Risk in an uncertain world
Charities with a rigorous risk management process will have been much better prepared for the impact of the pandemic, even if the pandemic had not been previously considered as a risk factor.
This article was written before the COVID-19 pandemic, and while this has totally overwhelmed all other risk considerations in the period, the risk process described below is more valid than ever. Charities with a rigorous risk management process will have been much better prepared for the impact of the pandemic, even if the pandemic had not been previously considered as a risk factor.
There are risks involved in running any organisation, including a charity. While many will suggest that their greatest risk is reputational, for risk identification to be useful it must suggest risks that can in some way be controlled, mitigated or simply avoided. Reputational damage is an outcome of one of many risks that have occurred and then been handled badly.
Here is an example: There has been a data breach that has resulted in the loss of a large quantity of personal information. The data loss becomes public knowledge with extensive and extended media coverage. The media coverage leads to reputational damage, the impact of which exceeds the costs of the fines levied by the ICO and the cost of rectification. The eventual reputational damage will have a lot to do with how effectively the crisis is handled, but it is not the starting point.
For this, we need to identify the types of risk to which an organisation is exposed, narrowing them down to the most important – those that could if un-managed lead to the greatest reputational damage or to the insolvency of the organisation - so that we can focus on managing those risks.
The best method of identifying risks is to ask experienced managers across the business a simple question: what is the worst thing that could happen in your part of the business? Then repeat with the Executive and the Board but this time focusing on the whole business.
Having identified the scenarios, it is possible to assess the strength of the organisation’s defences against these risks. Many organisations attempt to assess the impact and probability (or frequency) of each scenario occurring in order to quantify each risk.
This is a useful process, even if the outcome is only a guestimate, as it focuses the mind on the potential damage that could be caused if the risk is realised and also allows risks to be ranked. The scenario assessment may show that work is required to improve processes or controls. Alternatively, management may choose to exit the part of the business that gives rise to the risk.
Funding remains a key source of risk. The level of risk will depend on the type of funding: in general, endowments and membership dues tend to provide reliable sources of funding, while areas such as fundraising or legacies are more unpredictable. Equally, changes to government funding can provide a source of risk for charities. At all times, trustees need to stay on top of these risks, identifying and understanding these potential problems.
Fundraising is naturally unpredictable. It can depend on the public mood, what is in fashion and an element of luck. Environmental charities, for example, may fall in and out of favour depending on whether there has been a major crisis. Here, reputation will be important as well. Where there have been problems at a particular charity; other, similar, charities may also suffer.
The stability of the funding base will influence each charity’s reserve policy. It has become very ‘expensive’ to hold significant cash reserves because the return on cash is zero. Therefore, reserves are consistently being eroded by inflation. Due to their risk profile, some charities have little choice but to keep high cash and other reserves, but charity trustees should be aware that distorted markets have changed what constitutes ‘prudence’ in this environment. The recent trend of holding less in reserves is likely to be reversed as a result of the experience this year.
There are similar problems with investment risk. We look at the world through the two main investment asset classes, equities and fixed interest, with real estate, infrastructure, commodities and other alternatives considered as hybrids / derivatives of these two. Each asset class has its own characteristics and performs differently in different economic and market environments. As such, the risks faced when investing tend to lie in three broad areas; macro, investment strategy and operational.
The importance of macro risks reflect that we live in a complex world with a wide variety of economic and market influences that can and do have a material impact on the timing and extent of investment returns. Of all the macro risks we see changes to growth and inflation risk expectations as the two most significant as these changes drive many of the other risks and the relative performance of all the asset classes. For example, low growth and falling inflation has led to falling interest rates, which in turn has driven the strong performance in both fixed interest stocks and growth stocks in the last decade. Changes in relative inflation and growth can also drive currency and credit risk.
The impact of a global pandemic is a risk most of us underestimated at the start of the year. Climate change is another increasingly important risk factor. Geopolitical risk covers everything from US/China trade talks and Brexit to the risk of a Middle East event that interrupts the supply of oil and on to the rise in ‘popularism’ in developed world politics. As politics change economic priorities and policies change, regulatory risk rises.
The role of investment managers is to find the right combination of assets (investment strategy) for each client’s capacity and appetite for risk and their long-term objectives. This combination of assets makes up the long-term strategic asset allocation, around which shorter term tactical asset allocation changes are made.
Whether the combination of assets selected perform as expected is a key risk. Whether your investment manager performs as expected is another. Holding a diversified portfolio of assets is an attempt to provide greater stability of investment returns and reduce risk, so understanding the underlying factors impacting each asset type and the degree of correlation they have in different market environments is another part of the risk mitigation process. Liquidity risk - being able to withdraw your assets when you want to – should also be considered.
There will also be operational risks. This may be the robustness of the custodians where the assets are held, the quality of administration, whether the portfolio is exposed to stock lending, counterparty risks or credit risk? Do you get timely information to enable effective monitoring? Scenario analysis and stress testing can help monitor potential emerging risks.
Trustees need to assess and review all the risks that threaten the charities' ability to fulfil its key mission; and plan for the management of those risks. This is a key part of ensuring that a charity is fit for purpose.
Investment does involve risk. 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. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
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 2021
This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.