Charity Investment Annual 2020 - Cazenove Capital...policy. A long term endowment portfolio is likely to have generated returns of around 100% over the last decade, as compared to

A portfolio for the next decade

Charity Investment Annual 2020

ContentsInvestment Thoughts

02 A portfolio for the next decade

08 Is your charity prepared for the next market crisis?

18 Globaltransformation:tacklingclimatechangeinfivecharts

22 The Social State of the Market

26 IsBillGatesrightaboutthe“zero”climateimpactoffossilfueldivestment?

28 CharityFinanceRoundtable“Wewanttoinvestresponsiblybutalegalrulingcouldrestrictourfreedom”

32 Addingreturnandloweringriskwithprivateassets

Sector Thoughts

40 NCVO Almanac 2019

41 Foundationgivingtrends2019

42 Foundation Horizon Scan

1

WelcomeWelcometooursixthCharityInvestmentAnnual.Aswestartthenextdecadewetakea freshlookatcharityinvestmentportfolios,andcomeupwithfourrecommendations.

Ourchosenarticlesexaminemanyofthesetrendsinmoredetail;coveringsustainability,privateassetsandgovernance.Wehopethatyoufinditofuse.

Kate Rogers Co-Head of Charities

A portfolio for the next decade:

1.Embracesaglobalapproachinequities

2.Movesawayfrombondmarketsandseeksalternativesourcesofreturn

3.Investssustainably,inlinewithyourvalues

4.Focusesonvalueformoney

2

INVESTMENT THOUGHTS

Havingenjoyedthisgrowth,wethinkitistherighttimetoreviewandrefreshourcharityinvestmentsandhavefourrecommendations to ensure our charities’ portfoliosarefitforthenextdecade.

1. A global approach in equities

Equitiesrepresentthemostsignificantasset class in most long term charity investmentportfolios(70%*).InthepastUKcharitieshavehadabiastowardsUKequitiesforthreereasons:theincomepremium,thealignmentofcurrencyandtheglobalnatureoftheUKequitymarket.Whilst we can understand these from a historicalperspective,wenowrecommendaglobalapproach.Let’slookateachreason in turn:

Better income?

TheUKequitymarketdoesprovideayieldpremiumtotheglobalequitymarket(4%vs2.5%).However,theCharitiesTotalReturnRegulationsfirstintroducedin2013(andamendedin2018)meanthatcharityinvestors,evenifpermanentlyendowed,arenotrestrictedtospendingfromincomealone.Inourview,biasingportfoliostowardsUKequityincomewill

limitthereturnopportunityoverthe nextdecade.

Alignment of currency?

ItistruethatUKequitiesarepricedinsterling.However,anycomfortthatisgainedfromthisislargelyanillusion.Thelargest100companiesintheUKequitymarket(representing80%ofthetotal)haveonly23%oftheirrevenuesinsterling.Inotherwords77%ofFTSE100revenuesaresubjecttocurrencyrisk.AswesawposttheEUreferendum,largeswingsincurrencymarketscanhavearealimpactonthevalueoftheUKequitymarkets.

A global UK equity market?

ThestatisticsaboveshowthattheUKequitymarketismadeupofglobalcompanies;derivingmuchoftheirrevenueelsewhereintheworld.However,doesitrepresenttheglobalequitymarket; orindeedgiveusaccesstotheareas of growth?

The last decade has seen a rise in the technologygiants.Inthelast10yearsacombinationofFacebook,Apple,AlphabetandMicrosofthaveaddedatotalof$4.3trillion in market cap to the US market;

thisismorethanthevalueoftheUKmarket and nearly as much as the Chinese mainlandstockmarket.

WehavelittleexposuretothetechnologysectorintheUKlistedmarket(Figure2).WhiletheUKhashadanumberofverysuccessfultechnologycompanies,suchasArm,MisysandmorerecentlySophosandJustEat,manyhavebeentakenoverbytheirlargerinternationallistedrivalsdeprivingUKfocussedinvestorsofthefuturegrowth.Webelievethattechnological disruption will continue tobeathemeforthenextdecade,anddonotbelievethatcharityinvestmentportfolios should be limited or biased towardsanarrowuniverse.UKequitiesarealso concentrated in resources and banks; bothofwhichhavesignificantchallengesin the face of climate change and a shifting globaleconomy.

Our portfolio for the next decade takes aglobalequityapproachatitscore,andbydoingsoallowsourcharityinvestorsto access the exciting growth potential ofcompaniesallovertheworld.Inordertodeliverthisapproachsuccessfully,webelieveitisnotenoughtorelyonUKbasedinvestorsalone-wemustuse

Charityinvestorshaveenjoyedaprofitablelastdecadeastheglobaleconomyhasshowncontinuedgradualgrowthandassetpriceshavebeenboostedbyliquidityfromloosemonetarypolicy.Alongtermendowmentportfolioislikelytohavegeneratedreturnsofaround100%overthelastdecade,ascomparedtoinflationof23%(UKCPI).Thismeansthatafterspending, manycharityinvestorswillhaveendedthedecadehavingexperiencedsignificantreal portfoliogrowth.

A portfolio for the next decade

*Source:TeknometryCIGCharityFundUniverse,30thSeptember2019,1,298portfoliosoftotalvalue£12.4bn

3

In the last 10 years a combination of Facebook, Apple, Alphabet and Microsoft have added a total of $4.3 trillion in market cap to the US market; this is more than the value of the UK market and nearly as much as the Chinese mainland stock market.

UK USEurope

ex UK JapanPacific

ex JapanEmerging

Markets MSCI World

Financials 23% 14% 20% 12% 23% 21% 18%

Information Technology 1% 22% 6% 11% 29% 23% 17%

Consumer Discretionary 9% 13% 12% 20% 10% 12% 12%

Health Care 8% 14% 14% 7% 2% 3% 11%

Industrials 10% 10% 15% 21% 8% 7% 11%

Consumer Staples 14% 9% 12% 8% 5% 7% 9%

Energy 14% 6% 4% 1% 4% 6% 6%

Materials 9% 3% 8% 7% 5% 7% 5%

Telecommunications 7% 2% 4% 5% 5% 6% 3%

RealEstate 2% 3% 1% 5% 6% 3% 3%

Utilities 4% 3% 3% 2% 3% 3% 3%

Total 100% 100% 100% 100% 100% 100% 100%

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2019 1999

1,190 1,162

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576 507602

366316 308

Apple Microsoft Alphabet Amazon Facebook Microsoft GE Cisco WalmartOracle

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1,250

Figure 1: Top five US publicly traded stocks by market capitalisation (US$ billion)

Figure 2: Sector composition of major equity indices

Source:DatastreamRefinitivandSchroders.

Source:Bloomberg,CazenoveCapital.

4

INVESTMENT THOUGHTS

thehugeglobalinvestmentresourceofSchroders,drawingonmorethan750investmentprofessionalsin19countriesforinvestmentideasandinsight.

2. Looking for alternative sources of return

Thelastdecadeprovidedbondmarketswithastrongmonetarytailwind(Figure3). This reduced yields and pushed up capitalvalues(Figure4).

Havingbenefittedfromstrongbondmarket returns; our portfolio for the next decademovesawayfrombonds,withonlyasmallallocationfordiversification,andinsteadseeksalternativesourcesofreturn.Thesealternativeassetsincludeproperty;infrastructure,commoditiesandotherdiversifiers.Wearealsoaskingourcharityclientswithlongterminvestmenthorizonstolookatprivateassets.

Including private assets

Schroders’latestsurveyofglobalinstitutionalinvestorsshowsthat

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2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

US$

bill

ion

Central Bank Balance sheet (Fed + ECB + BOJ)

Figure 3: Increasing central bank balances

Source:Datastream,CazenoveCapital.Fed=FederalReserve,ECB=EuropeanCentralBank,BOJ=BankofJapan.31December2019.Past performance is not a guide to future performance.

Thishasbeenaglobalphenomenon. At the turn of the decade the 10 year UK governmentbondyieldstoodat0.8%,havingfallenfrom4%in2010.Itisclearthat bond yields cannot fall a similar extent overthecomingdecade;meaningthatcapitalreturnsarelikelytobelow,ifnotnegative.Oursevenyearforecastforbondmarketsshowsanegativerealreturn.Thisisunlikelytobeattractiveforcharityinvestorsseekingreturnsthatprotecttheirinvestmentsagainstinflationandgenerateexcessreturnstosupportspending.

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Figure 4: Declining bond yields

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privateassetscomprisearound10-15%ofinstitutionalportfolios.However,mostexpecttheallocationtoriseoverthenextthreeyears.Thismakessensetous. At a time when macroeconomic and geopolitical concernsareincreasinglyoninvestors’radars,privateassetscanoffermeaningfuldiversificationandcompellingreturns.

Anditisnotanewassetclassforcharities–privateassetshavebeenakeydriverofreturnsfortheverylargest foundations and endowment portfolios for decades.Oncethepreserveoftherichestcharitiesonly,wearepleasedtobeabletoofferprivateassetstoourclients.Inhispaper‘Addingreturnandloweringriskwithprivateassets’,DuncanLamont,ourHeadofResearchandAnalytics,highlightsthefourwaysinwhichprivateassetscanpotentiallyaddvalue–higherreturns,broadeningaccess,reducingriskanddiversifyingportfolios.Wherecharitiescantolerateilliquidity,webelievethatanallocationtoprivateassetscanhelpmeettheirinvestmentobjectivesforthenextdecade.

Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

Case Study: The Yale Endowment, $29.3bn

‘Overthelongerterm,Yaleseekstoallocateapproximatelyone-halfoftheportfoliototheilliquidassetclassesofleveragedbuyouts,venturecapital,realestate,andnaturalresources.’

‘Theheavyallocationtonon-traditionalassetclassesstemsfromtheirreturnpotentialanddiversifyingpower.’

‘TheEndowment’slongtimehorizoniswellsuitedtoexploitilliquid,lessefficientmarketssuchasrealestate,naturalresources,leveragedbuyouts,andventurecapital.’

‘Thetwenty-yeartimeweightedreturnofYale’sventurecapitalportfoliois24.6%p.a.’

Source:2018EndowmentUpdate

6

INVESTMENT THOUGHTS

3. Investing sustainablyIn2009just23%ofcharityinvestorshadapolicythatlinkedtheirinvestmentstrategytotheircharitableaims.Nowmorethanthreequartersofcharityinvestorsseektoaligntheirinvestmentapproachwiththeircharity’saims–bothavoidingconflictandseekingpositiveimpact(Figure5).

There are a number of explanations for thischange.Fromtheneedtoprotectreputations and build public trust in thefaceofpresscriticism(Figure6);totheincreasingevidencethatafocusonsustainabilityenhancesreturns(Figure7).

Our portfolio for the next decade integrates sustainability into the investmentdecision.Goingforward,allofourcharityinvestmentstrategieswillintegrateenvironmental,socialandgovernancefactorsandwewillcontinuetouseourinfluencetopushfor progress – standing up for what we believe,improvingfutures.Wecanhelpindividualclientsfindalignmentbetweentheirinvestmentsandtheirvalues,andmeasure the effect of portfolios on people andplanet.Investingsustainablyisnolongeranoption,itis anessential.

Figure 5: The increasing number of charities aligning mission and investments

2009 2014 2019

23% 59% 78%

Source:CazenoveCapital,IntentionalInvesting(2014).2019databasedonpractice.

Figure 6: Increasing reputational risk if investments are seen to conflict with aims

Figure 7: Compelling academic evidence shows investing sustainably makes financial sense

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60%

40%

20%

0%

Link higher CSR and ESG factors to lower cost of capital (debt and equities)

Link high ESG factor ratings to market-based outperformance

Oxford, 20141

– Firmswithsignificantenvironmental concerns pay higher credit spreads

– Awellgovernedfirmcanhaveanequity cost advantage between 0.8 to 1.32%

– Goodcorporategovernancecanleadtoa 1.8%reductioninthecostofequality

– 88% studiesshowedapositiverelationship between sustainable companies and operational performance

– Rating agenciestendtogivebetter ratingsissuerswithgoodESGpolicies

1FromtheStockholdertotheStakeholder,SmithSchoolofEnterpriseandtheEnvironment,UniversityofOxfordandArabesqueAssetManagement, September2014.

2Sustainableinvesting.EstablishingLong-TermValueandPerformance,Fulton,June2012.

Fulton, 20122

BBC,July2014 BBC,December2013

TheGuardian,March2018 TheGuardian,January2020

7

4. Focusing on value for money

The last decade has brought about an increasedfocusoncosts,asausterityandgreater scrutiny ensure that trustees are committedtodemonstratingvalueformoney.Therehasalsobeenasignificantreductioninthecostofinvestingpassively,withthecostofaUKequitytrackerfundfallingby80%since2010,from0.5%to0.1%today.Thishasrightlyledtoquestionsoverthecostofactivemanagement; and challenge from charity investorstodeliverinvestmentportfoliosatlowerlevelsoftotalcost.

Thetotalcostofourinvestmentapproachhasalsofallenoverthelastdecadeasweconstructportfolioswithbudgetsinmind.Wehavealreadyestablishedthatglobalequitiesformthemainpartofcharityinvestmentportfolios.Wethinkthere aretwo,costeffectivewaystoinvestinglobalequities:

1. Direct investment-whichavoidsthecostsassociatedwithpooledfunds,toreflectspecificresponsibleinvestmentpoliciesandtobenefitfromourglobalinvestmentresource;or

2. Pooled investment – combining low costpassiveapproacheswithspecialistactivemanagerstogenerateexcessreturnsandbenefitfromdiversificationofmanagerandstyle.

Investingwithbudgetinmindmakessurethatweanalyseeverypennywepayinfees,toensurevalueformoney.Thatdoesn’t mean we won’t pay up for a great opportunity,anewassetclassorastrongperformancetrackrecord,justthatweneedtobeconvincedthatthepotentialbenefitisworththecost.

Our portfolio approaches

Integrated sustainability

Pooled – Investinginfunds – Multi-manager – Coreinpassive

vehicles – Activemanagersfor

additional returns

Direct – Investingdirectlyin

globalequities – Investinginpooled

funds for other assets – Tailored ethical

screening

Our portfolio for the next decadeDesigningacharityinvestmentportfolioforthenexttenyearsandbeyondmeansfourthingstous:

1. Aglobalapproachinequities

2. Lookingforalternativesourcesofreturn

3. Investingsustainably

4. Focusingonvalueformoney

Combiningtheseintoanewcharityinvestmentapproachgivesusconfidencethatwecanmeetyourcharityinvestmentobjectiveswhateverthenextdecademighthaveinstore.

