Do the right thing

26 Apr 2021

Charitable foundations have investment approaches built on solid ESG foundations and are seeing returns that exceed their needs. Andrew Holt looks at how they are doing it.

Due to Covid-19, the income and expenditure gap across the UK charity sector could reach £10bn as shops close and fundraising events are cancelled, according to Pro Bono Economics, a consultancy. Yet there could be another way of closing this black hole.

A good investment approach can go a long way in addressing this big financial discrepancy. So, what investment approaches are charitable foundations taking to boost their balance sheet and maintain the stability of their organisation going forward?

Inevitably, ethical and socially responsible investment is a prominent issue for many charities. ‘Ethics’ was the most common response in a recent Newton Investment Management charity investment survey, when charities were asked to identify issues that they would like their investment managers to address, with charities’ ethical exclusion policies growing in frequency and in breadth of coverage. As we found when speaking to charitable foundations.

The good, the bad and the offensive

“We are increasingly conscious of which managers we delegate investment decisions to and how they think about ESG,” says James Brooke Turner, investment director at the Nuffield Foundation, which aims to improve social wellbeing. “We are now focused on knowing what we own and when managers vote against their proxy adviser.”

This strong ESG focus feeds through the whole investment process in a precise way. “We avoid unsustainable businesses, or those that routinely exploit vulnerable people. However, we also recognise that all companies have a mixture of good and bad, so we use an on-balance test to avoid the most offensive ones. We are very careful with illiquid assets too,” Brooke Turner says.

The Church Commissioners for England also has big ambitions in this area. Tom Joy, chief investment officer at the charitable foundation that runs the Church of England’s money, says: “We aim to be at the forefront, globally, of responsible investment. We have a comprehensive set of ethical investment policies and apply our stewardship activities in an integrated way across all asset classes and continually assess the real-world impact of our investments.”

Important exclusions

The Church Commissioners has an extensive exclusion policy, covering companies involved in weaponry, pornography, tobacco, alcohol, gambling, high interest rate lending, thermal coal extraction and producing oil from oil sands.

“Our policies also allow for investment restrictions on a case-by-case basis, usually as a last resort if we are not satisfied with our engagement experience with a company,” Joy says.

The commissioners has continued to invest in its responsible investment capabilities and now have a team of six, soon to be seven, working with its investment teams driving forward the ESG agenda. “We are committed to signing up to the new stewardship code and in 2020 joined the UN sponsored net zero AOA Alliance, and hence, have committed to being a net zero investor by 2050,” he adds.

The commissioners’ engagement approach has evolved with this net zero target and as expectations of corporate responsibility and companies’ role in society have increased. “Our climate change programme in particular has had a material impact on our portfolio in the past few years,” Joy says.

This has also led companies to change their approach through environmental, social and governmental (ESG) engagement.

“Having committed to the General Synod in 2018 that we would divest from fossil fuel companies that do not align with the Paris Agreement by 2023 we have engaged heavily with high carbon sectors,” Joy says. “We firmly believe in the power of engagement to effect real change – of 21 companies originally at risk of failing our first ‘hurdle’ in 2020, 12 improved their performance sufficiently to avoid restriction.”

The nine remaining companies were restricted in December 2020. “We are now engaging a broader scope of companies on our systematically increasing hurdles, seeking to push the world’s largest emitters towards Paris alignment,” he adds. “This is just one element of our push to reduce emissions in the real economy in order to meet net zero.”

A small but growing allocation within the £1.12bn Esmée Fairbairn Foundation’s endowment invests in funds looking to achieve enhanced ESG impact alongside financial return. “The idea has been to make incremental improvements each year,” says Matthew Cox, investment director at the Esmée Fairbairn Foundation. “It is about finding funds that invest in climate change solutions or exiting funds that are not thinking about ESG factors, through to writing letters to other investors to try and get corporates to change.”

The foundation signed the Funder Commitment on Climate Change in 2019, committing to steward its investments for a post-carbon future. “This is something we helped launch,” Cox says. “It is a series of commitments and we encourage others to sign up.”

