It has long been regarded that a charity investment portfolio needs an element of diversification, and a number of asset classes and products have been labelled as alternatives, including property. But what do people really mean by alternatives? And how should charity investors consider alternatives in the current high inflationary environment, and with an increasing focus on environmental, social and governance (ESG) factors?

Robert Hayes, investment director for charities at BlackRock, summarises: “A lot of charities have property in their portfolio and that is viewed as alternative. But we have seen interest from organisations wanting to move away from that, who are seeking things that can help in the current world. But what are they and how do they fit in? And how do you consider ESG in that context?”

For Coleman Long, managing director at Cambridge Associates, the key question is “alternative to what?” He explains: “If we consider the most simple possible portfolio, the classic 60/40 equity to bond mix, you need to decide that if you are going to do something different to benefit the portfolio, what would it be?”

George Graham, trustee at the Royal Literary Fund, has a similar view. “If you start from the premise of equity and bond type returns, and factor in interest rate sensitivity, alternatives are anything that offers you a different profile of return.”

For the Cripplegate Foundation, which has limited resources in terms of engagement with fund managers, alternatives are “about inflation hedging, and how different asset classes and opportunities can be built into the existing portfolio”, says Nilesh Pandya, director of finance and resources.

Andrew Wimble, investment committee member at the D’Oyly Carte Charitable Trust, points out that as well as talking about returns, risk is key. “How does equity-type risk fit in with alternatives?”

Mark O’Kelly, director of finance and administration at Barrow Cadbury Trust, thinks alternatives cover a range of things. “For me, it is not listed equities and bonds, or property, but hedge funds, private equity, commodities, some property funds, cryptocurrencies (though not for us).”

Simon Hopkins, director of finance and corporate resources at Versus Arthritis, says that “one other aspect to explore when we step out of the traditional mainstream of asset types is aligning how alternatives work with trustee comprehension”.

Tatyana Mursalimov, director at PMCL Consulting, states that the premise from its clients with long-term investments is that equities are core and everything else is an alternative to equities. “Our goal is not to manage money but to create a strategic benchmark that is sensible with multi-asset solutions.”

Inflation and risk

With inflation running at a 40-year high, it is obviously something trustees will be aware of. But for Long, it is important to make a distinction in how you define inflation risk. “When building a portfolio, everything should be bespoke to the risks that are relevant to the institution as different asset classes work on different time horizons.”

O’Kelly says the fact that Barrow Cadbury is a long-established foundation, helps trustees take a long term view. “But spending strategy is important. If you are spending capital you need to get the balance right and hold some investments that are liquid. Cash is not great for inflationary purposes, so what else is there?”

Time horizon is important, agrees Wimble. “You can take the surplus in good times and keep it for times of famine, average it out. But it still comes down to time. If you are a trustee, you don’t want it to all go wrong on your watch.”

Hopkins warns about treating charities as homogenous. “If you are a grant-giver with relatively low fixed overheads, you effectively take the yield and grant it out, although I appreciate it is more complex than that. Structurally you can play the long game in a way that a service provider perhaps can’t. You can make sure the underlying investment policy and philosophy match that. But often that doesn’t happen. Investment policies are sometimes created in isolation from the business model, which is when volatility starts to bite you.”

For an average charity, it is about what is accessible and investable, states Mursalimov. “That is where alternatives come in, for operational charities where cash flow and liabilities are hard to predict, direct investments into alternatives can be difficult. They can’t always sell the assets they should sell when they need to. More horizon planning is needed.”

Pandya reflects on Cripplegate’s operational model. “Considering the perspective of our grantees and their beneficiaries, we have a quandary to provide long-term sustainable funding for them. There is a temptation to take a short-term view in the current climate given they are facing inflationary pressures immediately. The challenge is being able to articulate to asset managers that we will feel pressure over the next three years but also have a long-term horizon we need to preserve. Having that conversation with asset managers is tricky, in terms of setting a realistic target for them to achieve.”

Hayes feels that there is a need to define risk in a framework that is aligned to the requirements of the organisation. “I would argue that instead of equities, for some very longestablished endowments, property has been the default investment, which is why I am framing it as an alternative to property. I worry that because of the success of UK and US markets over the last 100 years or so, we forget that reliance on equities is a relatively recent approach and that other equity markets have fallen to zero at points. When I think about alternatives, I think about alternative sources of return and risk that tie into the goals of the organisation. Which is why buying infrastructure, for example, which may or may not be inflationlinked is different from buying venture capital. Alternatives is a catch-all phrase for whole heap of things.”