8

INVESTMENT THOUGHTS

Itiscommonknowledgethatinvestinginfinancialmarketsbringswithitadegreeofrisk.Assetpricesriseandfalleachdayand by the close of play on some of those days,thevalueofyourinvestmentswillhavegonedown.Crisesinhistoryhavepresentedthemselvesinavarietyofways;somecharacterisedbyashortsharpjolt,some slow and drawn out and others a violentzigzagofpredominantlynegativereturns.Thereisnocleardefinitionofafinancialcrisis,althoughitwilltendtodifferentiateitselfbyasevereshock,distinguishing it from a bull market setback.Afinancialcrisisisusuallyimpossibletopredict,andignitedby asparkhithertounseen.

Despite knowing that we should expect to experienceaseriousdownturneveryso

Is your charity prepared for the next market crisis?

often,toomanyinvestorsignoreperceivedwisdom and sell out when it least makes sense.Stockmarketcrashesaresocialphenomena,whereexternaleconomiceventscombinewithcrowdbehaviourandinstinctivefear.Sellingbysomemarketparticipantsdrivesmoremarketparticipantstosell,leadingtoadownwardspiralinpriceandsignificantlossofpaperwealth.Investorsanticipatefurtherlossesaspessimismandsellingincreases, and the market’s descent becomes self-sustaining.

However,marketshaveahabitofrecoveringandforthosewiththeconstitutionandinvestmenttimehorizontostomachthefall,perseverancecanprovefruitful.

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We will examine the statistics behind market crises and the psychology underlying “irrational”investorbehaviourandofferadvicetotrusteesonhowbesttopreparefortheseeventsandhowtonavigatesuccessfullythroughthenextcrisis.Mindful oftheuniquefinancialcircumstancesofeachcharity,wealsoaimtocover arangeofscenariosthatwehopewillberelevanttoeveryreader.

Source:CazenoveCharities,Datastream,FTSEAllShare(priceindex)inGBPto31stOctober2018.Pastperformanceisnotaguidetofutureperformance.

How often do stock market crises occur?

Inthedepthsofabearmarket,investorsquestionwhetherthestockmarketisanappropriatemediumofinvestmentatall.However,historicalevidenceprovesthatcapitulationisworthavoiding.Forthetrulylong-terminvestor,andassuming financesareappropriatelypositioned,market falls should not be a cause for significantconcern.

LookingatUKequitymarketreturnsoverthelast50years(figure1),wecansee a number of eye watering market falls.EquitiespeakedinMay1972withacapitalvalueof228.Bytheendof1974themarketstoodat62,a73%declineincapitalvalue.Ittookjustundertwoyearsforthecapitalfall,andnearlyfouryearsformarketstorebound.The‘dotcomboom’ market peaked in September 2000 andthenfell51%overthenexttwoandahalfyears,bottominginMarch2003.Again,ittooknearlyfouryearsforthemarkettorecovertopreviouslevels.Mostrecently,thecreditcrisispromptedafallof50%inequitiesbetweenJune2007

Figure 1: UK Equity Market Returns 1962-2018

-57% Average‘crisis’decline

2 years Average‘crisis’longevity

4 years Averagerecoverytime

9

andMarch2009.ThemarketeventuallyregainedpreviouslevelsinMay2013.Asthechartshows,since1962wehaveseenthreedramaticfalls,withanaveragedeclineof57%,takinganaverageofjustmore than two years for the fall and four yearsfortherecovery.Thesewerethestockmarketcrisesofrecenthistory.

What is the likelihood of these market falls?

The table on the right looks back at the performanceofthepriceindexoftheFTSEAllShareoverthepast56years(asfarasthedataallows).Theevidenceshowsthat

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FTSE All Share Calendar year returns and intra-year declinesPeriods of negative returns are normal

Source: DataStream, FTSE, J.P. Morgan Asset Management. Returns are based on local price only and do not include dividends. Intra-year decline refers to the largest market fall from peak to trough within a short time periond during the calendar year. Returns shown are calendar years from 1986 to 2018. Past performance is not a guide to future performance.

Return less than

Rolling 1 year historical probability

-70% 0%

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-50% 1%

-40% 1%

-30% 3%

-20% 6%

-10% 15%

0% 29%

theprobabilityofanegativereturnonarolling1-yearbasisis29%.Basedonthisperiodofhistory,insevenoutof10yearstheUKmarketgeneratedapositivereturn(incapitalterms).Asignificantdropinmarketsisbothunusualandinfrequent;youwouldhavelost20%ormorejust11%ofthetime.However,shorter-termmarketoscillationsarecommonplace.Lookingatintra-yeardeclines,wecanseethatvolatilityofthemarketvalueisanormalpartofinvesting.Thechartbelowsetsout calendar year returns and intra-year declines,showingthatafallof10%ormorehappensinthreeoutoffouryears. Source:CazenoveCharities,Datastream,

FTSEAllShare(priceindex)inGBPto31stOctober2018. Past performance is not a guide to future performance.Figure 2: Periods of negative returns are normal

10

INVESTMENT THOUGHTS

Attempting to time the market can be a mistake

Whennegativenewsheadlinesareprolificandinvestorsarepanicking,itcanbetempting to try to stem your losses by sellingout.AsshowninFigure2,in25ofthelast33calendaryears,theUKequitymarkethasfallenbymorethan10%atsomestageduringtheyear.Trusteesmayaskthemselves,‘ifweactquickly,canwesell stocks before they lose too much of theirvalue?’

The probability of success in shielding your portfolio from large losses falls theshorterthetimeframeoverwhichit

happens.Whatismore,evidenceshowsthattotalreturnsinthedays,monthsandyears following a sharp drop in the market havebeenstrong;missingtherecoverycanbecostly.ThetablebelowshowshowtheUSequitymarketbehavedfollowingthe10worstone-dayfallsoverthelast30years.Thelightgreenboxesshowpositivereturns,thedarkgreendouble-ortriple-digitreturns.

Theoverridingthemeisthatreturnsareprimarilypositive;almostalwaysinthedayfollowingadramaticfall,double-digitinallbuttwooccurrencesoveroneyearandextraordinarilystrongoverfiveyears.

Date Return % 1day 1week 1mth 6mth 1yr 5yr

15 October 2008 -9.0 4.3 -1.2 -3.5 -4.7 24.0 109.0

01 December 2008 -8.9 4.0 11.5 11.0 17.2 39.3 147.0

29 September 2008 -8.8 5.4 -4.4 -15.8 -25.1 -1.5 70.9

09 October 2008 -7.6 -1.2 4.0 2.5 -4.4 20.9 103.5

27 October 1997 -6.9 5.1 7.1 8.7 24.9 23.4 9.6

31 August 1998 -6.8 3.9 1.8 6.4 30.3 39.8 13.0

20 November 2008 -6.7 6.3 18.1 16.1 21.8 48.8 164.3

08 August 2011 -6.6 4.7 7.7 6.2 22.0 28.1 117.0

13 October 1989 -6.1 2.8 4.1 2.1 5.0 -6.9 63.8

19 November 2008 -6.1 -6.7 10.1 10.3 14.2 39.2 147.5

Source: Datastream, Cazenove Capital, December 2018. Past performance is not a guide to future performance.

Fully Invested Missed 10 best days Missed 30 best days Missed 50 best days

1,000,0002,000,0003,000,0004,000,0005,000,0006,000,0007,000,0008,000,0009,000,000

10,000,00011,000,00012,000,00013,000,00014,000,00015,000,00016,000,00017,000,00018,000,00019,000,00020,000,00021,000,00022,000,000

9.6% p.a.

7.5% p.a.

4.9% p.a.

2.8% p.a.

The September 2008 crash distinguishes itself by being slower than the others to recoverlosses,althoughbytheendofthefifthyear,you’dhavemadeareturnof71%.Forthosedoubtingtherelevanceofapplying historical data to current market conditions,theperiodeithersideofNewYear’sEve2018/19wasacaseinpoint:in2018,USstocksexperiencedtheirworstDecemberreturnsince1931andin2019,theirbestJanuaryreturnsince19871.

ThispatternisnotexclusivetotheUSequitymarket.Between1986(whenthetotalreturnindexwascreated)andtheendof2017,theUK’sFTSEAllSharehas

Ten worst one-day falls for the S&P 500

Figure 3: Impact of being out of the UK Equity market

1Source:MorganStanleyResearch,Bloomberg,S&P500totalreturn,January2019.

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generatedanannualised9.6%perannum.Missingthebest50dayswouldhavereducedyourreturntojust2.8%.Missingthe30bestdayswouldachieveonly4.9%and missing as few as the 10 best days wouldyieldasignificantlylower7.5%. Figure 3 shows on the y-axis how much youwouldhavemadeona£1minitialinvestmentineachofthesescenarios.

Aninvestorwouldhavetobeuncommonlynimble to time correctly a sell-out and then to buy back in at the optimal moment to capturethebouncethatfollows.Evidenceshowsjusthowdifficultitistomarkettimewithanyconsistency.

Dalbar,afinancialmarketresearchcompanyintheUS,publishanannualstudythatcomparesreturnstoinvestorswithreturnsfromtheindex.The2017study showed that the annual return receivedbyinvestorsintheUSequitymarketover30yearstotheendof2016was4%perannum.ComparethistotheS&P500indexreturnof10%perannumandyoucanseetheproblem.Althoughpartofthisdifferenceisdowntocosts,thestudymakesitclearthatthemajority

Figure 4: UK Equity Returns

ofinvestorunderperformancecanbeattributedtoinvestorbehaviour.Theysay“theretentionratedata...…suggeststhatinvestorslackthepatienceandlong-termvisiontostayinvestedinanyonefundformuchmorethanfouryears.Jumpingintoandoutofinvestmentseveryfewyearsisnotaprudentstrategybecauseinvestorsare simply unable to correctly time when tomakesuchmoves.”

Trying to time your way into and out of markets could reduce the chances of protectingyourassetsfrominflation,which,formostcharityinvestors,ismoreof a threat to long-term sustainability than short-termvolatility.Historicalevidence

demonstrates that stock markets tend togeneratereturnsthat,overtime,outstriptheinflationthatwouldotherwiseerodethevalueoftheinitialsum.Howcan attempting to time the market compromise your chances of beating it?

Thechartbelow(Figure4)showstherateofUKinflation–representedbytheConsumerPriceIndex(CPI)–againstaportfolioinvestedintheFTSEAllShareusingthesametimeframeasabove.The blue line represents your return hadyouremainedfullyinvested,theredlinehavingmissedthe10bestdays,thegrey line missing the 30 best days and thegreenlinethe50bestdays.Beingout of the market at the wrong time can make a real difference to your long-term returns and endanger your ability to protecttheinflation-adjustedvalueofyourendowment,particularlyoncespendingistakenintoaccount.

Giventheevidencebelow,whydoinvestorscontinuetocapitulate?Theproblemisthatmoreoftenthannot,humanemotionoverridescalculatedlogic.

Source:Datastream,CazenoveCapital,FTSEAllSharetotalreturn,December2018.Past performance is not a guide to future performance.

10%p.a. US equity market

return

4%p.a. return

to a US equity investor

Source:Dalbar,2017.Returnsovera30yeartimeperiod,toendof2016.

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INVESTMENT THOUGHTS

The problem: logic vs instinctInvestorpsychologyandthebehaviouralbiasesthatleadtopoorinvestmentdecision-makingcanbeanimpediment tolong-termsuccess.Muchhaschangedoverthepastthreedecades;theavailabilityofinordinateamounts ofinformation,algorithmictrading,centrallyplannedfinancialmarketsetc.butonethingthathasnotchanged ishumannature.

LOSS AVERSION The market extrapolates the futurebasedonthepast.Supplyanddemand,company-specificnews-flow,sectortrends,geopoliticaldevelopments;allofthesehaveanimpactonshort-termmarketperformance.Whenapieceofnegativenewshitstheheadlines,weoftenactinstinctivelyandasmarketsstarttodecline,webecomefearfuloffurtherlosses.Greedisonething,butfearisquiteanother.Thelong-termevidenceinfavourofequityinvestmentcountsforagreatdeallessifyouareatrusteewhohasjustsuffereda25%fallinthevalueofyourcharity’sequityportfolio.Thosefearsarecompounded by the barrage of media outlets designed to target ouremotions–thatfantheflamesofthosefears,oftenleadingtoawithdrawalofcapitalattheworstpossibletime.Thisisalsoknown as “panic selling”.

ACTION BIASintheheightofmarketturmoil,trustees can feel that doing something is better than doing nothing.However,fromaninvestmentpointofview,short-termreactionsmighthinderlong-termgoals.Investmentprofessionalsworkinanindustrywherefreneticdealingactivityisseenasasignofconfidenceandability.Doingnothingissometimesthehardestthingtodobutfrequentlythebest.

ANCHORING The process of remaining focussed onwhathappenedpreviouslyandnotadaptingtonewdevelopmentsisknownasanchoring.Thissituationcanbeexacerbatedbyourtendencytoavoidchangingourviewsasmuchasweshouldinlightofnewinformation,andthefact that groups tend to shift decisions to the extreme when comparedtodecisionstakenbyindividuals(aprocessknown asgrouppolarisation).

HERDINGThisbehaviouralbiasreferstoourinstincttodothesameaseveryoneelse.Herdingofteninvolvespeople using the actions of others as a guide to sensible behaviour,insteadofthinkingandactingindependently.Fromanevolutionarystandpoint,itmakesperfectsense.However,applyingittothemarketcanbeahugemistake.Investorsoftenhavelimitedaccesstoinformationabouthowmarketsarelikelytodevelop,sotheybasetheirdecisionsontheactionsofothers.Inafallingmarket,herdinstinctfallsinthefaceoflogic,renderingaplummetingmarketself-fulfilling.

LogicStay the course; we know that marketsrecover…

Wearelong-terminvestors…

Volatilityisexpected.

InstinctWeneedtostoplosingmoney…

Actinginunisongivesuscomfort…

We must do something!

Thebiggestoftheseproblemsfortrusteesare“herding”and“lossaversion”.Thesetwobehaviourstendtofunctiontogether,compoundinginvestormistakesovertime.Asmarketsarerising,individualsbelievethatthecurrentpricetrendwillcontinuefor anindefiniteperiod,leadingtoeuphoria.Conversely,asmarketsfall,investorinstinctovercomeslogicandpanictakesover.

“ The stock market is a device for transferring money from the impatient to the patient” Warren Buffett

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How to prepareA“cycleofloss”startswhenaninvestorabandonstheirinvestmentsandsellsatatimewhenmarketsarelow.Thisisoftenfollowedbyfeelingsofremorseasthemarketsrecover.Theinvestoreventuallyre-investswhentheirconfidenceisrestored,oftenwhenmarketshaverecovered.Preparationhelpstopreventthiscycleofsellinglowandbuyinghigh;wesuggesta‘crisisplaybook’.