It also works with other foundations and investors through the Charities Responsible Investment Network and looks for opportunities to promote corporate and investment behaviour – which, it highlights, is in the interests of long-term shareholders. “This is a good example of a great networking organisation and getting a great deal of benefit by swapping ideas and hearing what other people are doing, which is invaluable.” There is, for Cox, also an evolution in the ESG investing process. “The next iteration of ESG investing is an upgrade to impact investing, where investors not only have financial targets but non-financial ones as well.”

Overcoming Covid

The investment challenges posed by Covid-19 are numerous, but the long game played by many charitable foundations in the investment arena means they are unmoved, a point highlighted by Nuffield.

“Covid won’t change our approach, but it might make our ride a bit bumpier,” James Brooke Turner says. “However, our spending on research is beginning to establish how dramatically different the outcomes are for different parts of society, especially those most affected by austerity measures prior to the pandemic.

“Diversification remains important,” he adds, “especially between the value and growth investing styles. But we will stick to our long-term asset allocation and our general agnosticism about the market outlook.”

Joy says that diversification is key here. “Covid-19 has clearly had a huge and devastating impact on the way we live, but nothing material has changed in our investment approach,” he adds. “We aim to be genuinely long-term and rely on genuine diversification to help manage shorter term risks. This strategy helped us navigate the volatile markets we experienced in 2020 as a result of Covid-19.”

The impact of the pandemic may not be completely negative, Joy says. “We think that Covid-19 has had a positive effect on our engagement efforts and enabled us to develop stronger links with other investors who we collaborate with on engagement and the companies we invest in.”

And on the political and economic developments to shape the investment outlook over the next year, Brooke Turner says: “Climate change will become ever more built into markets. Inflation will remain a topic of concern, but investors need to be clear whether they are worried by global or UK inflation, and why.”

Case studies

The Nuffield Foundation: Return Maximus

The Nuffield Foundation aims to improve social well-being by funding research and innovation projects in education and social policy and building research capacity in science and social science. As the end of last year, the foundation’s investment portfolio was worth £466m.

The approach behind its investments is simple: 10% in short-dated gilts, 70% in global equities and 20% in private equity. “We think of it as a 90/10 portfolio,” says James Brooke Turner, Nuffield Foundation’s investment director, who sums up the approach as “return maximising, volatility tolerant”.

“Making as much money as possible must be a natural ambition for any charitable investor, constrained only by their risk appetite,” Brooke Turner says. “We spend a lot of time thinking about our risk appetite and how we can maintain it at a high level. When bad times come, we rely on having sufficient liquidity to see us through, hence the gilts, and robust governance.”

Moral liabilities

But he stresses that foundations are not the same as insurers or pension schemes. “Endowments are different to other investors because they only have moral liabilities, not legal ones. We are free to expand or contract our pool of beneficiaries as circumstances dictate. We are never subject to actuarial reviews or triennial valuations, so asset stability is unnecessary. We spend about 5% of a smoothed asset value which we review every five years or so.”

Looking at Nuffield’s approach in more detail, Brooke Turner notes the importance of equities. “We think that as a long-term investor, equities are the only asset that we can afford to hold because they will give us a degree of inflation protection and a reasonable amount to spend – about 5%. “Other assets do this too”, he adds, “but our governance budget is limited so we stick to a few asset classes and try to understand them well.

“We delegate as much as we can to managers who we trust and who we think are benchmark agnostic long-term investors. I sometimes think the portfolio can be segmented as 10% in returns to safety [gilts], 20% from ingenuity [private equity/venture capital] and 70% from global economic activity [public equity].”

High risk

“People often think of our portfolio as very high risk, but we don’t,” Brooke Turner says. “So long as we hold our nerve through difficult times – which we have so far – it should perform well.” The underpinning of the portfolio is having absolute safety in its cash holdings. “Hence, we directly hold short-dated UK gilts from which we expect no return, insignificant capital loss and no counter party risk. With that core in place, we are prepared to take plenty of risk with the rest of the portfolio,” he adds.

Brooke Turner looks for diversification in global equities by using five managers, all appointed because their styles are “orthogonal” to each other. “We rebalance from the best to the worst performers – which has been painful recently with the value/growth hiatus. We do not hedge currencies back to the British pound, in part, because we see an unhedged position as a good counter-weight to higher UK inflation.”

