Investment

Crunch time

Over recent months, the headlines have contained more than the usual news about financial markets, much of which has been unsettling. James Bevan considers what this means for schools that are investing in UK markets

One of the UK’s largest mortgage lenders, Northern Rock, has had to seek emergency help from the Bank of England to remain in business, huge losses have been reported at some global financial giants such as Merrill Lynch and Citigroup, and unfamiliar terms such as “credit crunch” have become common currency among pundits. So what does this mean for those concerned with the management of investments for schools? After several years of benign economic conditions and strong returns from global markets, is a new course of action now required to deal with more uncertain times?

It is important to stress that while new problems have emerged, these have been largely confined to the financial sector. There has as yet been little evidence of any spill-over into the broader economy in the UK or elsewhere. Most schools will have a policy of reviewing their investments on a periodic basis to ensure that they remain fit for purpose. Recent developments certainly do not suggest that emergency action is required outside the usual timetable.

However, they can usefully serve to focus minds on the important balance between seeking good returns and taking risk when investing.

The causes
The root cause of the problems has been ill-advised lending to high-risk borrowers by a few banks. So far, so predictable – after a long period of solid economic expansion, the lending standards of some banks often become more lax in pursuit of high returns and some loans will be made which are never likely to be repaid.

The problem this time is two-fold. First, it has become clear that the size of the bad loans which have been made is massive, with up to $200 billion of sub-prime mortgages in the US unlikely to ever be repaid. Second, there is the way the loans have been packaged by banks, using new derivatives-based structures and sold on to a broad range of financial institutions all around the world.

This means that several months on from the beginning of the crisis, nobody still really knows for sure where the full exposure to losses lies. Throughout last summer, the high level of uncertainty over who was involved and to what extent, made banks unwilling to lend to each other, which created a threat to the financial system. It was this threat that caused share prices to fall sharply. The crisis required firm action by central banks such as the Bank of England and the US Federal Reserve, which moved swiftly to extend borrowing facilities to those in need. This defused the air of crisis but left a large problem to be solved.

Where now?
How should investors react to the situation? Given that the crisis has at its heart cash and increased risk, these are a sensible place to start a review. With cash, the lesson is clear – diversify. The Northern Rock problem illustrates how an organisation only tangentially involved in events can be sucked in and significantly weakened in the process.

Trustees can avoid the risk of putting all their eggs in one basket without sacrificing returns by using a top quality deposit fund that will provide a high rate of interest and keep risks low by lending not to a single borrower, but to many.

Getting the balance
In terms of risk, the UK stock market has become a riskier place to invest in recent years. It is now dominated by giant companies and huge sectors. Just two of these sectors account for over 30 per cent of the entire market and one of them, the banks, lies at the heart of the current crisis. This dominance by a few sectors means that other attractive areas such as consumer electronics and technology are not represented. Many schools continue to hold high weightings in the UK market in their portfolios as this market is perceived as being less risky than overseas markets and has the practical advantage of paying a higher income.

Now is a good time to challenge these assumptions. Increasing exposure to global markets will give access to a broader range of opportunities and help to reduce risk as well as providing more scope for rising income.

James Bevan is chief investment officer for CCLA.

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