Crisis playbook:

1 Establish what a crisis would look like for your charity

Somemarketcrisesarerelativelyconfinedandhavelittleimpactonthewidereconomy.Forexample,thefall-outof1987impactedinvestorsbutdidnotreverberateintootherareas.However,moreoftenthannot,financialcrisesarelinkedtoadownturn in growth and accompanied typically by increasing unemployment and reducedincome.

Inlightoftheabove,itisprudenttoreviewthreecriticalaspectsofthecharity’sfinancialassets:

Level of liquid reserves and cash deposit risk Ensurethatenoughcashisheldtosupport spending through a crisis and that deposits are spread between a number of counterparties,orinvestedinadiversifiedcashfund.

Concentration of investment risk Diversificationofinvestmentsensurethatwhenonetypeofassetclass,industry,companyormanagerperformslesswell,theriskisspread.Thisapproachmeansthatwhilesomeinvestmentsgodown,others might perform better or stay stable andsotheoveralljourneyissmoother.Apooledmulti-assetinvestmentfundcanoftenproveacost-effectivesolutionforsmallercharities.

Concentration of revenue risk Diversificationofincomecanreducefundingrisk.Makecontingencyplansfor downsizing if you know or suspect youcouldlosefundinginadownturn.Temporaryrevenuereductionsmaybemanaged by short term expenditure prudence,whereaspermanentlossofincomemayprovokemoresignificantstrategicandoperationalmeasures.

Thefollowingquestionsmayhelptoidentify what a crisis might look like for your charity:

– How much do you rely on your investmentsforincome?Whatifdividendswerecut?Canyoufundyourspendingfromelsewheretopreventhavingtocrystallisealossinyouinvestmentportfolio?

– Doyourelyondonations/legaciesormembership/feesforincome?Howreliablewouldtheserevenuesourcesbeinafinancialcrisisorrecession?

– Will the charity be called upon for higherspendonitsbeneficiariesatatime when resources to meet those needs are impaired?

– Can you cut back on spend? Will lower income threaten the ability of the charity to operate? Can you reduce programme spend?

– Could you take cash from elsewhere if needed?

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INVESTMENT THOUGHTS

2 Examine anticipated spend in the light of your overall finances and stress-test under various scenarios

Whenstockmarketsfall,itisimportanttoavoidsellingwhenvaluesarelow.Ifthereisnocashreserve,youmayruntheriskofbecomingaforcedseller,ie.needingtoliquidateassetsregardlessofprice,simplytomeetfinancialneeds.Acashfundheldalongsideaninvestmentportfolioprovidesapoolofmoneysetasidetomeetforeseenandunforeseenexpenses.Itisnot unusual for a charity to hold between three and six months of operating costs incashtosafeguardagainstashortfall.Some charities hold as much as 18 months’inreserve.Havingabufferofcashorliquidinvestmentstodrawontocovercommitments will help smooth periodic marketfallssothattrusteesdonothavetojeopardisetheirlong-termgoals.Theriskof a lack of cash to fund short-term spend can be mitigated by prudent planning ahead of time:

– Examineyourknownshort-termliabilities,probablemedium-termliabilities and possible long-term liabilities.Isthereenoughliquidity intheportfoliotocoverthem?

– Wherepossible,modelyourspendingfor the next 18 months to ensure you haveenoughcashavailable

– Consider applying a spending rule if appropriate

– Ensureyouhavearobustreservespolicy in place

– Considercarefullyfutureinflationexpectations and ontemplate building up capital in rising markets

– Stress test your arrangements assuminga5%,10%and20%fallinequitymarkets.Ifyouplanyourspendandkeepadequatecashaside,theseshouldhavelittleimpactonyourabilitytocoverknownliabilities

3 Agree a long-term strategy and stick to it

Onethingthatthebehaviouralbiaseshaveincommonisthattheycanleadinvestorstodeviatefromasoundinvestmentstrategytailoredtowardstheirtargets,risktoleranceandtimehorizon.Aprovenwaytowardoffnegativebehavioursistoagreea strategy that focuses on the charity’s overarchinggoalsandisnotdependentonshort-termmarketconditions.Spendingduetimeandcarecreatinganinvestmentstrategy that will see you through good andbadtimesisworththeinvestmentoftime; it should be articulated in writing andcrystallisedinaninvestmentpolicystatement.Forthe‘crisisplaybook’,theareas to focus on are:

Financial objectives:

– Whatroledoyourinvestmentsplay in your balance sheet?

– How important are they compared toyourotherfinancialactivities?

Attitude to risk:

– Does your charity depend on theincome,ortotalreturnof yourinvestmentstofundannualcharitable expenditure?

– What is the attitude of the trustees tocapitalvolatility?

Horizon/ liquidity needs:

– Defineyourtimehorizon.Areyourinvestmentassetsbestdescribedaslong-term,medium-termorshort-term?Youcouldconsidersplittingyourassetstoreflectdifferenttimehorizons

– Doyouhavespecificorgeneral liquidityneeds?

4 Prepare your board psychologically and implement processes

Assumingthereisasoundinvestmentpolicystatementinplace,adequatecashsetasideandrisksaccountedfor,youcouldbeforgivenforassumingthatthepsychological element of crisis planning isunimportant.Quantitativeanalysisisnormallytheboardfocus,withvolatilityfigures,valueatrisk,historicalassetcharacteristics and performance forecasts tendingtotakecentrestage.However,thebehaviouralaspectofinvestingcanbecrucialwhenfacedwithacrisis.Thefirststepistobecognisantofourhard-wiredinstincts:actionbias,lossaversion,herdingandanchoring.Second,keepyour long-term goals in mind: read and re-readyourinvestmentpolicystatementandremindyourselfwhyitwascreated.Consideryouroriginalgoals.Aretheystillaligned with the policy?

Has anything changed? Does your mission remain the same? This should shift emphasis from short-term market thinkingtoyourlong-termaims.Third,filteryournews:mostfinancialnewsisentertainment,writtentosellpapersandgenerateclicks.Headlinesaredesigned to target your emotions and heightenanxiety.Remindyourselfthatthey are written in isolation and without anyknowledgeofyourcharity’sspecificcircumstances.Instead,findtwoorthreehighquality,objectivesourcesoffinancialcommentaryanddiscardtherest.

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Is a crisis simply a state of mind?

Assumingthestepssuggestedabovearethoughtthroughthoroughly and the practical steps considered and implementedwhereappropriate,youwillbeinagoodpositiontoweatherevenadramaticmarketstorm.

To recap:

Youknowthatinthelongrun,investorsarerewardedfortakingrisk.Avoidingriskentirelymeansavoidingreturns.

Youknowthatthebestdaysoftencomedirectlyaftertheworstandthatmarkettimingisunlikelytoaddvalue.

Youknowthebehaviouralbiasestoexpectandaremindfultoavoidthem.

Youhaveamulti-generationaltimeframeandaninvestmentpolicytomatch.Shorter-termassetsareidentifiedandappropriatelyinvested.Intheeventofadownturn,youwillhaveadequatecashtocoveryourneeds.

Youhavepreparedforadownturnwithscenarioanalysisandareconfidentthatalossinportfoliovaluewillnotjeopardisethecharity’sabilitytooperate.

Youhaveprocessesinplacetodealwithdisputes,adiverseandexperiencedboard,awatertightinvestmentpolicy,andalong-termstrategydesignedtofityourlong-termgoals.

Marketfallsareregularandcanperiodicallyturnintoacrisis,buthistoryprovesthatresistingtheurgetorushfortheexitcanreaplong-termrewards.

Some practical suggestions:

– Ensurethatyouhaveadiverse board and investment committee.Diversitybygender,background,experienceandpersonalityhavebeenproventoimprovedecisionmaking.

– Structure a committee with adequate experience.TheCharityGovernanceCoderecommendsthattrusteeswhohaveservedofficeformorethannineyearsshouldonlybere-appointedafterarigorousassessment,andstressestheneedforaprogressiverefreshingoftheboard.However,forcharitieswithinvestments,thisshouldbebalancedwiththeneedtoretaintrusteeswithsufficientinvestmentexperience.Whichmembersofthecommitteewerenotaroundin2001or2008?Havingbeeninsulatedfromtheacutechallengespreviouscrisespresented,wouldthesemembersrecoilinthefaceofanxiety? Doinexperiencedtrusteesoutnumberthosewithalonger-termperspective?Ifso,howwouldthegroupreactinacrisis?

– Investinexpandingtrustees’knowledge and take advice.Consultantsandadviserscanhelpensurethatdiscussionsare wellfacilitated,informedandtestarangeofscenarios.Goodongoingtrainingwillhelptrusteestoownandunderstand thestrategy.

– Identify a long-term return targetforyourportfolioandavoidmeasuringperformanceagainstanarbitrarybenchmark.Focusonyouroverridinginvestmentgoalsandlong-termstrategy.Historyshowsthatinanyyearthevalueofaportfolioofinvestmentswillmoveupanddown.Onewaytodealwiththis‘noise’istofactoritintoyourstrategybysettingupperandlowerparameterswithinwhichtrusteesexpecttotoleratevariation–settingarangearoundthetargetreturntorecogniseexpectationsofvolatility.

– Avoidthetemptationtoreviewyourportfolio’sperformance too regularly.Marketsareinherentlyvolatileandcheckingthevalueofyourcharity’sinvestmentsdaily,weeklyandevenmonthlycanexacerbateanxietyandencourageshort-termism.

– Understress,contentiousissuescancometothefore.Implement processestostaveoffanyinternaldisputesandavoiddecision-makingdeadlock.Intheabsenceofunanimousagreement,willtheChairhavethepowertomakeafinaldecision?Willthecommitteevoteontheissue?Willthevotingbeopenoranonymous?Processescanmakeacommitteemoredisciplinedandsystematic–agreatadvantageinturbulenttimes.

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INVESTMENT THOUGHTS

What’s a crisis?Astockmarketcrisisisdifferenttoabearmarketandtoarecession.Arecessionrelatestotheeconomyandtendstoaffectallareasofsociety.Incontrast,abearmarkettendstosignifyaperiodofnegativereturnsforequitymarkets,whereasacrisisusuallydescribesashortersharperfall.

RebalancingSystematicportfoliorebalancing,setinadvance,canhelptoremoveemotionfromthedecision-makingprocessandensureallocationtotheareasthathavefallenthemost.Rules-basedrebalancinghelpstoovercomethebehaviouralbiasesbyforcingyoutobuywhenthemarkethasfallenandsellwhenithasgoneup.

Pound cost averaging: when placing cash into the markets, what’s the best strategy? – Investingmonthlycanhelptoremovethemarkettimingissue.

– Forthosewithalumpsum,agradualdeploymentyourinvestmentoveraperiodoftimesuchasthenextfourquarters,ratherthaninonelumpsumcouldhelpyoucometotermswiththeproblem.

– Ifmarketscorrect,thenatleastyoudidn’tcommitallofyourmoney,andifthemarketscontinuetorise,thenatleastyougotsomeworkingfromtheoutset.Thismethodismoreaboutcontrolling theemotionsofinvestingratherthantheresultitselfasitallowsyouavoidtheregretthatcancomefrommakingaone-timedecisionthatgoesagainstyou.

Definition

Market crisisSudden, steep >10% losses in a

stock market index over a period of several days

Declining stock market prices measured in months/years

A fall in economic activity (GDP) for 6 months or more

Pessimism, capitulation, despondency

Anxiety, depression

Dramatic headlines, panic selling

Bear market

Recession

Psychology

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INVESTMENT THOUGHTS

The2015ParisAgreementwasamilestoneinthebattleagainstclimatechange.Itwaswhen most countries in the world pledged to put their economies on a path to restrict the increase in global temperatures to below2degreescentigradethiscentury.This is against a baseline temperature from1850,beforethewidespreadburningoffossilfuelsreallygotunderway.

In2019,wearealreadyonedegreehigherthanthispre-industrialfigure.Mitigatingthe effects of climate change is not only going to transform all aspects of the globaleconomy,butwilldiverttrillionsofdollarsofinvestmenteachyear.Policyimplications are already far-reaching and willaffectallindustriesintime.However,this creates a powerful opportunity for investors,astheimplicationsofthechangesneededtoachievethetargetare,atpresent,poorlyunderstoodby themarket.

Thefollowingfivechartsexplainsome of the broader themes around climatechange,wherethenewgrowthopportunitieswillbeandwhyinvestorsreallyneedtocare.

The Schroders Climate Dashboard1 analysesanumberofdifferentindicators,such as political ambition and fossil fuel production,togaugetheworld’sprogressinachievingthetwodegreestarget.Itis

Global transformation: tackling climate change in five charts

Isabella Hervey-Bathurst GlobalEquities team Schroders

Simon Webber LeadPortfolioManager Schroders

Addressing climate change is not only going to transform theglobaleconomy,it’sgoingtodiverttrillionsofdollarsofinvestmenteveryyear.So,whatdoesthismeanforinvestors?

Political ambition Business and finance Technology solutions Entrenched industry

Political action Carbon prices CCS capacity Fossil fuel production

3.3° 3.1° 4.9° 5.9°

Public concern Climate finance Renewable capacity Fossil fuel reserves

3.3° 4.5° 4.9°2.5°

Political ambition Corporate planning Electric vehicles Oil and gas investment

3.0° 3.3° 2.8° 4.8°

Chart 1: The scale of change needed to achieve the target is going to be significant (and the changes need to be implemented faster)

Source:Schrodersanalysisbasedonindustrysources.

1 https://www.schroders.com/en/about-us/corporate-responsibility/sustainability/climate-progress-dashboard/

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currently indicating that we are on a path toa3.8degreeincrease.

This number highlights that the scale ofchangerequiredtoachievethetwodegreestargetismuchmoresignificantthanmanypeoplethink.Andit’sgoingtohavetohappenmuchquicker.

FollowingtheGlobalFinancialCrisis,carbon prices fell as industrial production weakenedandtherewasamassivesurplusofcarboncredits.Thecarbon pricebouncedalongataroundthe€5levelforanumberofyears,whichwasn’tenoughtoincentivisecompaniestochangetheirbehaviour.

However,followingareformofthesystemin 2018 the carbon price has more than quadrupled.Itisnowatanimportantinflectionpointwhereitisreachingalevelthatisstartingtoincentivisecompaniestoswitchtousingcleantechnology.