Such an approach has existed to benefit the foundation’s aims and objectives. “We have used roughly the same policy now for about 18 years, through peaks and troughs. It is very settled, as is the governance, which, is critically important.”
The proof of the pudding is in the eating as they say, and this policy has proved highly effective: returning about 10% a year for the last 10 years. “We are currently spending at about 5%,” Brooke Turner says. “Our charitable purpose runs across four main policy areas: bioethics, data ethics and inclusion, the UK family legal system and education policy.”

Westminster Foundation: Strong ethics

The Westminster Foundation, led by the Duke of Westminster, provides opportunities for young people and their families who live in Westminster, Chester and rural areas, while also looking to raise their aspirations and improve their prospects. The foundation’s £110m of assets are managed by charity investment specialist CCLA in a balanced portfolio which can invest in a wide range of products.

“We chose them after an extensive ‘beauty parade’ because they had a good mixture of great performance, within a balanced portfolio, and most importantly, their approach to ESG, sustainable and impact investing was very comprehensive,” says Henrietta Gourlay, investment manager at the Grosvenor Estate, the body that oversees all aspects of the foundation’s finances. “We have a strong ethical-impact-sustainable focus throughout Grosvenor, and this is an integral part of our investment philosophy within the Westminster Foundation,” Gourlay says.

Like all charitable foundations there is a need to ensure that the investment can generate sufficient income to allow the Westminster Foundation to make grants. “So, there is a balance to be met,” Gourlay says. “We did consider a couple of index funds, but they did not provide us with enough confidence from an ESG perspective.”

Don’t forget the fees

The charity has an internal target of return that needs to be met for it to award grants. “As it is important that grants are not made out of capital, which would result in a dwindling pot,” Gourlay says. With this in mind, the Westminster Foundation initially sent a quesionnaire to a list of managers with one question focused on their target returns. “This narrowed down the pool of potential managers, and the deciding factor was on their approach to ESG-sustainable investing. Fees were also an important factor in our choice,” Gourlay says.

As well as complying with the Westminster Foundation’s ESG ambitions, CCLA has its own exclusion list, which includes, amongst other things, pornography and cluster munitions. “When you invest in a fund you relinquish control of the investment, so it is important to make sure that the manager you choose is aligned with your own investment philosophy,” Gourlay says. “Investing with ESG in mind is very personal and presents a lot of conflicts.”

Thanks to the focused investment approach, nothing has changed due to Covid-19. “CCLA has proved to be nimble and we had a phenomenal return from them last year, given the circumstances,” Gourlay says, but adds: “We are well aware of the destructive impact that Covid-19 will have on the communities we support. I am pleased that we have been able to react quickly and with great flexibility to support those most in need.”

The Church Commissioners for England: Singing from the risk and return hymn sheet

The Church Commissioners for England manages a £8.7bn investment fund, all in a responsible and ethical way – via a diversified portfolio spread across a broad range of asset classes, consistent with its ethical guidelines.

“Our objective is to balance risk and return to deliver sustainable distributions. This aim is encapsulated in a target return of Consumer Prices Index (CPIH) +4% per annum measured over the long-term,” says Tom Joy, chief investment officer for the Church Commissioners for England.

This target is reviewed periodically by the commissioners’ board to ensure it is realistic, within acceptable risk tolerances, given major asset class valuations and resulting prospective returns. Several core investment beliefs govern the commissioners’ philosophy and investment approach. First is that asset allocation should be strategic but not static. “Markets are not efficient and excessive fear and optimism by market participants creates valuation extremes, which a patient investor can take advantage of,” Joy says.

“In the absence of valuation extremes, we expect our portfolio to be diversified across a broad range of real assets, like equities and property, which are tied to economic activity and provide the best long-term returns after taking account of inflation,” Joy says. “Taking account of ESG issues and good stewardship is an intrinsic part of being a good investor for ethical and financial reasons.”

“The best returns will be driven by combining aligned partnerships, with the strongest external managers, and holding assets directly where we have competitive advantages,” Joy adds.

By December, around 40% of its assets were managed internally and 60% by third parties. Cash management, a small element of public equities, most real estate and tactical asset allocation are managed internally, with the rest by external managers.

