More than investment returns: when culture matters

Strong principles and values define the not-for-profit sector, which can sometimes be at odds with the desire to maximise returns. Jeff Sitters discusses bringing together strong investment returns, risk management, and a culture aligned with the unique needs and objectives of not-for-profits.

The work of the not-for-profit (NFP) sector plays a vital role in underpinning our culture and community. But to provide this essential service, altruism needs the support of philanthropic donors, sponsors, corporations and other sources of income. Government simply can’t afford to fund everything.

Interestingly, income received into the NFP sector from investment returns currently generates more than one-third (36 per cent) of total donations, sponsorships, and funding, according to the latest annual Australian Taxation Office (ATO) data; thereby highlighting the importance of formulating appropriate investment strategies for NFPs to continue this positive trend.  

Therefore, charities, endowment funds, as well as public and private ancillary funds run by workplaces and individuals, must set clear investment objectives to meet their long-term commitments and distribution obligations. 

In doing so, they must balance the inherent risks of investing, their concessional tax status, and the interest of stakeholders. For NFPs, what they are investing is often the result of tireless fundraising efforts from people who support their work and trust them to manage the money well. 

It is no easy task given the unique needs of charitable and NFP organisations: one poor investment decision can undermine the flow of income and compromise their ability to provide services (and employment) to the community. 

A cultural bridge between risk and return

Strong principles and values define the NFP sector and those individuals who set up charitable giving foundations. Such values can sometimes be at odds with the desire to maximise returns and the potential conflicting interests of stakeholders, advisers and investments managers.

This creates a dilemma, given the crucial need to generate healthy investment income. 

The danger of chasing returns

Unfortunately, bank accounts are no longer generating significant returns for NFPs. A decade ago, official interest rates were around six to seven per cent. Today, they stand at just 1.5 per cent. NFPs need to achieve stronger returns, but viewing them in isolation brings its own dangers.

While Australian shares can be volatile, they can also have particular value to NFPs as part of a diversified portfolio, as local companies pay particularly high dividends by international standards. 

In 2015, Australian-domiciled listed companies paid out $78 billion in dividends, representing a payout ratio of 81 per cent of underlying earnings. This high level is partially underpinned by Australia’s dividend imputation system, which ensures company profits are only taxed once.

This provides a huge tailwind for NFPs, as they don’t pay company tax.

The S&P/ASX200 benchmark climbed 9.33 per cent in 2017. A strong flow of company dividends brought total returns for the year to 14.1 per cent; however, a NFP could also claim the value of the imputation credits, bringing their total return for the year to 15.86 per cent. 

However, this benefit is largely invisible since investment returns are generally reported on a pre-tax basis and therefore excludes the value of franking credits. 

Also, many investors still rely on past performance as their primary reason for choosing where to invest and rarely consider risk, according to a long-term study of Australian managed fund flows.

The Australian Securities and Investment Commission (ASIC) outlined the pitfalls of this approach in a 2003 review paper. It found that past performance was often a weak predictor of future good performance and that managed fund returns could only be meaningful if adjusted for risk or volatility.

Strong investment returns grab headlines, but without good advice, those gains may introduce unnecessary risk or have less impact than expected.

Goals needed to define investment targets

Outperforming arbitrary benchmarks such as the S&P/ASX200 may demonstrate skill but it can equally demonstrate short-term luck, and is of limited relevance to a NFP’s long-term goals. Perhaps due to the easy accessibility of information and investment data, investors too often focus on short-term performance indicators. Of more importance is whether a portfolio has an appropriate investment strategy aimed at meeting the philanthropic investor or organisation’s goals which often takes a very long-term view. 

Many NFPs and foundations need to generate a set amount of income each year to meet fixed costs and distribute required proportions of income or assets and, over the long-term, aim to outperform the inflation rate by two to four per cent

While growth assets such as shares tend to deliver higher returns than defensive or risk-free assets such as government bonds, timing is crucial. A study by Bianchi, Drew and Walk found a roughly one-in-five chance that a 20-year historical share return would be lower than the risk-free return across 21 countries starting from 1900.

Inherent volatility of investment markets needs to be managed as part of a diversified portfolio that is aligned with the risk profile and goals of NFP organisations. This requires ongoing professional input from specialist advisers and managers with a deep understanding of the philanthropic/NFP sector.

For example, a NFP Aboriginal trust receiving regular royalties from mining activities on their land may need to review their investment strategy when those mining activities cease or are suspended due to mine closures. 

This will require a review of their risk appetite, immediate income requirements, and the community’s long-term objectives. 

This in turn may result in a change in focus for the management of the trust’s portfolio in order to satisfy short-to-medium-term funding requirements while still having an eye on longer term objectives.  

Partners, like a trustee company, who understands the complexities and nuances of risk management and embrace a more conservative culture are crucial to helping a NFP organisation along that path.

Bringing together strong investment returns, risk management, and a culture that is aligned with the unique needs and objectives of NFPs require a special combination of skills and experience. 

All players in the financial services industry – from financial planners to fund managers and industry advisers – need to recognise and instil this in their DNA, if the impact of charitable work is to be effectively and sustainably achieved over the long-term.  

Jeff Sitters is national manager for investment mandates and donor relations at Equity Trustees.