Toachievethecurrenttargetstherewillneedtobean80%reductionpercapitain greenhouse gases in the next 30 years.Althoughthiswillprimarilyaffect

EU 1 year forward carbon price (E/t)

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Chart 2: Carbon price increases are incentivising companies to use clean technology

Source:Bloomberg,Schroders,asof31July2019.

industries such as electricity and heat production,areassuchasagriculture,forestry,land,buildings,transportandinfrastructurewillalsobeaffected.Many

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INVESTMENT THOUGHTS

industrieswillhavetodrasticallychangetheiremissionsprofile.Thisisnotjustabout building a few more solar and wind farms; this is going to be a radical transformation of the structure of the globaleconomy.

Wealsothinkthat$2trillionofnewinvestmentperyearwillbeneededintobusiness,servicesandtechnology.Moreimportantly,15%ofthevalueoftheglobalequitymarketisatrisk(equivalenttothevalueoftheentireRussianeconomy).Thisreferstobusinessesandservicesthatarenot consistent with meeting the climate changetarget,whosebusinessmodelhasbeenrenderedunviablebyrisingcarbonpricesorwhoseproductshavebeenregulatedoutofexistence.

Wehavenowreachedanimportantinflectionpointwherenewtechnologies,suchassolarandwind,havenowbecomecheaperthanthermalpowergeneration.Switching to renewable energy is not onlyessentialinthefightagainstclimatechange,butnowmakessoundeconomicsensetoo.

Use of internal combustion engines will havetobealmostcompletelyphasedoutin the next 30 years if the target to reduce greenhousegasemissionsby80%istobeachieved.However,theelectricvehicle(EV)marketismaturingfast.Inthenextfiveto10yearsEVswillnotonlybethegreenestformoftransport,butalsothecheapest.

Thisexpansionwillnotonlyprovidenewopportunities for companies supplying thevehiclesandbatteries,butalso for those making specialist battery testingequipment.

Newinfrastructure,suchasEVchargingpoints,willalsobeneeded,providingfurthergrowthopportunities.

Chart 3: What will it take to achieve the climate change target?

Chart 4: Renewable energy is now the cheapest form of energy

Chart 5: The market for electric vehicle batteries could be huge

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INVESTMENT THOUGHTS

The Social State of the Market

Thatquestionisnolongertheoretical.Havingbeenabletooperateforthelastfew decades without much concern for thesocialandenvironmentalcoststheymaybeinflicting,companiesareunderincreasing pressure to take responsibility fortheiractions,throughacombinationofhardregulationandsoftersocialpressure.Asaresult,coststhatwerepreviouslyexternalised to society will become internalisedoncompanies’financialstatements.Minimumwagelegislation,sugartaxes,gamblingrestrictions,carbon prices are spreading along with arangeofsimilarinterventionsinotherareas,creatingfinancialexpensesinplaceofpreviouslyunaccountedsocialproblems.Thatshift,acrossindustriesandcountries,willchallengeestablishedbusinessprinciples,posingsignificantriskstocompetitivepositionsandreshapingindustriesandmarkets.

SustainEx quantifies costs and benefits

Asaresult,itismoreimportantthaneverthatinvestorsconsiderthesocialimpactsofcompaniesandportfolios,ratherthanrelyingpurelyonfinancialmeasures.Howcompaniesmakemoneyisjustasimportantashowmuchtheymaketoday.WedevelopedSustainExtoprovideanobjectiveviewofthethreats

Andrew Howard Head of Sustainable Research Schroders

andopportunitiescompaniesface,expandingtheESGtoolkitwehavebuiltoverthelast20yearstohelpouranalysts,fundmanagersandclientsnavigateanincreasinglycomplexworld.

Wehaveexaminedc.9,000companies’positiveandnegativeimpactsacrossthe47areasofsocialandenvironmentalimpactourresearchhasidentified1.Thissummary synthesises that analysis to provideasnapshotofthestrongestandweakestregionsandsectors.Ithighlightstheareasofglobalequitymarketsmakingthe biggest contributions and imposing thebiggestcosts.Itgivesinvestorsanewviewofstockmarkets,lookingpasttheearnings they generate today to the risks theyfaceinthefuture.Wehaverankedsectors and countries with at least 20 companies,highlightingthoseatthetopandbottomofthoselists.

Water sector provides the biggest societal benefits

The water sector stands out at the top of thelistofsectorscontributingpositively(figure1).Accesstowaterhasbeenoneofthemostimportantdriversofeconomicandsocialdevelopmentoverthelastcentury.Today,over90%oftheworld’spopulation is connected to clean water supply,typicallyprovidedatlowprices.Thebenefitofthatserviceisfrequentlytaken

TheSustainExframeworkwehavedevelopedbringseconomicrigourtosocialandenvironmentalimpactmeasurement.Itanswersthequestion“whatbillorcreditwouldacompanyreceiveifthecostsitimposesonsociety,orthebenefitsitbrings,wererecognisedfinancially?”

forgrantedbutnolesssignificant.Thatindustry is followed by the biotech and pharmaceuticalsectors,whosemedicinesanddrugsprovidesocialbenefitsfarbigger than the earnings companies extract.Ouranalysisofthebenefitsofmedicaladvancesisbasedon12academicstudies,leadingtotheconclusionthatonaveragethosesectorsdeliverpublicsocialbenefitsalmostaslargeastheprivatesalestheygenerate.

Gambling and beverages impose the biggest costs

Unsurprisingly,givenbotharedirectlytiedtoprominentlydamagingactivities,gamblingandalcoholicbeveragecompanies stand out as most exposed to a world in which social costs are internalised asfinancialcosts.

The costs associated with gambling arediverseandrangefromcrimecosts(policingandincarcerationspending),businesscosts(lowerproductivityandlosttime),bankruptcycosts,suicidecostsandtheregulatorycostsrelatedtogovernmentoversightontheindustry.Alcoholconsumption results in both direct health andindirectsocietalcosts.Whilestudiesvary,mostshowthatcostsassociatedwith health and crime comprise around halfthetotalimpact,withindirectcostslinkedtounemployment,absenteeismand

23

productivityaccountingfortherest.Toyscomesinthirdfrombottom,reflectingthesocialcostsimposedbyvideogamedevelopers,forwhichouranalysisofacademic literature highlights material negativeimpacts.

Wide dispersion between country costs and benefits

Cutting the analysis by country highlights a wide dispersion between those whose companies are well-placed to weather the growing pressures they face and thosemorelikelytostruggle(figure2,overleaf).Swisscompaniesstandoutamongthebestprotected,giventheiraggregatepositivesocialimpact,followedbyNorthernEuropeanpeersandthetech-andinnovation-heavyUSandSingaporeanmarkets.Attheotherendofthespectrum,resource-dependent emerging markets lookparticularlyvulnerable.

Diggingdeeperintothenationalanalysis,wefindthatinmanycases,companies’impact and the risks they face are linked tothesocialprotectioncountriesprovide.

Companies used to operating in countries thatencourageresponsiblebehaviourorrestraindamagingactivitiesaregenerallybetter placed to adapt to a world in which thisisbecomingthenorm.

Figure3,overleaf,comparesthelevelofprotectiongovernmentsprovidetoworkersindevelopedcountriestothesocial impact exposure of companies listed inthosemarkets.Ingeneral,higherlevelsofgovernmentprotectionareassociatedwithgreaterpositivesocialimpacts.

The analysis looks at one aspect of corporaterestraint,buttheprincipleremains: in many case companies used to operating in countries emphasising social protection will be better prepared as those pressuresspreadglobally.

Social pressures also affect companies’ readinesstoadapttogrowingchallenges.WehaveuseddatafromtheannualSchrodersGlobalInvestorSurvey,whichasksinvestorsandconsumersin30countries how concerned they are by socialandenvironmentalissues.Countries

whosecompaniescreatelargesocialcosts,butwhereconcernoverthosecostsaregreatest–towardthetopleftquadrantoffigure4,overleaf–arelikelytofacethebiggestchallenges.

Sustainability analysis is crucial going forward

Thecorporateandinvestmentworldsfaceanincreasinglycomplexfuture.Fordecades,bothhavebecomemorefocused on today’s earnings rather than the threats or opportunities shaping futureprofitability.Thetailwindsofweakening pressure for those companies to take responsibility for the damage they create are turning into headwinds whichpromisetoreshapecompetitiveadvantagesandtorewriteinvestmentrules.Itismoreimportantthaneverforinvestorstolookbeyondheadlinefinancialfigures,takingamorecompleteviewofcompanies’prospects.Companiessucceedby adapting to changes in the social and environmentalbackdropinwhichtheyoperate;investorswilldowelltolookforthosebest-placedtodoso.

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Figure 1: The social impact of different global equity sectors

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INVESTMENT THOUGHTS

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Figure 2: The social and environmental impact of companies listed in different countries

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Figure 3: Worker rights and protection vs social impact Figure 4: Consumer sustainability vs social impact

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INVESTMENT THOUGHTS

Is Bill Gates right about the “zero” climate impact of fossil fuel divestment?BillionaireBillGatesclaimssellingsharesoffossilfuelcompaniesisineffectiveinthefightagainstclimatechangeandhashad“zero”effectonemissions.Wethinkitraisesinterestingquestionsforinvestors.

BillionaireBillGates,knownforhismanyphilanthropicinitiatives,isbecomingincreasinglyvocalonclimatechange.He’smadeitclearthathebelievesfossilfueldivestment–sellingsharesoffossilfuelcompanies–isineffectiveinthefightagainstglobalwarming.Thisisanareawhere Schroders has recently undertaken in-depthresearch.

Our view? There’s an element of truth to it.

GatesisquotedintheFinancialTimesashavingsaid:“Divestment,todate,probablyhas reduced about zero tonnes ofemissions”.

Inreality,thepictureisfarmorecomplexthanasimplelinkbetweendivestmentandcarbonemissions.Yes,weagreethatdivestmentisnotnecessarilythebestwaytopromotepositivechangebutwealsounderstandthatmanyinvestorssimplydonotwantto.Webelievethatinvestorslookingtodirectlyinfluencefossil fuel companies’ operations can be moreeffectivethroughothermeans.We

“ Divestment, to date, probably has reduced about zero tonnes of emissions”Bill Gates

proposeanewmodeltodrivechangethatcentres on tactical engagement and which restricts the supply of new capital to theindustry.

Has divestment worked?

Fossilfueldivestmentcampaignershopethatdivestingwilleventuallystarvecompaniesofcapital.SinceitsgenesisonahandfulofUScollegecampusesin2011,thefossilfueldivestmentmovementhascontinuedtospreadglobally,andnowincludespensionfunds,foundations,citiesandmunicipalities.ResearchbyOxfordUniversitysuggeststhatithasbecomethefastestgrowingdivestmentcampaigninhistory.Whilecampaignershavedoneagreatjobofraisingpublicawarenessandstigmatisingcompanies,divestmentitself has not had the desired impact on companies’operationsorviability.

According to Gates: “It’s not like [divestmenthas]capital-starved[the]people making steel and gasoline” and we agree: our research shows that attempts toremovecapitalsourceshavehadalimitedeffect.

Takethestockmarket.Thenatureofthemarketmeansthatwhenyoudivest,yousell your fossil fuel shares to a willing buyer.Inthisway,equitydivestmentdoesn’t actually impact the operations of thosecompanies,especiallyifthereareprofit-seekinginvestorswhoarewillingtobuythem.

Focusingondebtcanhaveagreaterimpactoperationally.Companiesrelyon bonds and bank loans to fund their exploration,developmentandproductionactivities,ortorefinanceexistingdebt.Thedebt funding for the industry dwarfs any newcapitalprovidedbyshareholders.

Somebankshaveceasedorhavecommittedtoceasefinancingforfossil

27

fuelprojectsandcompaniesbutotherbankshavebeenmorethanwillingtostepin;similarly,investorsarestillwillingtolend.Thenumberssayitall:theamountofdebtfinancingprovidedtotheoiland gas sector between 2010 and 2018 isestimatedatmorethan$5trillion,according to research by technology andcontentproviderDealogic.

Thesefiguresshowthatdivestmentcampaignshavehadlittleimpactoncompanies’abilitytoraisefinancing.

If divestment doesn’t limit capital to fossil fuel companies, what can be done?

Ifdivestmentstrategieshavelimiteddirectimpact,whatotheroptionsareavailable toinvestors?

Engagewithcompanies

Investorsshouldbeholdingcompaniesto

accountbyactivelyengagingwiththemtoinfluencetheirbehaviourratherthanwashingtheirhandsofthesituation.Thisapproachrequirespatience-itcantake years for a company to transition its business model to one that is less carbon-intensive.Andofcourseassetownerscanhaveevengreaterimpactbyengagingwithcompaniescollectively.

File shareholder resolutions and voteagainstmanagement

If engagement on a more informal basisfailstohavethedesiredeffect,shareholderscantakemoreformalaction.Andthey’realreadydoingit.Thenumberof shareholder resolutions related to climatechangehasrisensignificantlyinrecentyears.Thescopeoftheresolutionsvaries,butincludesthingslikereportingannually on carbon emissions and adding aclimatechangeexperttotheboard.While many of these resolutions are being supported,someofthelargestassetownersintheworldarevotingagainstthem.Havingtheseassetownersonboard could make a meaningful difference in getting companies to transition their businessmodelssooner.

Focus on the new supply of capital

To impact the companies’ operations andprofitabilityinvestorscanfocustheireffortsoncreditmarkets,aswellasonthebanksthatsupplycapitalto,andtheinsurerswhounderwrite,theindustry.Webelievethisismorelikelythandivestmenttohavearealimpactonfossilfuelcompanies.

Putpressureonpublicpolicymakers

Investorscanonlydosomuch;therealpower lies with public policy and much moreeffectivepublicpolicyisneeded. Ifwearetohaveachanceofmeetingthe2degreetarget,weneedtoseehighercarbonprices,incentivestoreduceconsumerdemandforfossilfuels,aphasing out of the sale of petrol and diesel

vehiclesandanendtothesignificantsubsidiesandexportfinancefortheindustryasawhole.Takentogether, thesubsidiesandexportfinanceprovidedto the industry by G20 nations total nearly $138billionannuallybetween2013and2015.Amere$3billionofexportfinancewasdirectedtocleanenergyprojectseachyearoverthatsameperiod,accordingto researchbyOilChangeInternational,FriendsoftheEarthUSandWWF.

These are clearly large and important sourcesoffinancefortheindustry.Redirecting the funds towards clean energy will help countries transition toalower-carbonworld.

There are better ways to protect our planet

Clearlyfossilfueldivestmentalonewillnotcurbglobalwarming.Divestmentitself hasn’t had a meaningful impact on companies’operationsorprofitabilitysofarbutcampaignershavesuccessfullytainteditsreputation.

