IMPACT DEC 2015: How risky is that chase for income

Not-For-Profit & Philanthropy

Perpetual Impact

NFP AND PHILANTHROPIC PORTFOLIOS: HOW RISKY IS THAT CHASE FOR INCOME?

Maximising returns means more than chasing income. In fact, the chase for income can be downright risky and may fail to grow capital, particularly when an investment portfolio is heavily concentrated on income producing assets. Thankfully, NFPs and philanthropists can take extra steps to get better financial outcomes from their portfolios.

 

A BROADER PERSPECTIVE IS IMPORTANT

Many NFP and charitable trust investment portfolios are concerned with generating income from their investments to direct towards operations or grantmaking. While generating income from investments is critical, it should fall within a broader investment framework that captures governance, risk factors, capital protection and the suitability of the overall investment strategy.

 

EXTERNAL INVESTMENT ADVICE COMPLEMENTS GOOD FINANCIAL GOVERNANCE

For all types of NFPs, the key component of good financial governance is the articulation of a clearly defined investment strategy that incorporates the circumstances and risk and return objectives of the organisation. When determining the most appropriate investment strategy, NFP directors and trustees should consider seeking external advice.

“For an NFP that is developing or reviewing an investment strategy, external insight and advice is paramount, even when the NFP has financial expertise on its board. It helps to provide perspective on the link between performance and mission,” explains Scott Hawker, National Manager, Not for Profit Endowments at Perpetual Private.

“An external adviser is likely to provide important and alternative perspectives on the management of risks and the preservation of capital.”

Scott Hawker, National Manager, Not for Profit Endowments, Perpetual Private

“It’s important that external advisers present the Board and trustees with fresh investment perspectives and provide approaches that are suitable for very long-term, not-for-profit organisations. “This includes the use of tax credits, the role of alternative assets in the investment mix and other elements that might not be familiar to the Board,” Hawker says.

 

PUTTING IN PLACE A PRUDENT INVESTMENT STRATEGY

A prudent investment strategy should always consider the specific circumstances and risk and return preferences of the NFP, or for philanthropists, their Private Ancillary Fund (PAF).

Philanthropists often apply the same strategy in their PAF as they do in their personal investments when, in fact, different strategies need to be employed.

“A PAF is a trust that can exist in perpetuity, so the investment objective and time horizon for a PAF is vastly different to a philanthropist’s personal investment strategy.”

Kyle Lidbury, Head of Investment Research, Perpetual Private


A PRUDENT INVESTMENT STRATEGY MUST INCLUDE RISK MANAGEMENT

Now more than ever, as returns in Australia are challenged by the end of the resources boom, it is critical that a sound investment strategy is in place that can continue to deliver the long-term financial objectives of the portfolio. Particularly in challenging environments, risk management becomes increasingly important. 

    
         Portfolio check for philanthropists and NFPs:
  • The most important rule in making every dollar count is to protect capital from potential losses.
  • The next most important rule is diversification.


DIVERSIFICATION MAY BE COMPROMISED WHEN PORTFOLIOS ARE FOCUSED ON INCOME AND FRANKING CREDITS

NFPs and tax-exempt entities can typically claim franking credits on dividend income from investments in Australian equities. Consequently, many NFPs are preoccupied with extracting income from franking credits.

“This focus on franking credits can often result in investment portfolios that are heavily biased to Australian equities, and particularly to high dividend paying companies,” says Kyle Lidbury.

This can be problematic as the limited diversification from a domestic focused portfolio can increase risk, particularly given the high sector and industry concentration of the Australian share market.

 

ECONOMIC HEADWINDS IN AUSTRALIA AND PORTFOLIO IMPLICATIONS

We have seen over recent months how vulnerable the overall performance of the Australian sharemarket can be to headwinds in the financials and resources sectors, which combined, represent around 50% of the ASX300 (2015 S&P/ASX300 market data)

In the fixed income market, yields are near historic lows and future returns from bond markets are expected to be lower than their long-term average. To compensate for weaker returns, NFPs and philanthropists may be tempted to move up the risk curve and increase the credit risk in their portfolios. However, this means portfolios may be exposed to greater volatility and capital losses during periods of market weakness.  

 

FOCUS ON INVESTMENT STRATEGY ON TOTAL RETURNS AND TOTAL RISK

By focusing on total return and determining the desired long-term spending rate, portfolios can allocate to a broader, better mix of assets.

Over a given period, if the income generated by the portfolio is less than the long-term spending rate, NFPs and philanthropists can consider drawing down on capital to fund that shortfall. If the income generated is more than the spending obligation, the surplus income can be kept in reserve.

“An advantage for NFPs and PAFs is the ability to draw down on capital as well as distributed income. A focus on total return, as opposed to maximising income, should result in better portfolio diversification and outcomes.”

Kyle Lidbury, Head of Investment Research, Perpetual Private


INTERNATIONAL INVESTMENTS: THE DIVERSIFICATION GLADIATOR IN YOUR PORTFOLIO

An allocation to international assets can actually help to reduce overall portfolio risk because investments are spread across a wider number of countries, industries and companies. NFP Boards will also need to make informed decisions about currency hedging in the portfolio – another factor on which external advice will be invaluable.

By allocating to assets such as global shares, it is possible to achieve a similar total return to Australian shares, but with an overall reduction in portfolio risk.

This delivers an improvement in what is known as portfolio ‘efficiency.’  

Australian share investors tend to be reluctant to invest in international shares owing to the lack of franking credits, generally lower dividend distributions and currency risk. 

“NFPs and philanthropists who are entirely invested in Australia might consider retaining an overall domestic bias to their portfolios but allocate modestly to international assets.” 

Kyle Lidbury, Head of Investment Research, Perpetual Private

“Even a small allocation can provide good diversification and a reduction in potential risk for a given expected return,” explains Lidbury. “This is because the portfolio is less exposed to specific Australian economic risks.”

“For NFPs with less stable fund inflows, it may be appropriate to allocate a smaller proportion of the portfolio to international assets,” says Lidbury.

 

CONSIDER ALTERNATIVE ASSETS WHEN BUILDING AN INTERNATIONAL INVESTMENT EXPOSURE

Non-traditional investments are referred to as alternative assets. Assets typically included in an allocation to alternative investments are:

  • unlisted property
  • unlisted infrastructure
  • private corporate debt
  • absolute return funds
  • private equity.

Extending exposure to alternative assets that generate income can increase diversification but often, the cost is a reduction in liquidity. For those portfolios that can tolerate allocating a portion of total capital to less liquid assets, there is an added benefit. “Investors in less liquid alternative assets are paid a premium, which can boost overall portfolio returns while reducing overall risk,” explains Lidbury.

At Perpetual, allocations to alternative assets within the Perpetual Foundation portfolios are predominantly international. More than 90% of alternative exposures are invested offshore, using a structured, disciplined process. 

Importantly, these investments represent good sources of diversification from listed Australian assets. This means overall portfolio risk can be reduced.

“As local assets face headwinds, international sources of risk and return should be considered,” emphasises Hawker.


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