Hayes continues: “With any investment, you need to ask what are the characteristics of that investment that make it appropriate to what you want to achieve. Start with a blank piece of paper. If you want some cash flows or long-term return, ask what is the most attractive way of achieving that and build from the beginning.”

Property

A lot of charities are more exposed to alternatives than they think, muses Hopkins. “I am thinking of those with large property portfolios, because they have always had them, rather than as a result of a deliberate and overt decision to go into property as an alternative. These are almost managed separately from the rest of the investment portfolio. But we still need to apply benchmarks to them. We tend to think of alternatives as non-traditional but the lure of property is often based on traditional considerations.”

Long states that this is why you start with bespoke considerations. “Ask, is property strategically important? Is it core? You need to have that discussion. There is often a behavioural ‘home bias’ towards owning more of the things that are closer to you, but you need to step back and consider diversification through alternative measures and risk.”

Property is an interesting case, according to Graham. “Unlike some other areas classified as alternatives, there are property funds, structured in a way that doesn’t overtly rip you off in terms of fees, not incredibly difficult to access with 600-page documents like private equity for example.”

Language

Another issue for Long is that “the industry is so willing to sell you stuff labelled as diversification. But it can be fake diversification and really just different flavours of equity.”

Hayes says that this is why what matters with any investment is what is in there, not what it is called or labelled. “What are the fundamental drivers of return and risk? This is why the label of alternative is unhelpful.”

The word alternative has become a bit pejorative, argues Hopkins. “It might imply to the lay trustee doing something a bit too uncomfortable, yet in reality an alternative asset as part of a blended, considered, deliberate investment strategy, underpinning a healthy organisational strategy and business model can be wholly appropriate. But language can be a barrier to this.”

Pandya picks up on this. “If I was to talk to my board about impact investment, it sounds exciting. However, alternatives sound scary even if they can be the same thing.”

Long agrees that language is important for investment committees. “The lingo can be horrific, too much jargon. It can be helpful to write out what they are trying to achieve rather than saying, for example, ‘hedge funds’, so that expectations are matched.”

Language also matters to Mursalimov. “Some charities have created a benchmark that is a legacy of many years, and no one knows why it is there. So how do you select who happens to match this random benchmark? You need a clear conversation about what you are trying to achieve.”

Blank piece of paper

In terms of the blank sheet of paper approach, how easy is it for an organisation with a portfolio that has emerged over time to simply start from scratch and change it overnight?

O’Kelly thinks it can be done, if not overnight then certainly in a short space of time. “Ours has changed over 10 years. Legacy properties can be a challenge but you can see where you want to be and work towards that. Allocation to alternatives has changed for most foundations over the last few years, and there has been a move from UK to global equities, and allocation to bonds have gone down.”

Long calls it an enterprise review. “Before you devise the investment policy, assess what the financial objective is. Don’t start with a 4% real return for example, but instead do the work to understand how your investments tie into the organisation’s broader financial objective.”

For Graham, the conversation with trustees can be complicated. “We are wrestling with how to get trustees to understand it when things go wrong. But communicating what the characteristics are is a better avenue than listing asset classes.”

Hopkins alludes to the age-old problem where the investment committee is dealing with investment matters, and the perception by other trustees is that they know what they are doing.

ESG

Hayes thinks of ESG risk as investment risk. “In the context of private assets/alternatives, when you buy something in private markets you are typically locked into holding it for longer. For example, private equity, you may hold it for 10 years so when you go into it you have to consider the risks that might emerge. Those ESG risks can affect your ability to sell it at value you expected. ESG considerations should be fundamentally built into the process. Responsible investment is, after all, just good investment.”

O’Kelly says that there is increasing alignment between charities investing in line with their mission and their fund manager considering ESG risks. “Some alternatives have clear positive impacts, such as funds in renewable energy and social housing, but it can be harder when assessing individual private companies.”

Hayes says that in theory, influencing ESG factors should be easier with private companies as there are fewer shareholders and investors may have a more direct involvement.

Graham says that the discussion about ESG risk is interesting. “There is a corollary that risk has a price. If the market reaches a point where risk is priced in, you might buy unpopular assets. It is plausible that the global warming risk isn’t priced in, but a lot of it is based on what the Principles for Responsible Investment (UNPRI), an independent organisation with backing from the UN, call the inevitable policy response, which is much less inevitable than UNPRI would like it be.”

Long identifies a shift from divestment. “Portfolios that focus on exclusions may look good on certain ESG measures, but are they helping solve the bigger problem and are they aligned with real world outcomes?”

Wimble agrees that engagement has become more prominent. “Divesting from an economic point of view is fine but don’t do it for the sake of it.”

With thanks to BlackRock for its support with this feature