Gates’suggestionthatinvestorsratherbacktechnologyfirmsthatareworkingtowardsagreenerworldisoneoption. Webelievetherearealsoeffectiveways to promote change in the fossil fuel industry.Investorsshouldbeactivelypushingcompaniestoimprovetheirpractices through engagement and votingefforts.Theycanalsoputfinancialpressure on operations by restricting the newsupplyofdebtcapital.Butpoliticianscanhaveafargreaterimpactontheindustrythanindividualinvestors,andsoasset owners should also be demanding more on the policy front to ensure economicincentivesandenvironmentalgoalsaremorecloselyaligned.

Whilenoneofthesearequickfixes,therecan be no denying that more action is needed to really and truly protect our planet,andthatinvestorsareanimportantpartofbringingaboutchange.

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INVESTMENT THOUGHTS

Charity Finance Roundtable:“We want to invest responsibly but a legal ruling could restrict our freedom”

Responsibleinvestinghaslongbeenofinteresttocharities,buthasbecomemoreofaliveissuesinceMarchthisyear.Thatwas when a group of charities wrote to the Charity Commission seeking urgent clarificationontheextenttowhichtheirinvestmentsshouldalignwiththeircharitableobjects.SupportedbylawfirmBatesWells,charitiesincludingRSPB,theJoseph Rowntree Foundation and Nesta askedwhethertheCommission,with theconsentoftheattorneygeneral, wouldreferaquestionabouttheoperationofcharityinvestmentlawto theCharityTribunal.

The fact that there is no regulatory requirementforcharitiestohavearesponsibleinvestmentpolicyhasledto a debate about whether the law and guidanceneedupdating.Trusteeshavedutiesnottomakeinvestmentsthat mightconflictwiththeircharity’sobjects,buttheyarealsorequiredtoprotectfinancialreturns.Sohowmuchshouldtrusteesconsiderwiderpublicbenefitwheninvesting?

Legal perspective

JamesMaloney,solicitoratFarrer&Co,

“ Charities should use the financial knowledge on their boards to enhance impact through investments”

summarisesthelegalpositiontoprovidesomecontextforthedebate.

“Thereisawidelyheldviewthatthelawneedsupdating.Thecaselawgoesbackto 1992 and the Bishop of Oxford case; this was important as it recognised for thefirsttimethattrusteescouldbringethical considerations into decisions in certaincircumstances.Forexample,ifaninvestmentwascontrarytotheaimsofthecharity or if it could hamper their work by alienatingbeneficiaries,donors orsupporters.”

Hepointstoa“vaguethirdareaoftheruling where moral considerations can be accommodated if there is no risk of significantfinancialdetriment”.Thisishelpful because its ambiguity allows trustees to make an interpretation in linewiththeircharity’scircumstances,but it also presents a challenge because trusteesmustdecidehowtodefinetheterm“significant”.“Wherethatlineshould

IanAllsopconvenedapanelofexpertstodiscussresponsibleinvestingforcharities. ThisarticleoriginallyappearedinCharityFinancemagazineinJune2019.

bedrawniskeytothiswholedebate,” hesays.

Elsewhere,Maloneyhighlightssomesmallbutsignificantlegislativechangessince1992.Forexample,the2006Companies Act included a duty on directors to promote the success of a company,havingregardindoingsotothe impact of the company’s operations onthecommunityandtheenvironment.“This is interesting because many charitiesarethemselvesincorporated,asare many of the organisations into which theyinvest.”

Healsocitesdevelopmentsinpublicbenefit,andthelastwholesaleupdateof the Commission’s CC14 guidance in 2011.“Thiswasinnovativeatthetimebut is it now outdated? While it states clearlythatcharitiescandecidetoinvestethically,itdoesnotprovideanyclearexamplesofhowcharitiesestablishedfor,say,educationalpurposescanconsider

29

theenvironmentorsustainabilitywheninvesting.Alothaschangedsince2011andthereisaprettywidespreadviewthattheguidanceneedsupdating.”

KateRogers,headofpolicyatCazenoveCharities,acknowledgesthattherearestrongopinionsbothforandagainstfirmrequirementsbeingputinplacetoforcecharitiestoinvestresponsibly.

“There is a certain sense of it being black andwhiteinpeople’sminds.Somesaythatthey don’t want someone else deciding whatis‘ethical’fortheircharity.Ifitiswrittenintolaw,theyfearthatdecision-making would be taken away from trusteesandimpacttheirabilitytofulfiltheirduties.

“Buttherearealsoverypassionatepeoplewhobelieveincrediblystronglythatallcharities,aslong-terminvestors,needtoconsiderthingslikeclimatechange,soneedtostructuretheirinvestmentsaccordingly,nomatterwhattheiraimsandmission,asitwillaffectfuturegenerationsofbeneficiaries.”

She thinks that there may in fact be some middle ground between these two positions.“Charitiescaninvestresponsiblywithoutprescriptiveguidanceon‘rightandwrong’.Therearewaystofuture-proofandinvestinawaythatisconsistentwithlong-termmissionandaimswithoutsacrificingreturns.Theperceptionthatfinancialreturnsandpublicbenefitaremutuallyexclusiveisnotalwaysaccurate.”

AnitaBhatia,investmentdirectoratGuy’sandStThomas’Charity,saysherfoundation last year launched an impact investmentstrategytobuilduponitsexistinguseofESG[environmental,socialandgovernance]criteriatoconductduediligenceonfundsandmanagers.

“Inseekinghealthimpact,welooknotonlyatinvestmentsinthehealthcareorbiotechsectors,butalsothewiderdeterminantsofhealth,forexamplehousingforthevulnerable,andtacklingmajorsocialandenvironmentalchallenges.GiventherelevanceweattributeinourendowmenttoESGconsiderationsandimpact,atribunalrulingmightfettertheflexibilityandindependencethattrusteeshavein relation to decision-making and progressingtheircharitiesmission.”

AndrewWimble,whochairstheinvestmentcommitteeattheD’OylyCarteCharitableFoundation,says:“Weliketheflexibilitysowouldbeuneasyabout someone saying from on high that youcan’tdosomething,assumingthatthingdoesn’tconflictwithourmission.How it affects stakeholders is also a consideration.Butthereisnoreasonwhywecan’tbemoreethicalandstillhavestrongreturns.”

HeobservesthatinvestingincompanieswithsoundESGpracticeshasbecomethenorm.“Goodgovernance–theGinESG–isnowagivenandithasn’thitreturns. I suspect that in ten years’ time we will be saying the same about impact investing.InsomewaysESGisyesterday’s

“ Should we divest? Other tools such as engagement and ongoing dialogue might be more effective”

Bhatia adds that there needs to be clarity aroundtermssuchasESG/sociallyresponsibleinvestment/impactinvestingifboardsaretomakeinformedinvestmentdecisions,andMirandaRichardsofthe United Westminster and Grey Coat Foundation’sinvestmentcommitteeagrees.“Weneedclarityofdefinition. Onlythencanwemoveforward.”

story,andimpactinvestingistomorrow’sstory.Howshouldyoustructureinvestmentsaccordingly?”

ResourcesdirectorNavjyotJohalsaystheCripplegate Foundation has been looking atwaystouseitsendowmenttohavegreaterimpact.“Wekeepcomingbacktolinkingtoouraims.Ifitdoesn’taffectIslington[Cripplegate’sareaofbenefit], dowehavetoworryaboutit?”

Forplace-basedfoundations,itisasignificantchallengetocalculatetheimpactonbeneficiariesinadefinedgeographicalareafrominvestmentswithawiderpublicbenefit,andmeasurethecontributiontomission.

Better board skills

Infact,impactinvestingasawholeseemsto come with a number of challenges that areoff-puttingforsome.Howdocharitiesand the fund management industry changenegativeperceptions?

Left to right (clockwise): JamesMaloney, Farrer&Co, KateRogers,CazenoveCharities,AnitaBhatia,Guy’sandStThomas’Charity,MirandaRichards,United Westminster and GreyCoatFoundation,AndrewWimble,D’Oyly Carte Charitable Foundation,NavjyotJohal,Cripplegate Foundation

30

INVESTMENT THOUGHTS

ForWimble,itisabouteducation.“Theprofessionalisation of trustee boards isvital.Thereisahugevariationinthequalityofdebate.”

Rogers agrees and says it is about using resourcestothebesteffect.“Skillsonatrusteeboardareassetsinthemselves.Charitiesshouldutilisethefinancialknowledge on their boards to enhance impactthroughinvestments.Andthereisadefiniteroleforthefundmanagementindustrytoeducate.”

Richardsobservesthattheaccountancyindustryalsohasarolebyprovidingandencouraging sustainability reporting intrustees’annualreports,whileJohalacknowledges the role of trustee training butthinksthat,ultimately,itisabouthavingtheappetitetouseinvestmentstobringaboutchange.

ForRogers,italsocomesbacktotheCommission’sguidance.“Anupdate,evenifnotbasedonalegalpositionchange,toreflectbestpracticeandcurrentthinkingcouldbereallyhelpful.Therehasbeenadefiniteincreaseincharitiesadoptingresponsibleinvestmentpolicies,witharealevolutioninpracticesincetheguidancewaslastupdated.”

Engagement rings

Rogers wonders whether some trustees think too narrowly when considering investingresponsibly.“Weneedtobroaden the perception in the lay person thatRI[responsibleinvestment]isaboutexcludingstuff.”

MaloneyobservesthatCC14referstoshareholdersengagingwithinvesteecompanies,butaskswhetheritgivesenoughconfidencetotrusteesinits

currentformat.AndWimblesaysitiseasier for trustees to exclude than to activelyengage.Hesuggests:“Perhapstheyshouldbeinvestingintocompaniesthattheydon’tlikeandbeingactiveandengagingtomakethembetter.Runningaway from the problem is not the best wayoffixingit.”

Huge resources from the fund managementindustryhavegoneintoprofessionalising the robustness of information gleaned from companies to assess impact from a sustainability point ofview,notesRogers.“Theabilitytogetmorethanone-dimensionalfinancialinformationfromcompaniesisimportant.Ifweuseitwell,wecanhavea positiveimpact.”

She thinks that charities could do more tocollaboratewithotherinvestorsandwiththefundmanagersthattheyinvestthrough.“Thepowerofanindividualclient to create discussion and promote changeisreallypowerful.Collaboratingcan increase the chance of successful engagement.Weshouldseemoreofitinthecharitysector.”

Bhatiaquestionstheeffectivenessofdivestment.“Theinvestorbaseisadiverseandbroadspectrum.RIcantakeon different meanings depending on the natureandtypeofinvestor.Withsomuchdrypowderinfinancialmarkets,oneinvestor’sdivestmentcanbeeasilyfilledwithanotherinvestor’scash,inwhichcasethedesiredoutcomeisn’tfullyachieved.

“Other tools such as engagement might bemoreeffectiveinchangingbehaviours.Throughengagement,wecaninfluencecompaniestointroduceorimprovetheirRI,ESGandimpactframeworks.”

Another concern relates to the risk that some companies and fund managers may begreenwashingtheirproducts,servicesorstrategies.

Bhatia says: “With global attention on environmentalandsocialchallenges,andindeedgrowinginvestordemandforinvestmentsthatareprovidingsustainablesolutionstothosechallenges,some companies and fund managers aremakingthemselvesouttoberesponsible,sustainableandpositivelyimpactfulwheninrealitytheyarenot.Thekeyforinvestorsistododuediligenceand monitor their companies and fund managers in a thorough and robust way so that they support those businesses that aretransparentandtrulycommittedtoRI,ESGorimpact.

Generation games

Is there a generational aspect to the whole sustainability debate? Wimble comments thatwhenhestartedininvestmentmanagement,the“JeremyClarkson”schoolofethicalinvestmentwasthe onlyone.

“Some older-style trustees think that impactinvestingisirrelevant.Theysaythatimpact is what we do with the money we spendasacharity.Theimpactcomesfromthegrant,”hesays.

Rogers mentions studies showing that millennials feel more strongly aboutpurpose-ledbusiness.“Ifyouare an organisation that relies on good people,youhavetotakeonboardtheseviews.Buttherewillbetensionswithinintergenerationaltrusteeboards.”

Employeesareincreasinglydemandingcertainbehavioursfromtheiremployer,saysRichards.“Thereisevidencethatif

31

yousegmentinvestors,thosewhoaremostinterestedinsustainableinvestmentarewomen,millennialsandtheveryrich.Ifyouareacharity,youwanttoattracttheseasdonors.”

Maloneyadds:“Goingbacktocaselaw, the Bishop of Oxford case looks at the impact of the work of charity being affectedbytheviewsofbeneficiariesandsupporters,whichsuggeststhatyoungerbeneficiariesandsupportersmustbeimportant.Shiftsinpublicopinionontheseissuesarethereforerelevanttohowcharitiesapproachresponsibleinvestment.But the law does see this as a balancing exercise and it affects different charities in differentways.”

Extreme positions

Insummarisingthedebate,panellistsdescribedtwoextremepositions.Onesideof the argument says that the Commission shouldcompelallcharitiestoinvestinasustainableway–oratleastprovidegoodreasonsnotto.Afterall,itisonlybydoingsomething completely radical that things willchange.

However,ontheotherhand,thereisalegitimateconcernthataspecificrulingmight cause trustees to become more reservedandcautiousbecauseofafearofreputationalriskandoflitigation.

Whatisdefinitelyclearisthatallcharitiesneedtohavethoughtaboutthisissue.It does not necessarily matter what their RI policy is – they need to be able to demonstratetheyhaveconsideredtheargumentsiftheyarechallenged.

32

INVESTMENT THOUGHTS

Adding return and lowering risk with private assets A burgeoning marketPrivateassetshavebeenpopularwithendowmentsandofficialinstitutions(suchassovereignwealthfundsandgovernmentpensionplans)forsometime.However,morerecently,theyhavealso been attracting increasing interest from other institutional investors.Privatedebtinparticularhascomeofageintheyearsafterthefinancialcrisis.Our2018InstitutionalInvestorSurveyfoundthataverageprivateassetallocationsareexpectedtoincreaseabove13%in2018,withgrowthacrossallmajorinvestortypesandregions.Inthispaperweaddresstwoofthemostcommonreservationswehearaboutprivateassets:

1. Whylockyourmoneyupforyears(andsometimesdecades)when there are plenty of other assets which don’t constrain you in this way?

