the past year.
The average charity fund achieved a total return of 13%, according to preliminary results for the latest Charity Fund survey from WM Performance Services.
However, the gains are largely caused by the strong market rally in the final quarter of 2004. Returns so far this calendar year have been much more modest, with charities gaining just over 2%.
Furthermore, the return for the past three years - the most typical performance assessment period - is just under 3% annually, showing that the after-effects of the 2000 crash are still working their way through the performance numbers.
WM does not provide similar data for charitable organisations across continental Europe.
Nevertheless, those European institutions that rely on income from their investment portfolio have had to deal with roller coaster returns.
“In 2002, we made losses on our portfolio, both on the equity portion and overall,” says Ake Alteus, deputy executive director in charge of finance and accounting at the Nobelstiftelsen (Nobel Foundation) in Stockholm, provider of the funding for the Nobel Prizes.
Unlike many other charitable foundations in continental Europe, the Nobel Foundation’s e330m-worth portfolio has a relatively high - 62% at present - equity content, mostly invested in Europe and the US. The portfolio is split between external managers Brandes, UBS, Carnegie and Catella for the European portion, and T Rowe Price and Bernstein for the US investments.
“In 2003, however, we made a 14% gain, followed by an 8.2% gain, on equities last year,” says Alteus. “But the gains have still not been big enough to recoup the losses in 2002.”
However, the fixed income portion of the Nobel Foundation’s portfolio did act as a cushion against the equity losses in 2002, making 8.5% on a total return basis. And it has made further gains in the two years since then, although not as much as the equity holdings.
As more and more voluntary institutions diversify into, or increase, equity exposure, and invest on a pan-European or global basis, they are likely to experience a similar bumpy investment performance.
But as a whole, it is difficult to uncover any broad themes within the sector.
Voluntary sector and non-governmental organisations throughout Europe are structured on a piecemeal basis, each country having its own specific regulations and investment trends.
However, there are certain points of similarity between all these organisations.
“There are two main creatures in the voluntary sector – foundations and associations,” says Chris Carnie, director of The Factary, a fundraising consultancy, and researcher in philanthropy and fundraising. “These occur in nearly every European country.”
A foundation is any charitable body with capital which carries out charitable activities. So while the name ‘foundation’ usually suggests a
grant-making body, it can in fact also mean a fully operating charity.
Associations are similar in purpose to foundations, but are not required to put up capital. In general, the rules and regulations governing them are less strict.
“So forming a patients’ self-help group would probably be done as an association, whereas a new hospital would be built through a foundation,” says Carnie.
One of the reasons for a stricter regime for foundations is because in most European countries, these organisations get tax relief.
The regulatory authority for foundations is normally the ministry of finance or the national tax authority for a particular country, but the strength of regulation varies from country to country.
There are several hundred thousand foundations throughout Europe, varying from the huge Fondation de France with its portfolio worth e0.5bn, to small fundraising charities. These organisations cover a wide range of sectors, running residential homes and libraries, cancer research and aid programmes.
However, the precise nature of a foundation can differ from country to country.
“For example, of the 1,100 or so foundations in Austria, only a handful are charitable, the rest being investment vehicles for wealthy Austrians,” says Carnie. “In contrast, foundations in Holland are mainly fundraisers, but because there is no requirement to publish annual accounts, many of these also own businesses.”
In fact, a number of European companies are owned by a foundation.
“In European countries, it is legitimate to have a foundation to safeguard the family’s wealth, but it does not have to be a charitable foundation to do that,” says Carnie. “In Switzerland, a number of family funds can still pass money down the generations without incurring inheritance tax.
“For instance, the Sandoz Fondation de Famille owns a large chunk of the Novartis pharmaceutical company, although it also has some charitable activity.”
But in France, there are relatively few private foundations. French foundations are more of an extension of the state, which supports them financially, and uses them for the implementation of policy. Because of this, they have relatively little invested for the long term.
