Risk is often considered in terms of volatility, the bumpiness of the ride, or how much a portfolio falls from peak to trough. But our recent Charity Survey showed that permanent loss of capital was often more of a concern for Trustees than these statistical measures of risk. As such, we think it’s worth considering three additional areas of risk. These are often overlooked by investors but can have a dramatic impact on a charity’s finances.
Liquidity is the ability to turn investments into cash quickly and at a fair price. There have been many liquidity crises, but the problems at Neil Woodford’s LF Woodford Equity Income Fund will still be fresh in the mind for many trustees.
The fund invested in a mixture of large, listed equities and shares in smaller private companies. When the fund started to under perform, retail investors began to withdraw their capital. To meet these withdrawals the manager sold out of the larger, more liquid positions first, leaving the unlisted private companies a larger portion of the whole. Unsurprisingly, when the manager needed to sell these unlisted positions, he couldn’t.
The fund was forced to close to further withdrawals, and remaining investors were locked in. This was followed by a long process of winding up the fund, with forced sales of the private companies at relatively unattractive prices. Although investors got some of their money back, it was much lower than their initial investment.
Very similar risks are at play in the charity sector right now. A lot of charities are invested in pooled funds, some of which are investing in illiquid underlying assets as they search for higher returns in a competitive market. In a period of volatility, if other charity investors pull their money out, fire sales and fund closures are a genuine possibility.
Holding a segregated portfolio of direct investments removes the risks of being pooled alongside other investors who want to get their money out, and it means that the manager can avoid forced sales.
Key person risk
‘Key person risk’ is where an investment solution is run by a single individual with little accountability. An extreme example would be Bernie Madoff and the Ponzi scheme he ran in the US. Returns received by investors - many of them large charitable organisations - were entirely fraudulent. Madoff was able to achieve fraud on this scale because he controlled his investment firm entirely, the other staff were family members and close friends. There was no oversight of his investment decisions or compliance procedures.
On lesser scale, key person risk can occur when a highly successful Chief Investment Officer retires or perhaps market conditions change, and a once successful fund manager finds their style no longer works as well. A common theme with key person risk is that it often follows a period of strong investment performance that attracts client capital. This in turn can distort the behaviour of the manager and undermine the checks and balances that would normally surround their decisions.
When charities evaluate investment managers, it is worth looking beyond performance. In particular, does a firm’s investment process reflect the views of a single individual, or a broad group of people? We strongly suggest that a collegiate investment process is less risky for charity clients and an insurance policy against key person risk.
Disruption risk comes from the underlying investments held in a portfolio. It’s really about being on the wrong side of structural shifts in global economies. It often relates to technological change, which can make business models redundant very quickly.
Obvious examples include the decline of Kodak as film and digital cameras were replaced by smartphones. During the pandemic, we’ve seen how quickly technological changes can undermine once stable business models. The key difference between disruption risk and other traditional risk metrics is that it can permanently impair the value of an investment.
It is important to be genuinely diversified across different sectors and investment styles. Investment managers should have a breadth of analytical expertise, and be able to draw on a broad pool of analysts. Finally, with the impact of the pandemic and geopolitics key concerns for charity trustees, a forward-looking investment manager who can move on from an idea if the world changes may be in a better position to manage risk.
Issued by Smith & Williamson Investment Management LLP, part of the Tilney Smith & Williamson group of companies (the “Group”) which comprises Tilney Smith & Williamson Limited and any subsidiary of Tilney Smith & Williamson Limited from time to time. Further details about the Group are available at www.tsandw.com/compliance/registered-details.
This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance
Smith & Williamson Investment Management LLP
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Smith & Williamson Investment Management LLP is part of the Tilney Smith & Williamson group.
© Tilney Smith & Williamson Limited 2022
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.