2. AmItoolatetoinvestinprivateassets?Earlierinvestorsmayhavedoneverywellbutarevaluationsnowtoohigh?

Wecoverthemaincategoriesofprivateassets,assetoutinFigure1,below.Risk,returnandliquidityprofilesvarysignificantly.Someoffertheprospectofhigherreturns,othersgreatercertaintyofreturns.AsimplifiedsummaryofsomeofthemaincharacteristicsisshowninFigure2onthenextpage,withpublicly-tradedequities,corporatebondsandhigh-yielddebtincludedforcomparison2018purposes.Thisisnotanexhaustive

list and a discussion of the full spectrum is outside the scope ofthispaper.However,manyoftheprinciplesandargumentsintroducedcanbeappliedmorebroadly.Therestofthepaperisdevotedtoprovidingfurtherdetailsandexplanationoftheprivateassetsandcharacteristicssummarisedinthetable.

IlliquidityAkeyfeatureofprivateassetsistheirilliquidity–thisisacorereason why they can offer the prospect of higher returns – but evenherethereisgreatvariety.Moneycanbelockedawayforaslittleasafewyearstoaslongasseveraldecadesonsomeinfrastructureprojects.Furthermore,whileaninvestmentvehiclecouldhavealonglife,thiscanbebrokendownintoanumberofdifferentphases.Itwillincludeaperiodduringwhichcapitaliscommittedtoitbutnotyetdrawndown(whenitcanbeinvestedelsewherebutmaybecalledonatshortnotice),aperiodwhencapitalisdrawndownandinvested,andthenadivestmentperiod,whenassetsaresoldordebtmaturesandtheproceedsaredistributedtoinvestors.Theresultisthatcapitalisnottiedupfortheentirelifeofthevehicle.Forexample,whileprivateequitybuyoutfundstypicallyhavealifeof10to12years,individualtranches of capital will generally only be drawn down for an averageoffourtosevenyearsatatime.Itisthissecondperiodwhentheinvestmentistrulyilliquid.

Duncan Lamont Head of Research and Analytics Schroders

Private assets bring a number of potential advantages to potential portfolios, from return enhancement to reduced risk. However, increased demand means that the low hanging fruit have now largely gone. Highly attractive opportunities remain, but buyers need to be more discriminating in their sector and manager selection.

Marketing material for professional investors and advisers only

October 2018

Summary paper: Adding return and lowering risk with private assets

Duncan LamontHead of Research and Analytics

A burgeoning marketPrivate assets have been popular with endowments and official institutions (such as sovereign wealth funds and government pension plans) for some time. However, more recently, they have also been attracting increasing interest from other institutional investors. Private debt in particular has come of age in the years after the financial crisis. Our 2018 Institutional Investor Survey found that average private asset allocations are expected to increase above 13% in 2018, with growth across all major investor types and regions1.

In this paper we address two of the most common reservations we hear about private assets:

1 Why lock your money up for years (and sometimes decades) when there are plenty of other assets which don’t constrain you in this way?

2 Am I too late to invest in private assets? Earlier investors may have done very well but are valuations now too high?

We cover the main categories of private assets, as set out in Figure 1, below. Risk, return and liquidity profiles vary significantly. Some offer the prospect of higher returns, others greater certainty of returns. A simplified summary of some of the main characteristics is shown in Figure 2 on the next page, with publicly-traded equities, corporate bonds and high-yield debt included for comparison 1 Schroders Institutional Investor Survey, 2018

purposes. This is not an exhaustive list and a discussion of the full spectrum is outside the scope of this paper. However, many of the principles and arguments introduced can be applied more broadly. The rest of the paper is devoted to providing further details and explanation of the private assets and characteristics summarised in the table. For more details, please see the full version of this paper.

IlliquidityA key feature of private assets is their illiquidity – this is a core reason why they can offer the prospect of higher returns – but even here there is great variety. Money can be locked away for as little as a few years to as long as several decades on some infrastructure projects. Furthermore, while an investment vehicle could have a long life, this can be broken down into a number of different phases. It will include a period during which capital is committed to it but not yet drawn down (when it can be invested elsewhere but may be called on at short notice), a period when capital is drawn down and invested, and then a divestment period, when assets are sold or debt matures and the proceeds are distributed to investors. The result is that capital is not tied up for the entire life of the vehicle. For example, while private equity buyout funds typically have a life of 10 to 12 years, individual tranches of capital will generally only be drawn down for an average of four to seven years at a time. It is this second period when the investment is truly illiquid.

Source: Schroders

Figure 1: Private assets – the main categories

Private equity

Direct lending / SME lending

Infrastructure equity

Infrastructure debt

Real estate equity

Real estate debt

DebtEquity

1

Figure 1: Main categories of Private Assets

Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

33

34

INVESTMENT THOUGHTS

Figure 2: A bird’s eye view of the private asset landscape

Holding period of underlying investments

(years) GBP yield (%)*Credit spread

(%)

Extent of investor control Alpha potential

High potential returns

Stable income generating Security

Low risk of capital

loss (single investment)

Low risk of capital loss (portfolio)

Equity diversifier

Government bond

diversifier

Equi

ty

Global equities Daily liquidity 2-3 n/a √ √ √√ X XX XX XX XX √√

PE: large buyout 4-7 n/a n/a √√ √√ √√ XX XX XX XX XX √

PE: small/mid buyout 4-7 n/a n/a √√ √√ √√ XX XX X X √ √√

PE: venture capital 5-8 n/a n/a √√ √√ √√ XX XX XX X √√ √√

Infra equity 10+ 5 n/a √√ √√ √ √ X X X √ √

Real estate 4-6 4-5 n/a √√ √√ √ √√ X X X √ √

Deb

t

IG corporate bonds Daily liquidity 2-3 1.0-1.5 XX X XX √√ X √√ √√ √√ XX

Senior infra debt 10+ 3.5-4.5 1.75-2.25 √ X XX √√ √√ √√ √√ √√ XX

Senior real estate debt*** 5-7 2.5-3.5 1.0**-2.5 √ X XX √√ √√ √√ √√ √√ √√

High yield debt Daily liquidity 4-5 3-4 XX √ √ √ XX X X √ √

Junior infra debt*** 5 5-6 4-5 X X √ √ √ √ √ √√ √√

Mid-market direct lending*** 3 5-7 4-6 √ √ √ √ X X X √√ √√

SME lending*** 5 8-11 7-10 √ √ √√ √ X X X √ √√

Reporting dates vary. Analysis based on the most up to date data obtainable as at June 2018. Infra = infrastructure, IG = investment grade, SME = small and medium-sized enterprise

Although they do not normally have a formal credit rating, senior infrastructure debt and senior real estate debt share characteristics with investment grade corporate bonds, in terms of credit quality. Similarly, junior infrastructure debt, mid-market lending and SME lending share characteristics with high yield (sub-investment grade) debt.* Currency exposure assumed to be unhedged for equity investments and hedged for debt investments. GBP shown for illustrative purposes only to permit comparison across assets. Equity yields unchanged in other currencies. Hedged debt yields vary according to interest rate differentials. For example, as at 31 July 2018, USD-hedged yields would be approximately 1.6% higher than those shown, EUR-hedged yields 1.2% lower and JPY-hedged yields 0.9% lower.

** Lower end of range is for Germany. *** Typically floating rate debt, paying a coupon which increases with interest rates

Categories above are not exhaustive and are shown for illustrative purposes only.

Sources: Bank of America Merrill Lynch, Callan Associates, CBRE, De Montfort University, Ernst & Young, International Property Forum, NEOS, Preqin, Schroders and Thomson Reuters Datastream,

Reportingdatesvary.AnalysisbasedonthemostuptodatedataobtainableasatJune2018.

Infra=infrastructure,IG=investmentgrade,SME=smallandmedium-sizedenterprise

Althoughtheydonotnormallyhaveaformalcreditrating,seniorinfrastructuredebtandseniorrealestatedebtsharecharacteristicswithinvestmentgradecorporatebonds,intermsofcreditquality.Similarly,juniorinfrastructuredebt,mid-marketlendingandSMElendingsharecharacteristicswithhighyield(sub-investmentgrade)debt.

*Currencyexposureassumedtobeunhedgedforequityinvestmentsandhedgedfordebtinvestments.GBPshownforillustrativepurposesonlytopermitcomparisonacrossassets.Equityyieldsunchangedinothercurrencies.Hedgeddebtyieldsvaryaccordingtointerestratedifferentials.Forexample,asat31July2018,USD-hedgedyieldswouldbeapproximately1.6%higherthanthoseshown,EUR-hedgedyields1.2%lowerandJPY-hedgedyields0.9%lower.

Figure 2: Main Characteristics of Private Assets

35

Figure 2: A bird’s eye view of the private asset landscape

Holding period of underlying investments

(years) GBP yield (%)*Credit spread

(%)

Extent of investor control Alpha potential

High potential returns

Stable income generating Security

Low risk of capital

loss (single investment)

Low risk of capital loss (portfolio)

Equity diversifier

Government bond

diversifier

Equi

ty

Global equities Daily liquidity 2-3 n/a √ √ √√ X XX XX XX XX √√

PE: large buyout 4-7 n/a n/a √√ √√ √√ XX XX XX XX XX √

PE: small/mid buyout 4-7 n/a n/a √√ √√ √√ XX XX X X √ √√

PE: venture capital 5-8 n/a n/a √√ √√ √√ XX XX XX X √√ √√

Infra equity 10+ 5 n/a √√ √√ √ √ X X X √ √

Real estate 4-6 4-5 n/a √√ √√ √ √√ X X X √ √

Deb

t

IG corporate bonds Daily liquidity 2-3 1.0-1.5 XX X XX √√ X √√ √√ √√ XX

Senior infra debt 10+ 3.5-4.5 1.75-2.25 √ X XX √√ √√ √√ √√ √√ XX

Senior real estate debt*** 5-7 2.5-3.5 1.0**-2.5 √ X XX √√ √√ √√ √√ √√ √√

High yield debt Daily liquidity 4-5 3-4 XX √ √ √ XX X X √ √

Junior infra debt*** 5 5-6 4-5 X X √ √ √ √ √ √√ √√

Mid-market direct lending*** 3 5-7 4-6 √ √ √ √ X X X √√ √√

SME lending*** 5 8-11 7-10 √ √ √√ √ X X X √ √√

Reporting dates vary. Analysis based on the most up to date data obtainable as at June 2018. Infra = infrastructure, IG = investment grade, SME = small and medium-sized enterprise

Although they do not normally have a formal credit rating, senior infrastructure debt and senior real estate debt share characteristics with investment grade corporate bonds, in terms of credit quality. Similarly, junior infrastructure debt, mid-market lending and SME lending share characteristics with high yield (sub-investment grade) debt.* Currency exposure assumed to be unhedged for equity investments and hedged for debt investments. GBP shown for illustrative purposes only to permit comparison across assets. Equity yields unchanged in other currencies. Hedged debt yields vary according to interest rate differentials. For example, as at 31 July 2018, USD-hedged yields would be approximately 1.6% higher than those shown, EUR-hedged yields 1.2% lower and JPY-hedged yields 0.9% lower.

** Lower end of range is for Germany. *** Typically floating rate debt, paying a coupon which increases with interest rates

Categories above are not exhaustive and are shown for illustrative purposes only.

Sources: Bank of America Merrill Lynch, Callan Associates, CBRE, De Montfort University, Ernst & Young, International Property Forum, NEOS, Preqin, Schroders and Thomson Reuters Datastream,

**LowerendofrangeisforGermany.

***Typicallyfloatingratedebt,payingacouponwhichincreaseswithinterestrates

Categoriesabovearenotexhaustiveandareshownforillustrativepurposesonly.

Sources:BankofAmericaMerrillLynch,CallanAssociates,CBRE,DeMontfortUniversity,Ernst&Young,InternationalPropertyForum,NEOS,Preqin,SchrodersandThomsonReutersDatastream,Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

36

INVESTMENT THOUGHTS

1. Why private assets?Therearefourwaysinwhichprivateassetscanpotentially addvalue:

1.1Providehigherreturns

1.2Giveaccesstoabroaderrangeofexposures,industriesoroutcomes

1.3Reducerisk(volatilityand/orriskofloss)

1.4Adddiversificationbenefits

1.1 Higher returnsAnattractionofprivateassetsistheirabilitytoearnahigherreturnthanpublicequivalents.AsshowninFigure3,privateequityhashandsomelyoutperformedpublicequityovertime.Thesameisalsotrueofprivateinfrastructureequity,whichhasoutperformedpublicinfrastructureequityby1.3%ayearoverthepastdecade.Attentionoftenfocusesonthehigherfeeschargedbyprivateassetinvestmentmanagers,buttheseresultsarenetofallfees.Inthefixedincomeworld,privatedebtcommandsacreditspreadpremiumoverpublicmarketswithouttheneedtotakeonadditionalcreditrisk,ashighlightedinFigure2.Intoday’sworldoflowreturnexpectations,thisreturnpremiumhastakenonaddedimportance.

Real estate’s experience is more mixed as listed real estate investmenttrusts(REITs)haveactuallyoutperformedprivatecorerealestatefundsoverthelongrun,althoughthiscanbeexplainedbythehigherleverageinREITs(whichalsomakes themmorevolatile).

Alargepartofthereturnpick-upinprivateassetsarisesbecausetheirilliquiditymeanstheyarelessattractivetomanyinvestors.Thiscanresultinanilliquiditypremium,areductioninthepriceoradditionalyieldtocompensateforhavingmoneytiedup.

Inreality,themagnitudeoftheadditionalreturnofferedbyprivateassetsisnotduesolelytoilliquiditybutalsotootherfactorsliketransactionsize,complexityandthedealsourcingabilityofaninvestmentmanager.

Anotheradvantageisthatinvestmentmanagersinprivatemarketshavemoreleversattheirdisposaltoimprovereturns(Figure4).Theyaremuchmorehands-onthantheirpublicequivalentsandhaveaccesstoawiderrangeofinformationinatimeliermannerthanispossibleinpublicmarkets.Privateequitygeneralpartnersroutinelyinfluencecorporatestrategyandappointdirectorsandmanagement.Realestatemanagersactivelymanageleaseextensionsandbuildingrefurbishments.Privatedebtmanagersnegotiatecovenantswhichgivethemgreaterprotectionthanwouldbestandardincorporatebonds.Insomecases,thesegivethemtherighttostepinanddirectstrategyifaborrowerisstruggling.

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Real estate’s experience is more mixed as listed real estate investment trusts (REITs) have actually outperformed private core real estate funds over the long run, although this can be explained by the higher leverage in REITs (which also makes them more volatile).

A large part of the return pick-up in private assets arises because their illiquidity means they are less attractive to many investors. This can result in an illiquidity premium, a reduction in the price or additional yield to compensate for having money tied up.

In reality, the magnitude of the additional return offered by private assets is not due solely to illiquidity but also to other factors like transaction size, complexity and the deal sourcing ability of an investment manager.