Charitable foundations in Europe can also carry out pseudo-political activities – the Green Party for instance is associated with a foundation. In contrast, UK charities are only allowed to take part in political campaigning to a very limited extent. However, there is a split in the UK between registered charities - which enjoy tax relief and regulated by the Charity Commission - and clubs and associations, which tend to be smaller but have fewer restrictions on their activities.
However, the charity sector in the UK is somewhat more developed than on the continent, with 186,000 charities currently registered.
Collectively, of course, the charitable investment market across Europe amounts to tens of billions of euros. Traditionally, these institutions have lagged behind pension funds in terms of sophistication.
“Broadly, European organisations do use investment managers and have a combination of pooled and direct investments depending on the size of their portfolios,” says David Miller, head of investments for the British Isles for Royal Bank of Canada Global Private Banking. Miller has advised charities and managed their investments since the mid-1980s.
“However, charities are still very conventional in terms of the bond/equity approach to investment,” he says. “That is, they have less in alternative investments compared with pension funds. And on the continent, there is slightly more focus on funds - as opposed to direct equities - than in the UK.”
According to Miller, bond exposure in continental Europe is higher than in the UK, which he says is a reflection of better inflation over a period of time. “Real interest rates in Europe used to be a lot higher than in the UK,” he says. “Now it’s much of a muchness, but old habits die hard.”
Guy Davies, director of charities, Barings, says: “For UK charities, the preservation of capital and a need for income are still very prevalent. It’s a challenge to find ways to achieve that because they have lost money in the equity market. So they are looking to hedge their weighting in equities. Five years ago, pooled funds were not considered particularly appropriate except for small funds. But over the last year or two, charities have been looking at more packaged funds as opposed to direct equities, mainly to diversify and preserve capital.”
These comments are backed up by the latest Charity Investment Industry Survey from JP Morgan Fleming Asset Management, which shows that 72% of the 110 UK charities surveyed manage some or all of their assets, worth over £11.1bn (e16.3bn) in total, on a pooled fund basis. This is the first time that more charities have favoured pooled funds over a segregated method.
The survey also showed that over half the respondents expect an annual return of 6% or less, and that one-third have made significant asset allocation changes in the past 12 months, mainly to control or reduce investment risk.
Barings’ own response to the conundrum of maximising return while keeping risk at a minimum has been to stay away from equity benchmarks, using an absolute return basis instead to manage money.
“We are diversifying the asset allocation as much as possible, using equity funds, funds of hedge funds, property and even looking at commodities,” says Davies. “The financial pressure on charities has risen, and charities are also mindful of reducing risk. The Trustee Act has made trustees nervous about making decisions on their own.”
Bastian Schmedding, managing director, Union Investment Institutional (UIN) in Frankfurt, says: “It is the same challenge all over Europe to maximise income and preserve capital. Foundations need a return of a few per cent over inflation, which is what they can then spend on their activities.”
In fact, there is generally a requirement for German foundations to spend a specified minimum amount of their income on operational activities, otherwise they risk losing their tax-exempt status. They are also subject to other rules, which differ according to where in Germany the foundation is based, since the regulatory authority is the local state.
UIN’s clients tend to come from the few German foundations with e100m-plus portfolios.
“There is a huge number of smaller foundations, and many of these use money market products, because they are very conservative,” says Schmedding. “The bigger ones are more open to investments such as corporate bonds. Even so, I suspect that the typical asset allocation of the bigger foundations is 90% bonds and 10% equities, because they cannot afford to take big risks.”
One of UIN’s products for foundations is an inflation-linked bond portfolio. This offers a premium above inflation as well as capital protection.
But UIN’s most popular solution for foundations is its risk budgeting process for investing in bonds and equities. “Foundations have become more flexible, but most still have a plain vanilla approach to investing,” says Schmedding. “They go directly into bonds and equities with structures which are quite simple. The reason we have won new mandates is that we propose an absolute return concept, using risk budgeting to get returns slightly above inflation. We hope to get more than 4% annually. With inflation under 2%, that means our clients have nearly 2% they can spend.”
The Netherlands is one of the countries in Europe with a large number of foundations.
“Dutch charities are quite conservative in their investment, but getting more professional by the day,” says Mark van Weezenveek, head of sales and relationship management, institutional investors, Europe, with Kas Bank, which offers global custody and special services for charities.
