As an investment manager, managing risk is always front of mind in how we at Sarasin & Partners serve our clients. Here we outline our thought processes in how we balance different risks, to maximise the possibility of the best outcomes for our clients.
At its core, ‘risk’ relates to the probability, severity and frequency of an adverse outcome or event occurring. The management of risk is therefore centred on the reduction of related uncertainty and the creation of an environment where it can be adopted and harnessed in a controlled manner. One of the fundamental tenets of investing is the notion that taking measured and calculated risk is a necessary function of generating attractive investment returns.
We are frequently asked by charity trustees how best to consider investment risk when managing charity portfolios. Ultimately, we recognise that risk takes different forms for different organisations and that each charity will naturally have its specific areas of focus.
In its broadest sense, risk to most charities will encompass:
Inflation risk – the concept that capital and spending power can both be eroded by rising prices.
Spending/withdrawal risk – the risk that returns generated are ultimately insufficient to fund a charity’s mission or operations.
Reputational risk – owning assets that contradict an organisation’s objectives to the detriment of a charity’s reputation and standing.
Investment risk – a measure of an organisation’s tolerance for capital volatility and capacity for loss.
To assess a charity’s risk profile, investment managers will typically refer to common risk metrics. While these often provide useful historical context and a helpful guide when building investment strategies, at Sarasin & Partners we tend to view investment risk through two distinct lenses.
The first is absolute risk, the risk of a decline in values in absolute terms resulting in absolute loss of capital in extremis. Secondly, relative risk, which is a measure of the variability of returns when compared to a composite benchmark and/or a peer group comparator.
Absolute risk
Industry established measures of investment risk include: volatility (standard deviation); maximum annual drawdown (a measure of the magnitude of peak to trough paper losses (i.e. unrealised), typically over 12-month rolling periods); and value at risk or VaR (an indication of a typical paper loss in normal market conditions, excluding the most extreme outcomes). While these are instructive, like performance records, they are inherently backward looking.
Caution is needed when extrapolating historic trends into the future, as it is possible that the next economic or market crisis could take a different shape to that experienced previously.
Similarly, while it is worthwhile taking time to understand an organisation’s capacity to tolerate variability in capital values (which is what the three risk measures above seek to illustrate), these risks are only brought into relief if they are crystallised through forced asset sales at the worst possible moment. We have long advocated that, when taking on investment risk, the best protection against loss in absolute terms is through robust strategic planning. An organisation’s investments have to be managed in keeping with its liabilities, expected future cashflows and spending requirements.
At a more granular level, absolute loss can also encompass the loss of capital in a single individual investment. While no investment manager would ever set out to lose money, unfortunately this a very real risk when managing investment capital. A charity investor’s greatest protection in this regard is to scrutinise a potential or existing investment manager’s process. In particular, a thorough understanding of the prior track record, security selection process, depth of resource and ex-ante risk controls should be sought.
Liquidity risk (the ease with which an asset or security can be sold) is especially important in this context, particularly if an investment manager is seeking to invest in smaller companies or less liquid markets. Attention should be paid to position sizing in these sorts of investments. Experienced managers will likely have self-imposed ownership limits in smaller companies and collective investments such as investment trusts, where in periods of market stress liquidity can sometimes be constrained.
At Sarasin & Partners, our process tends to focus attention on areas in which we believe the probability of success is higher. Businesses that display ‘quality’ characteristics typically create more enduring and sustainable value for shareholders. These characteristics include: high return: higher returns on invested capital, sustained competitive advantages expressed through higher and more persistent margins, competent management teams with strong and transparent governance, coupled with lower, or well understood, environmental, social and governance (ESG) risks.
Conversely, we recognise the threats posed by uncertainty and opacity. Businesses that are overly exposed to the business cycle, exogenous factors such as commodity prices or government funding streams, or those which are especially sensitive to interest rates, all represent potentially more uncertain and therefore higher risk investments. Where we invest in collectives, such as investment trusts, we impose a maximum ownership limit of 10% of the shares in free float, but in practice exposure is often closer to 5%. We typically restrict ourselves to trusts that are greater than £1bn in market capitalisation. When investing in direct equities, the vast majority of the companies on our buy list are larger than $5bn. This protects us in times of market stress and allows us to be nimble if our investment thesis changes at short notice..