Another advantage is that investment managers in private markets have more levers at their disposal to improve returns (Figure 6). They are much more hands-on than their public equivalents and have access to a wider range of information in a timelier manner than is possible in public markets. Private equity general partners routinely influence corporate strategy and appoint directors and management. Real estate managers actively manage lease extensions and building refurbishments. Private debt managers negotiate covenants which give them greater protection than would be standard in corporate bonds. In some cases, these give them the right to step in and direct strategy if a borrower is struggling.

The private debt return advantage over public marketsAs well as a higher credit spread or yield, private debt comes with the added attraction that it is normally exposed to a lower risk of loss than equivalent-rated corporate bonds. This has one of two drivers (or both in some cases):

1. Lower average default rates2. Higher average recovery rates

Infrastructure debt scores highly on both metrics. The projects themselves are less susceptible to default risk than the broader corporate sector and the debt is secured on an underlying physical asset, such as an airport or toll road. This boosts recovery rates in the event of a default - the most common recovery rate has been 100%, meaning most investors have incurred no losses at all, even when there has been a default.

1. Why private assets?There are four ways in which private assets can potentially add value:

1.1 Provide higher returns1.2 Give access to a broader range of exposures,

industries or outcomes1.3 Reduce risk (volatility and/or risk of loss)1.4 Add diversification benefits

1.1 Higher returnsAn attraction of private assets is their ability to earn a higher return than public equivalents. As shown in Figure 3, private equity has handsomely outperformed public equity over time. The same is also true of private infrastructure equity, which has outperformed public infrastructure equity by 1.3% a year over the past decade. Attention often focuses on the higher fees charged by private asset investment managers, but these results are net of all fees. In the fixed income world, private debt commands a credit spread premium over public markets without the need to take on additional credit risk, as highlighted in Figure 2. In today’s world of low return expectations, this return premium has taken on added importance.

Figure 3: Private assets have typically outperformed, net of fees

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Past performance is not a guide to future performance and may not be repeated

For illustrative purposes only. US large cap is S&P 500 index; US small cap is Russell 2000 index; private equity is PrEQIn index; All figures are total returns and private equity returns are net of fees. Sources: FTSE Russell, Preqin, Standard & Poors and Thomson Reuters Datastream.

Figure 4: Sources of added value

Factor Source of add value Public market Private market

Market timing Deciding appropriate entry/exit point √ √

Stock selection Identifying most attractive opportunities √ √

Negotiations Ability to negotiate attractive entry price/conditions X √

Operational improvement “Hands-on” approach with ability to effect change ~ √

Leverage Ability to boost equity returns and instil financial discipline at portfolio companies

~* √

* The ability of public market investors to influence a company’s capital structure is more limited than in private equity. The efforts of activist investor are the main exception. Individual investors can borrow to invest in the stock market, but the additional risks associated with this strategy, including the need to make margin payments, mean that this is relatively uncommon.Source: Schroders

3

Figure 3: Returns to 31 December 2017 (%)

Figure 4: Sources of additional return in private markets

Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

Past performance is not a guide to future performance.

37

The private debt return advantage over public markets

Aswellasahighercreditspreadoryield,privatedebtcomeswiththe added attraction that it is normally exposed to a lower risk of lossthanequivalent-ratedcorporatebonds.Thishasoneoftwodrivers(orbothinsomecases):

1.Loweraveragedefaultrates

2.Higheraveragerecoveryrates

Infrastructuredebtscoreshighlyonbothmetrics.Theprojectsthemselvesarelesssusceptibletodefaultriskthanthebroadercorporate sector and the debt is secured on an underlying physicalasset,suchasanairportortollroad.Thisboostsrecoveryratesintheeventofadefault-themostcommonrecoveryratehasbeen100%,meaningmostinvestorshaveincurrednolossesatall,evenwhentherehasbeenadefault.

Thesecurednatureofrealestatedebtalsoprovidesprotectionfromlosses,especiallynowthatfinancingstructuresaremoreconservativethaninthepast.Averageloan-to-valueratiosonEuropeancommercialrealestatearenowaround50%,meaninga50%declineinvaluewouldnowberequiredbeforeseniordebtholderswouldbeexposedtotheriskofloss.

Lendingtosmallandmid-marketcompaniesisgenerally“sub-investmentgrade”(sometimesreferredtoashighyield)riskbuttheuniverseishighlydiverseandcanbeonanunsecuredbasis.However,evenhere,recoveryratesof40-50%arehigherthanonnormalcorporatebonds.

A combination of higher credit spreads and lower expected credit lossescombinetogreateffectforprivatedebt.(Figure5).

1.2 Access to a broader range of exposures, industries or outcomes

Forcertainassets,thepublicmarketcapturesonlyasmallsubsetoftheoverallmarket.ThisisaparticularissueinEuropeandebtmarkets,whereonlyaround20%ofcorporatefinancinghashistoricallybeenprovidedbycapitalmarkets,withthevastmajorityoftherestbeingprovidedbythebanks.Withthepost-crisisretrenchmentofthebankingsectorinEurope,thereisnowanattractiveopportunityforinstitutionalinvestorstostepinandfillthevoidleftbehindbythebanks.Thisopportunityisonlyaccessibleinprivatemarkets.

The narrower focus of the public market can also result in sector orregionalallocationsthatmisrepresentthebroaderassetclass.Thepublicinfrastructuredebtmarket,forexample,is90%utilitiesand60%USdollardebt,apoorreflectionofthemoregloballyandsectorallydiversifiedinfrastructureindustry.

Publicequityandbondmarketsalsotendtobeopenonlytolargerissuers,giventhecostsofacquiringandmaintaining publicstatus.

Afurtherissueisthat,foravarietyofreasons,companiesareincreasinglyturningtheirbackonpublicequitymarketsandpreferringtostayprivateforlonger,ifnotindefinitely.Investorsfocusedsolelyonpublicmarketsriskmissingout.

1.3 Lower riskPrivateassetsexhibitlowervolatilitythanpublicmarkets.However,measuringandunderstandingriskinprivateassets ischallenging.

The secured nature of real estate debt also provides

structures are more conservative than in the past. Average loan-to-value ratios on European commercial real estate are now around 50%, meaning a 50% decline in value would now be required before senior debt holders would be exposed to the risk of loss.

Lending to small and mid-market companies is generally “sub-investment grade” (sometimes referred to as high yield) risk but the universe is highly diverse and can be on an unsecured basis. However, even here, recovery rates of 40-50% are higher than on normal corporate bonds.

A combination of higher credit spreads and lower expected credit losses combine to great effect for private debt. (Figure 5, right hand chart).

1.2 Access to a broader range of exposures, industries or outcomesFor certain assets, the public market captures only a small subset of the overall market. This is a particular issue in European debt markets, where only around 20%

capital markets, with the vast majority of the rest being provided by the banks. With the post-crisis retrenchment of the banking sector in Europe, there is now an attractive

the void left behind by the banks. This opportunity is only accessible in private markets.

The narrower focus of the public market can also result in sector or regional allocations that misrepresent the broader asset class. The public infrastructure debt market, for example, is 90% utilities and 60% US dollar debt, a poor

infrastructure industry.

Public equity and bond markets also tend to be open only to larger issuers, given the costs of acquiring and maintaining public status.

A further issue is that, for a variety of reasons2, companies are increasingly turning their back on public equity markets

Investors focused solely on public markets risk missing out.

1.3 Lower riskPrivate assets exhibit lower volatility than public markets. However, measuring and understanding risk in private assets is challenging.

While there can be fundamental reasons why certain private assets could be considered lower risk than their public peers, this is also partly down to the fact that valuations are only updated infrequently, if at all, and are not always tested against public market prices (“marked to market”). Both features dampen volatility. In the main version of this paper we discuss some of the possible approaches to tackling this issue and this is a subject we intend to return to in future work.

Putting aside measurement issues, there are a number of fundamental drivers of private asset volatility that can be qualitatively appreciated:

– Infrastructure’s reduced sensitivity to the economic cycle and the contractual nature of real estate leases provide more stable underpinnings to returns than in public equities.

– For a given asset, a more leveraged investment is riskier than a less leveraged one. This would suggest that large buyouts are riskier than public equities…but small and mid cap buyouts are less highly leveraged and some other strategies employ little or no leverage at all.

2 What is the point of the equity market?, Schroders, April 2018.

Figure 5: A win-win for private credit from higher credit spreads and lower loss rates Higher credit spreads (%) Lower credit loss rates (%) Higher net credit spreads (%)

Note: IG and HY corporate bond credit loss rates incorporate default losses (default rates adjusted for recovery rates) and price changes arising from changes in credit quality (net downgrade losses). Investors in private debt will not generally experience downgrade losses (or upgrade gains) as the credit spread component typically remains unchanged

De Montfort University, NEOS, Preqin and Schroders

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Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

38

INVESTMENT THOUGHTS

Whiletherecanbefundamentalreasonswhycertainprivateassetscouldbeconsideredlowerriskthantheirpublicpeers,thisisalsopartlydowntothefactthatvaluationsareonlyupdatedinfrequently,ifatall,andarenotalwaystestedagainstpublicmarketprices(“markedtomarket”).Bothfeaturesdampenvolatility.

Puttingasidemeasurementissues,thereareanumberoffundamentaldriversofprivateassetvolatilitythatcanbequalitativelyappreciated:

– Infrastructure’sreducedsensitivitytotheeconomiccycleandthecontractualnatureofrealestateleasesprovidemorestableunderpinningstoreturnsthaninpublicequities.

– Foragivenasset,amoreleveragedinvestmentisriskierthanalessleveragedone.Thiswouldsuggestthatlargebuyoutsareriskierthanpublicequities…butsmallandmidcapbuyoutsarelesshighlyleveragedandsomeotherstrategiesemploylittleornoleverageatall.

– Enhancedaccesstotimelyinformationandtheabilitytodomuch deeper due diligence helps to mitigate the risk of any individualinvestment.

– Someofthevolatilityinpublicmarketsisdrivenbyfearandgreedratherthanunderlyingfundamentals.Privateassetinvestorsaretypicallyunabletoselltheirstakesinsuchanenvironment,preventingthemfrommakingthesamebehaviouralmistakes.

Notwithstandingthedesiretofitprivateassetsintoatraditionalrisk/returnframeworkwhichallowseasycomparisonwithotherassetclasses,abiggerquestioniswhethervolatilityisreallytherightmeasureforinvestorsinprivateassetstobelookingat?Itmeasureshowbumpytherideis,butthatissomewhatmeaninglessforaprivateassetinvestorwhohascommittedthemselvestolockingtheirmoneyupforaperiodofseveralyears.Riskofcapitallossisamoreworthyfocusandthiscanbeshowntobemorefavourableinmanyprivateassetscomparedwiththeirpublicequivalents.

1.4 Diversification benefitsGiventheirdifferingunderlyingexposuresandreturndrivers,privateassetsofferdiversificationbenefitscomparedtopublicmarkets.Thesevarybyassetclassandmarket.Analysisofcorrelationsrunsintodifficultiesgiventhechallengesinassessingvaluations.Abetterapproachistolookthroughtotheunderlyingexposures.Forexample,economicallysensitiveassetsarelikelytohavesimilarunderlyingreturndriverstoequitymarketswhereasthereturnprofileforotherscanbequitedifferent.Figure6providesindicativeguidanceabouttherelativestrengthofrelationshipthatvariousprivateassetshavewithreturnsfrompublicequityandgovernmentbondmarkets.

2. Am I too late?Demandforprivateassetshasacceleratedinrecentyears.Anunfortunateconsequenceisthattherehasbeentoomuchmoney

lookingforahome.“Drypowder”,moneythathasbeenraisedbutnotyetdrawndown,isatrecordlevels.Increasedcompetitionforassetshaspushedpricesup.However,thispressurehasnotbeenuniversal.Forexample,ourproprietarySchroderAdveqFundRaisingIndicator(SchroderAdveqFRI),developedtoassistinvestorsinassessingtheprivateequitylandscape,highlightsadividedmarket.Itsuggeststhatinvestorswouldbewisetoprioritiseexitsinthelargebuyout,late-stageventure/growth andChineserenminbimarkets.Fornewinvestments,morefavourableconditionsexistinsmall/midbuyouts,earlystageventurecapitalandincertainemergingmarkets.Similardifferentiationcanbeseeninrealestateandinfrastructureequitymarkets.Onthedebtside,themarketforlong-datedseniorinfrastructuredebtishighlycompetitivebutthejuniormarketisfarlessso.Thelargerendoftheprivatecorporatedebtmarkethasalsobecomeverycrowded,withrecordvolumesofcapitalraised.However,thesmallerendofthemarketremainslesswellserved.Ingeneralterms,thelowhangingfruithavenowlargelygone.Highvaluationsincreasetheriskofoverpaying.

Theilliquidityofprivateassetsmakesthisabiggerproblembyfuellingregretrisk.However,asillustratedintheexamplesaboveandinFigures2and5,manypartsoftheprivateuniversecontinuetooffergoodvalue.Atthisstageofthecycle,investorsneed to be more discerning about where and with whom they investtheirmoney.

3. Practical considerationsAnotablefeatureofprivateassetsisthewiderdispersionofreturnsthaninpublicmarkets.ThedifferenceinreturnbetweentopandbottomquartileUSprivateequitymanagershasbeenaround15%,onaverage(figure7).Managerselectionisthereforemoreimportantthanever.

Investinginprivateassetsalsointroducessomefreshchallenges.Thecashflowprofileofaninvestor’sliabilities–suchastheneedto make payments to members of a pension scheme for instance –hasimplicationsfortheamounttheycanaffordtoinvestinilliquidassets.However,inourexperience,mostinvestorshavegreatercapacitytoinvestinilliquidassetsthantheyrealise.

Inaddition,privatedebt,infrastructureandrealestateequity areallhighlycashgenerativeandcanbeusedtohelpmeetcashflowliabilities.

Asecondelementofliquiditymanagementisthepracticalissueofmanagingwithdrawalsofcapitalandfurtherinvestmentstoensureexposuretoanassetclassisbuiltupandmaintained,ifdesired.Decisionsmustbemadeabouthowcommittedcapitalisinvestedtoensureitisavailablewhencalledupon,withoutdetractingfromaninvestor’soverallobjectives.Adetaileddiscussion of these topics is outside the scope of this paper but theyshouldbecarefullyconsideredbeforeaninvestmentinprivateassetsisundertaken.

Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

39

– Enhanced access to timely information and the ability to do much deeper due diligence helps to mitigate the risk of any individual investment.