“A few years ago, they used to manage their assets themselves, basically receiving legacies and leaving them as they were. Nowadays they have investment committees and mixed portfolios, and are looking more and more like institutional investors.”
Traditionally, Dutch foundations looked for investment advice from their own bank, but now the trend is to select investment managers as their assets grow – possibly even using consultants. Even so, the investment policy is still fairly cautious.
“The breakdown of the portfolio depends on the charity and the risk they want to incur,” says van Weezenbeek. “In general there is a mix of different assets, but more is usually allocated to bonds than to equities.”
Of course, one of the ways in which any institution can get round the thorny problem of insufficient income is to spend capital. In the UK, many charities have trust deeds which prohibit this, but others have more liberal regimes allowing them to expend money on a total return basis.
But this is an issue throughout Europe. For instance, the Royal Swedish Academy of Science is allowed to spend capital gains as well as income.
The academy is partly funded by government, with the rest of its income coming from investments.
It is advised by the Swedish bank SEB, and its SK400m (e42.5m) portfolio is split 50:50 between equities and bonds, the emphasis now being shifted more towards equities. Between 10% and 20% is invested in Swedish securities, with the rest in Europe and the US.
“We need a 3% yield on investments to cover our running costs,” says Lisbeth Wallin, the academy’s chief accountant. “The declines in equity values in the past few years have created losses for those years. However, we are allowed to spend capital gains as well as income. But we are not keen on taking money out of capital if costs increase, so we would then reduce our costs next year.”
Conversely, most Swedish foundations are hampered from building up reserves by the requirement that they pay out 80% of their income over five-year periods in order to retain their tax-exempt status.
One investment issue which is likely to become increasingly important for charitable foundations is the use of ethical or socially responsible investment (SRI).
In the UK, the guiding principle in recent years came out of the ‘Bishop of Oxford’ lawsuit, where the then bishop of Oxford sued the Church of England over its policy of investing in South Africa. The judge recognised the moral principles of the Bishop’s arguments, but said that a trustee’s first priority was to maximise a charity’s income in order for it to accomplish more.
There are exceptions to this rule. For instance, a cancer charity may screen out the tobacco sector from its list of potential investments because cigarette smoking is known to be linked to lung cancer.
Ethical investing has become increasingly sophisticated, and many organisations invest in funds using an SRI approach. This tends to result in more positive screening, ie, looking for companies with, say, good environmental management systems or those which are active in renewable resources.
Other funds track indices such as the FTSE4Good or Dow Jones Sustainability Index.
Another approach is to continue investing in companies about which the voluntary organisation has ethical concerns, but use its status as a shareholder to ask the company to make changes.
Even so, UK ethical managers still have to market their products by claiming that an ethical or SRI approach does not necessarily damage financial performance.
This principles versus profits dilemma is also becoming more important to certain sections of the voluntary sector throughout Europe.
“Churches and foundations in Germany have started to invest in suitable products because of their own regulations and because sustainability has become an essential topic,” says Stefan Peller, head of institutional clients, Germany and Austria, with Sustainable Asset Management (SAM).
The Swiss-based asset manager offers funds investing in issuers (large caps and pioneers) which make use of global sustainability trends. SAM says these issuers generate better value for investors than their peers.
“We do not use ethical but sustainability screens,” says Peller. “We have a best in class concept, believing that companies with a sustainable philosophy are better at managing risks and taking opportunities offered by sustainable developments. However, if any of our clients have individual criteria, we do add negative screens, in small amounts.”
He says that SAM’s investment record has shown that best-in-class sustainability investing can yield excess returns against the MSCI World/Europe indices.
Peller says that since foundations and churches have liabilities like projects and salaries, it is even more important to preserve their existing capital. For this reason SAM offers not only equity solutions but has - together with HSBC Trinkaus & Burkhardt, its partner in Germany and Austria - also launched funds that invest in corporate bonds and government bonds.
“With our offerings we try to help our clients to achieve their financial goals, and on a sustainable basis,” says Peller.