Secrets Of Success: A Wellcome addition to bond market

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The Independent Online

This week's most interesting development was the announcement by the charitable foundation The Wellcome Trust that it is issuing a long-term bond. In doing so, it has become the first non-public entity to earn an AAA debt rating, and cast a spotlight on the current state of the markets and the interesting charitable investment sector.

Coming so soon after Warren Buffett's decision to donate his fortune to the Gates Foundation, it raises some issues about how charitable foundations should manage their endowments - a process that has intriguing parallels with the way individuals put their money to work.

The Wellcome Trust is the largest charity in Britain, with an endowment of some £12bn, and supports a wide range of research and educational activities, primarily in the field of drugs and medical research. This is the field in which Sir Henry Wellcome, its founder, made his fortune. The pharmaceutical business that bore his name was floated on the stock market in 1986, leaving the Trust with a substantial shareholding. The company was acquired by Glaxo in 1995.

Over 20 years, the Trust has moved from being a relatively small £1bn charitable foundation to become the world's largest charitable foundation devoted solely to biomedical research.

Its endowment is now spread across a well-diversified portfolio of quoted and unquoted investments - a classic case of diversification that has reduced the risk the trust will no longer be able to sustain its £400m a year of grants into the future, and substantially increased its annual investment income.

The Trust recently appointed a new chief investment officer, Danny Truell, formerly the head of the asset management division at Goldman Sachs. The bond issue is one of the first fruits of his tenure.

As with every charity, the Trust's investment challenge is to strike a balance between preserving the real (after inflation) capital value of its endowment and sustaining the real (after inflation) value of its grants, where, in the Trust's case, there is virtually unlimited demand for help.

In an era of low interest rates, and, by implication, single-figure investment returns, this is no easy matter. Just as many private investors who rely on income from their portfolios worry about eating into their capital, so charities are caught between a responsibility to invest for long-term capital growth and the need to maintain their charitable programmes.

The trade-offs are never easy, especially when you run into bear markets like the one between 2000 and 2003. For many charities, the problem is compounded by the fact their investments are still - as with Wellcome in its original form - wholly dependent on a single investment, typically shares in the business that the originator of the endowment had built up. Professor Elroy Dimson, of London Business School, a leading expert in this field, says as many as 40 per cent of charitable organisations may be dependent on a single asset in this way.

Single asset endowments can be great when the investment grows fast, as drugs company shares did during most of the bull market of the late 20th century, but a dangerous concentration of risk over the longer haul. In the case of Wellcome, a London Business School case study states, the diversification drive of the past 20 years owes a lot to the experience that Sir Roger Gibbs, the trust's chairman in the 1990s, had learned from his father, who was chairman of the Nuffield Foundation for many years.

His failure to convince Lord Nuffield to diversify the foundation's assets away from its reliance on the fortunes of his business, the British Motor Corporation (later British Leyland) proved to be a huge and costly mistake.

The Trust has maintained a fairly aggressive investment strategy, with some 65 per cent and 70 per cent of its assets in UK and global equities, a small weighting in bonds, and the balance in property and private equity and hedge funds. Unlike many pension funds, it did not get bounced out of equities by the bear market, but held its nerve. Even so, the value of its endowment fell sharply from a peak of £15bn in 2000 to just over £9bn in 2003 before recovering to its current £12bn.

The Trust has a long-term target rate of return for its investments of 6 per cent a year in real terms, and aims to distribute, on average, around 4 per cent of its assets each year as grants. The value of its diversification policy has been underlined by the fact that the value of the endowment and its annual income would have been materially lower in the past five years had it maintained its heavy reliance on pharmaceutical shares.

They have provided an unattractive combination of below-average income and above-average underperformance since 2000.

The bond issue is a new but interesting development. In part, it appears to be driven by the fact that long-term bond yields are ridiculously low at the moment, primarily for well-documented reasons to do with pension fund regulation and accounting standards. The value bet for any sensible investor has to be to sell long-term bonds at current yields, not to buy them. The Trust has the capacity to do just that and deserves credit for having the gumption to do it

In effect, the Trust is borrowing money at very cheap long term rates in the belief that it will be able to earn a higher rate of return from its ordinary investment activities over the longer term. It is unusual for a charity to borrow money in this way - hedge funds have been doing something similar on a very short term scale - but these are unusual market conditions.

The effective risk is so low you can have a high degree of confidence that it will work to the long term advantage of the charitable causes the Trust supports. It will be interesting to see what other tricks Truell has up his sleeves.

jd@independent-investor.com

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