“There is an inverse correlation between the efficiency of an asset class and the success of active management. We focus our research efforts on inefficient parts of the market,” Joy says. “We seek to capitalise and extract value from our long-time horizon, our ability to tolerate short-term volatility, our strong balance sheet and our governance structure.

“As long-term investors we can engage in opportunistic or contrarian investing, buying assets when others are forced to sell and prices are falling, or by selling when prices are rising. Our tactical asset allocation strategy is aimed at adding value to the fund by improving long-term returns and, in particular, mitigating the risk of drawdowns.”

Although a strong part of the process is to be disciplined in implementing a consistent investment approach grounded in a clear set of investment beliefs, there has been some evolution in the portfolio. “We have evolved over time as a result of the investment landscape. Since the global financial crisis, markets, in our view, have been fragile and prone to bouts of volatility and sell-offs,”

Joy says. “This is the result of a number of factors. For example, the changes in regulations which means investment banks cannot provide the level of liquidity they used to, the growth in algorithmic and quantitative trading and also the fact that interest rates have been anchored at, or close to, zero, limiting the ability of central banks to stimulate growth in the event of a set-back.”

As a result, the commissioners have created an internal derivative capability to manage investment risk dynamically through time, in what Joy calls “a contrarian way.”

The health of its financial returns enables the Church Commissioners to continue supporting the church’s vital work in communities throughout England. In 2019, it contributed around 15% of the Church’s annual running costs. “Our returns were used to support the mission and ministry of the Church, including grants for mission activities, bishops and cathedrals.”

The long view

Joy’s focus is on the longer term. “Over a 10-years plus horizon, we think valuation, or the price you have to pay today for an investment, is the most important determinant of future returns. We assess long-term return forecasts across asset classes to assess what it is realistic to expect our portfolio to deliver, including and excluding the impact of active management.”

Although he offers caution on the investment prospects. “Return prospects are low and delivering our CPIH +4% target in the next decade will be challenging. This is made worse by the whole fixed income spectrum offering low, and in many cases negative, prospective returns, which makes diversification harder.”

Therefore, looking to this year, Joy says: “Most commentators and market participants expected equity markets and risk assets to make further gains in 2021. It would not be a surprise to us if 2021 was a mirror image of 2020, that is strong economic activity but weaker financial markets.”

Esmée Fairbairn Foundation: The long horizon

The Esmée Fairbairn Foundation is focused on the arts, children and young people, the environment and social change. Its £1.12bn portfolio is diversified across asset classes, geographies, investment managers and investment strategies, based on a global approach, looking for the best funds, with a target of UK inflation plus 4%.

“We try to have half the risk of equity markets roughly. We avoid big drawdowns if possible,” says Matthew Cox, Esmée Fairbairn Foundation’s investment director. “We find active managers with concentrated positions – a fund with 20 positions rather than eighty and illiquid investments over the longer term.”

The key thing for the foundation is this long-term horizon. “We talk about a 10-year time horizon and things in the endowment that have been there for more than 10 years. Being patient, investing for the long term,” Cox says. “That also means we are happy to invest in things that are illiquid. About a third of our portfolio is in illiquid funds: venture capital mainly and a little bit of private equity.”

Quite a big proportion is in the US, where it is locked typically for up to 10 to 15 years. “We have been doing that for more than 10 years now and that has been a strong performing part of our portfolio,” Cox says. “That style of investing is probably closer to a US pension scheme than a UK charity. Harvard and Yale would have a high allocation of illiquid things, so we are not typical of a lot of UK charities. We do not own a lot of property, for example.

“We need a high allocation to equities to hit our targets. Our cash levels are the top end of the range, which is about 8% to 9%, and that may come down. We see more correction in the equity markets, which are currently pricing optimistic growth.”

The Covid pandemic and other financial challenges should not present the portfolio with problems, Cox says, as it is designed with a 10-year time horizon. “We are less concerned about performance and volatility during any one calendar year – we are much more focused on making sure we are not forced sellers of assets to raise cash at those times. We need cash to fund our grant-making programme. So, we haven’t changed our allocation as a result of the pandemic.”

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