Relative risk
Most charity investors, regardless of experience, suffer to a greater or lesser extent from ‘loss aversion’ – the phenomenon where a real or potential loss is perceived as psychologically or emotionally significant than an equivalent gain. For this reason, absolute risk will often be the overriding focus. However, given the increasing sophistication of many charity investment committees, relative risk – the performance of an investment portfolio relative to a pre-agreed comparative benchmark – is increasingly under scrutiny. Put another way, trustees will assess the opportunity cost that occurs as the result of an investment manager’s decisions and actions.
Over the long-term, most charitable organisations with investment reserves are, understandably, concerned with achieving a ‘real’ return objective i.e. generating a given level of return ahead of inflation. This is typically to fund grant programmes, charitable expenditure or operations, while growing the capital base such that the spending power of the assets is maintained. However, we also encourage clients to measure their investment performance over a wide range of time periods against a composite index-based benchmark and an appropriate peer-group comparator.
The measurement and assessment of relative risk, when compared to an index-based composite benchmark can be fraught with complexity. Composite benchmarks typically exist to compare the performance of an active fund manager against a group of composite indices, gross of costs. This is to see whether or not value has been added through stock selection (the identification of specific companies and investments) and tactical asset allocation (expressing a view on certain asset classes vs a pre-agreed ‘neutral’ position). However, the very composition of modern capital markets has resulted in these comparators containing inherent and unexpected risks in and of themselves.
First of all, there is the selection of benchmark constituents. By way of example, measuring global equity performance against the MSCI World benchmark index, which excludes emerging markets, as opposed to the MSCI All Countries World Index (ACWI), which includes them, would have yielded markedly different results over the past decade. The latter has underperformed the former by over 20% over the ten years to 31 December 2024, as emerging markets have lagged their developed market equivalents[1]. While the pattern may not necessarily repeat over the years ahead, and the vast majority of our clients use the broadest measure of global equities available, understanding the reasons behind the disparity in the performance of comparable indices, and any resulting under- or out-performance of that comparator, is crucial.
Then, there is the composition of modern stock markets and the level of concentration risk inherent within them. The US now represents over 66% of global stock market capitalisation, as measured in dollar terms via the MSCI ACWI. The next largest single market is Japan at 4.8%, followed by the UK at 3.1%. The entire UK equity market is now smaller than individual companies such as Apple (4.9% / $3.8tn), Nvidia (4.3% / $3.3tn) and Microsoft (3.8% / $3.0tn). Similarly, Amazon represents roughly 2.7% of the global index, comparable to that of the entire Chinese stock market (2.7%)[2].
Concentration isn’t a new phenomenon but the size and dominance of US technology businesses has resulted in a challenging backdrop for global investors used to relying on global indices for diversification.
This, of course, only paints part of the picture. Advocates of US exceptionalism would point to recent headlines underscoring the exodus of UK businesses from domestic stock markets in favour of the US. According to the London Stock Exchange Group, in 2024 alone, a total of 88 companies delisted or transferred their primary listing from London’s main market with only 18 new listings taking their place[3]. With the US market acting as such a powerful pull for global business, it could be argued that geography, based on a company’s listing, is losing its effectiveness as a measure of diversification.
One solution for sceptics could be to focus attention on equally weighted indices, which normalise the size of these behemoths. However, doing so could significantly impact returns, as we have been reporting to clients throughout the past 18 months. Regardless of your perspective, charity investors must be aware of these nuances when considering relative risk.
At Sarasin & Partners, we believe that the skewing of geographies and the sectoral imbalances in certain stock markets call for a more holistic approach to diversification and risk management. While many institutional investment managers focus on factor risks – identifying certain styles that may be responsible or explain the returns generated over a particular time period – we still believe that taking a thematic approach to investing ensures that portfolios are well exposed to the trends that are likely to generate superior returns over the medium to long term.
Of course, understanding positioning relative to benchmark indices and geographies is important for the purposes of effective portfolio construction, but country listings are increasingly becoming an inefficient way to build and diversify portfolios on a standalone basis.
The fact that some index constituents are now so large that isolating relative risk from absolute risk has become nigh on impossible, means that investors must increasingly challenge a manager’s process and seek justification for individual investment decisions.
A bespoke approach
We understand that every charity encounters different risks at different times, and a bespoke approach to managing these challenges is critical. For this reason, at Sarasin & Partners we work with our clients on a discretionary basis, where we have the opportunity to add value through our strategic expertise and unique approach to risk management and portfolio construction.
[1] Source: Bloomberg (MSCI ACWI (Net Total Return) vs MSCI World (Net Total Return)), 31 December 2024
[2] Source: MSCI, 31 December 2024
[3] https://www.ft.com/content/aef053ce-c94d-4a72-8dce-bdbf56dd67e1
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