– Some of the volatility in public markets is driven by fear and greed rather than underlying fundamentals. Private asset investors are typically unable to sell their stakes in such an environment, preventing them from making the same behavioural mistakes.

traditional risk/return framework which allows easy comparison with other asset classes, a bigger question is whether volatility is really the right measure for investors in private assets to be looking at? It measures how bumpy the ride is, but that is somewhat meaningless for a private asset investor who has committed themselves to locking their money up for a period of several years. Risk of capital loss is a more worthy focus and this can be shown to be more favourable in many private assets compared with their public equivalents. The full version of this paper includes more detail on this topic.

Given their differing underlying exposures and return

compared to public markets. These vary by asset class and market.

challenges in assessing valuations. A better approach is to look through to the underlying exposures. For example, economically sensitive assets are likely to have similar underlying return drivers to equity markets whereas the

provides indicative guidance about the relative strength of relationship that various private assets have with returns from public equity and government bond markets.

Figure 6: Private assets have different underlying risks to public markets

Asset-backing/security Investor protections /covenants

Superior access to information for active manager

Long term nature shields from short term noise

Illiquidity LeverageMore limited valuation

transparency for end investor

Concentrated individual funds

Elevated performance dispersion between

funds

Source: Schroders

Figure 7: Sensitivity to public equity and bond markets varies by sectorIllustrative relationships

Note: gov = government, corp = corporate, infra = infrastructure, opp. = opportunistic, RE = real estate, SME = small and medium-sized enterprises

Source: Schroders

Corpbonds

Relationship with government bond returns +Gov

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ConclusionPrivate markets offer a rich variety of investment options. They provide a return uplift over public markets and, in some cases, a reduction in risk. Prices have risen but attractive opportunities remain. In the more competitive markets, access to deals has grown in importance as a source of alpha. At this stage in the cycle investors need to be more discriminating in where they invest and who they appoint to manage their money.

Investors should recognise that the interests in private asset investments will rise and fall in value. Investors should only invest in private assets (and other similar illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. Past performance of an investment is no guarantee of its current and future performance.

Figure 6: Illustrative relationships between private assets and public bond and equity markets

Figure 7: Interquartile range for US private equity net internal rates of return by vintage year, %

Past performance is not a guide to future performance.

40

SECTOR THOUGHTS

NCVO Almanac 2019

WeareproudtosponsortheNCVOUKCivilSocietyAlmanac2019,whichgivesauniquepictureoftheUKvoluntarysector’sfinancialhealth.Availableatdata.ncvo.org.uk

166,854UK charities

owning

£131bn total assets

£102bn investment

assets 67% of the total assets

own

41% of investment assets

with each investing over £1bn*7

organisations

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* Wellcome Trust alone owns 23%

41

*Thegrant-makingarmofBridgeHouseEstatesis City Bridges Trust

Foundation Giving Trends 2019WearepleasedtobeanofficialpartneroftheAssociationof CharitableFoundations.TheirFoundationGivingTrendsseriespresentsannualresearchonthespending,incomeandassetsoftheTop300philanthropically-fundedfoundations.

Key findings included:

Assets: Top 300 foundations net assets reached a record £67billioninvaluein2017/18,howeveroverallgrowthratessloweddramatically,rangingfromlowtonegative.Incomefrominvestmentsfellforthefirsttimein5years.

Theownershipofassetsishighlyskewed.Thetopsevenfoundationsbyassetvalueeachhavemorethan£1billion innetassets,representingalmosttwo-thirdsofTop300 assets(62%).

Grant-making: Almost two-thirds of foundations in the Top 300(193)madeareal-termsincreaseingrant-makingin2017/18.Themajorityofthese(146)alsoexperiencedafallintheirincome,assets,orboth.Grantswereworth£2.6billionandgrewbyarealannual9.9%(exWellcomeTrust).

Social Investment:Thelevelofsocialinvestmentcontinuestogrow(+23%),albeitfromlowlevels.Thirty-fourTop300foundations(11%)identifiedprogramme-related,mission-relatedorsocialinvestmentsintheirbalancesheet,annualreportnarrativeornotestotheiraccounts,worth£146million.

Formoreinformationandtodownloadacopyofthereport,pleasevisittheACFwebsite: https://www.acf.org.uk/policy-practice/research-publications/foundation-giving-trends-2019

Top 10 foundations by net assets

A/C yearNet asset

£million

1 Wellcome Trust Sept 2018 24,200.1

2GarfieldWestonFoundation

Apr 2018 9,933.8

3Children’s InvestmentFundFoundation

Dec2017 3,838.7

4 LeverhulmeTrust Dec 2018 3,178.0

5Bridge House Estates*

Mar 2018 1,395.8

6 Henry Smith Charity Dec2017 1,010.9

7The Health Foundation

Dec2017 1,008.8

8EsméeFairbairnFoundation

Dec 2018 997.3

9PaulHamlynFoundation

Mar 2018 755.1

10Wolfson Foundation

Apr 2018 739.2

42

SECTOR THOUGHTS

Foundation Horizon Scan

Geoff Mulgan CEO,Nesta

Philanthropicfoundationstendtoblossomwheneconomiesaregoingthroughperiodsofprofoundchange.Thelasttwodecadeshave,inthissenseatleast,beenpropitious.

Vastamountsofwealthhavebeenaccumulatedindigitalindustries.Hugefortuneshavebeengrowninwhatusedtobecalled‘emergingeconomies’.Astretcheddistributionofwealththathasfavouredthetop1percent,andevenmorethetop0.1percentand0.01percenthasmeantthatmanypeoplehavefarmoremoneythantheycaneasilyspend onthemselves.

Thatexplainsthegrowthinsupply,justasattheturnofthe19thand20thcenturiesphilanthropywasanobviousoutletforapreviousgenerationofindustrialtitans.Then,Carnegie,RockefellerandFordusedtheirmoneytodogoodbut also to gain credit and to distract attention from the often questionablewaystheyhadmadetheirfortunes.Thesamemixofmotivesandresponsesisvisibletoday.

Whatofthedemand?Herethepictureismorecomplex.Ontheonehand,mostpeoplewouldprefertoseemoneybeingspentonsocialgoodratherthanyetanotherlavishhomeorsportscar.Philanthropymeansloveofhumanity–whocouldbeagainstthat?Socialandenvironmentalactionneedsatleastsomemoneytofuelit,andhelptheworldprotecteverythingfromthreatenedoceanstodividedcommunities.

Ontheotherhand,manyfearthatphilanthropyisasuperficialresponsetodeepquestions,thatitdistractsattentionfromthereal causes of social problems and that it makes people who arealreadypowerfulintheeconomyevenmorepowerfulinsocietytoo.

Themoodhascertainlyshiftedfromafewyearsago.Thentherewasmuchtalkofphilanthrocapitalism,ofthenewlywealthysolvingsocialproblemswhichgovernmentsandtraditionalcivilsocietyhadfailedtosolve.Nowthere’salotmorehumility.Philanthropyhasmadeabigimpactonsomeissues,notablydiseases.Butithasn’t‘solved’anybigsocialchallenges.Itsscalerarelymatchesuptothescaleofproblems.Andthephilanthropiststhemselves–particularlythosewhomadetheirmoneyinfinanceordigital–areseeninamuchlessrosylightthaninthe2000s.

Yetwithgovernmentsoftenweakordistracted,whootherthanfoundations can address the big long-term issues head on? Whoelsecantakebigrisks,unconstrainedbyaccountabilitytoshareholdersorvoters?

Foundationsareuniquelyendowednotjustwithmoneybutalsowithfreedomandsolidity.Theyshouldbeuniquelywellsuitedtoworkonthetrulybigchallengesofourtime,fromclimatechangetoinequality,ageingtounemployment.

OurFoundationHorizonScanresearchpapersurveysthechanginglandscape,andexploresthereadinessoffoundationstoplayabiggerrole.Theinsightshighlightsomeoftheeternaldilemmasofphilanthropy,summarisedbyShakespeare’scommentthatitisexcellenttohaveagiant’sstrengthbutnottouseitlikeagiant,andtheirparadoxicalpositionofhavingpowerandmoralpurposebutlittleformalaccountability.

In this landscape each foundation has to decide how it will answeraseriesofdifficultquestions:

Challenge government or collaborate?

Incountrieswherepoliticalleadersarehostiletocivilsociety,resistanttocriticismorindependentpower,andespeciallypronetobristleatforeignfoundations,foundationshavetodecidewhethertobecomemoreovertlypolitical,supportingoppositionandprotest,orwhethertokeeptheirheadsdown.Inotherplaces,bycontrast,foundationsarelearningtoworkmorecloselywithgovernmentrecognisingthatinmanycontextsthatistheonlywaytohaveseriousimpactatthescaleofproblems.

Challenge business or collaborate?

Most foundations are naturally close to business and many wanttoapplybusinessmethodstosocialissues.Butproximitytobusinesscancreatetensions,especiallyonenvironmentalissues where business may be more the problem than the solution.Anevenmorechallengingquestion,afteraperiodthat has seen such a big shift of power and wealth from labour tocapital,iswhatroletoplayinrelationtoprecariousworkers,empowermentandtradeunions.

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Predictable impact or big bets?

All foundations grapple with how to ensure their money has ausefulimpactintheworld.Theirchallengeisnotjustaboutmetricsbutalsoabouttimescalesandrisk.Itisfareasiertomeasureimpactifyou’reworkingonrelativelyincrementaltasksandonrelativelyshorttimescales.Bycontrast,theresultsofbig,longtermbetsareinherentlyhardertopredict,and itmaybedecadesbeforeanyonecanconfidentlysaythey areworking.

Transparency or secrecy?

Somefoundationshaveopenedthemselvesuptoscrutiny.Butothersarenervous,andhaveremainedsecretive,bothforbadreasons(notwantingtobeaccountable)andforbetterones(ifthey’reoperatinginhostileenvironmentswhereanyopeninformationcanempowerenemies).

Transforming systems or modest improvements?

Manyfoundationsunderstandablywanttobeinvolvedin profound systems change – shifting to a low-carbon economyortransforminghealthcare.Butthemoretheyplayaleadershiproleofthiskind,themorethelimitsoftheirlegitimacycomeintoview.Soanoppositeviewsaysthat theyshouldbehumble,limited,andwillingtoplayasubordinaterole.

Fast or slow?

Foundationsfacefewcompetitivepressurestoinnovate. Asaresultmostuseverytraditionaltoolsofgrantmaking.Theyhavebeenslowtoadoptorexperimentwithalternatives,slow to engage seriously with the new possibilities arising fromdata,AIandcollectiveintelligence,slowtoempowerbeneficiaries.Butusingnewmethodsisitselfriskyandmayinvolveshort-termimpairmenttoperformancebeforegainskickin.

Thesearenot,ofcourse,binarychoices.Thebestanswerswillbesubtleandnuanced.Buthopefully,ourhorizonscan– packed with good examples from around the world – will

encouragemoreimagination,boldnessandhonestyonthepart of foundations in thinking through answers that make sensetothem.

Insomerespects,foundationsarealmostmedievalinstitutions,somewhatanachronisticintheworldof24/7mediaandaneconomychangingatwarpspeed.Yetwerelyonthemmorethanevertousetheiruniquepower–andtheiruniquefreedom–todowhatisnecessary,andnotjustwhatiscomfortableoreasy.

Summary findings

Thenexttenyearswillbeadefiningdecadeforfoundations.Internationally,thetrendspointtoaboomingphilanthropicsector,onewhichispoisedtoexpandinbothsizeandambition.Incontrasttogovernmentsandbusinesses,foundations are capitalising on their power to focus on long timehorizons,andmanyaresettingouttoshapethefutureinevermoreprofoundways.

Future challenges: legitimacy and impact

Twothemessurfacedrepeatedlyinourexpertinterviewsandtheliteraturereview.Firstly,iffoundationsdonotfindawaytoconvincetheircritics–andthewiderpublic–thattheyarebecomingmoretransparentandaccountable,thentheywillfindthemselvesconfrontingthedifficultconsequencesofdeepeningmistrust.Scepticismaboutthelegitimacyoftheirpower is only likely to increase at a time of rising populism and antipathytowards‘elitesandtheestablishment’.

Secondly,foundationsmustbeabletoarguerobustlythattheyareeffective,ratherthansimplyservingasfigleavestoprotectthewealthyfromcloserscrutiny.Aretheycapableofbringingabout deep social change or are they simply too embedded in thesystemtodoso?Arethetoolsattheirdisposalequaltothetaskofaddressinghighlycomplex,systemicproblemssuchassocialinequalityandclimatechange?

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SECTOR THOUGHTS

Emerging responses: foundation practices

1. Enhancing legitimacy

– Investingendowmentstoalignwithsocialmission

– Making data transparent

– (Re)definingrelationshipswiththepublicsector

– Addressing the power imbalance

2. Enhancing Impact

– Collaboration

– Adoptingprivatesectorapproaches;combining profitandpurpose

– ‘Systemschange’:movingfromrhetorictoaction

– Leveragingdigitalanddataanalytics

– Rethinking impact measurement

– Reimagining place-based approaches

– Using strategic foresight to explore emerging trends

– Supportingmovements,peopleorideas

A look ahead: strategic choices

The challenges facing the foundation sector in future do not havesimplesolutions.Whilstfoundationsareexperimentingwithadiversearrayofapproachestoenhancetheirlegitimacyanddeepentheirimpact,indevisingtheirstrategiestheywillinevitablyhavetomaketradeoffsbetweendifferentpriorities.Pursuingonepathmightwellmeanforfeitingthebenefitsaffordedbyadifferentapproach.Wehighlightsomeofthelivetensionsfoundationswillneedtomanageincomingyears.

Power and control

Centralised Distributed

Diversity

Professionalexperience Livedexperience

Transparency

Lowexposure High exposure

Role in public service delivery

Safety net Test bed

Time horizons

Near-term Long-term

Monitoring, evaluation and learning

Metric-led Iterativelearning

Assets

Financial return Social return

Collaboration

Independent action Collectiveeffort

Thefullresearchpaper,FoundationHorizonScan,Takingthelongview,MagdalenaKuenkelandCeliaHannonwithEdmundLeBrun,Nesta,November2019isavailableonline. https://media.nesta.org.uk/documents/Future_Foundations_Taking_the_long_view.pdf

Nestaisaninnovationfoundation.Forus,innovationmeansturningboldideasintorealityandchanginglives forthebetter.Weuseourexpertise,skillsandfundinginareaswheretherearebigchallengesfacingsociety.

NestaisbasedintheUKandsupportedbyafinancialendowment.Weworkwithpartnersaroundtheglobeto bringboldideastolifetochangetheworldforgood.

www.nesta.org.uk

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