A Time of Change. Committee Report: Investments

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1 june 2011 Committee Report: Investments A Time of Change By Monica Issar Refining portfolio construction for endowments and foundations A recent headline in The Chronicle of Philanthropy tells the story: Recession s Hard Lessons Lead to Changes in Endowment Policies: The bulls may be back in control on Wall Street, but the painful lessons that endowment managers endured just a year ago are leading to a number of changes that affect how the funds are managed. 1 The article goes on to cite the results of a recent survey, in which 23 organizations roughly twice as many as a year ago told the Chronicle their boards had adopted new policies regarding investments. Another 25 said they were considering new investment policies. This isn t a surprising development, given the huge losses suffered by endowments over the past few years: The top 10 university endowments lost a collective $36 billion for the fiscal year ending June 30, While (economic) pressures have eased a bit for some groups, the country s richest foundations expect their distributions to increase slightly in Many more organizations, both large and small, continue to spend down, lay off staff, merge with other groups or close their doors forever. Against this backdrop, finance committees and boards of directors continue to evaluate investment policies, weighing the need for rigorous portfolio risk management relative to their organization s ongoing financial and societal commitments. Along the way, there will be tough questions to answer everything from Who has investment discretion and accountability? to Are the right systems in place to measure total return and evaluate performance? Monica Issar is head of the J.P. Morgan E n d ow m e n t s & F o u n d a t i o n s G ro u p headquartered in New York The Challenges A 30-year-long bull market in credit, coupled with negative S&P 500 returns over the past decade, have long made it difficult for endowments and foundations to depend on normalized returns with traditional asset classes. In the current market environment with low-for-long interest rates in the United States and lower-than-historical returns anticipated long-term for the S&P the 5 percent legally mandated payout ratio for private foundations and/or the comparable target distributions for other nonprofits become more aggressive hurdles. Factor in administrative costs, excise taxes and inflation, and it s clear that non-profit organizations more realistically need investment returns of at least 8 percent to 9 percent to meet their payout targets. (See Key Investment Challenges, p. 56.) Generating consistent returns at requisite levels, therefore, requires unique portfolio construction considerations to meet the required distribution streams and administrative costs of non-profit entities. Managing Risk and Reward At any given moment, there s risk and opportunity in the market. Today, we see strong corporate earnings, averaging about 10 percent this year and a relatively inexpensive stock market. Emerging markets are driving global growth, accounting for roughly half of global gross domestic product and eclipsing the growth rate of most developed nations. Meanwhile, the U.S. economy has moved from recession to recovery and, very recently and very slowly, into expansion. At the same time, we don t know what we don t know. We didn t anticipate recent events in Pakistan or North Africa, although we could have expected higher oil prices. We had no idea Japan would experience disaster on a grand scale. As if those events weren t enough, the

2 massive deleveraging going on around the world has already posed serious concerns; and inflation, once again, threatens. Event risk is everywhere. In this bifurcated environment of trouble spots and growth opportunities, both traditional approaches to portfolio construction (a 60/40 equity/bond split) and the more innovative but less liquid endowment model, which gives alternative investments a central role, may not serve foundations and endowments as well as they have in the past. Instead, taking a third path call it full diversification may be more appropriate, both in terms of managing various levels of risk and generating performance. A portfolio that balances equity and credit allocations and is augmented with an allocation to return-oriented alternative investments may help address the shortfalls between required versus expected returns that many organizations are facing. In this approach, performance isn t dependent solely on either equities or alternative investments. Rather, allocations to equity, alternatives and fixed income are apportioned, as is the accompanying risk. Another distinguishing characteristic of the full diversification approach is that credit or return-oriented instruments (for example, high yield and high grade bonds, emerging market debt and bank loans) account for a significant share of the fixed income portion of the portfolio, thereby adding stability as well as cash flow. Why credit? As an asset class, it has a long track record of consistently producing meaningful returns with significantly less volatility than equities. For example, returns on S&P 500 investments were negative from 2000 to 2010 making it a lost decade for equities. As we know, the past isn t a prologue to the future. The best investment strategy is one based on long-term not historical forecasts. Thus, in the late 1990s, investors who believed stocks would return 14 percent a year in the next decade because that s how they performed in the previous 30 years were sorely disappointed by the outcome. Volatility Creates Opportunity Making decisions between board meetings has become more critical and underscores the importance of add- ing a tactical overlay to long-term strategic allocations. Adopting a mindset that aims to hit singles and doubles rather than swinging for the fences can be equally important. These more time-sensitive allocations are designed to capture opportunities or limit risks resulting from changing market conditions. In 2010, tactical moves might have led investors to shift from cash to mid-cap equities, from investment grade to high yield bonds or to levered loans; these last investment vehicles yielded four or five times, and, in some Portfolio construction, while at the core of the investment process, is only one part of the equation. cases, significantly more than corporate bonds. Portfolio construction, while at the core of the investment process, is only one part of the equation. Risk management, manager selection, tactical overlays and market assumptions play equally critical roles. Rethinking Market Risk Refining the way a portfolio is constructed generally requires taking a closer look at its underlying risks. Creating a factor allocation an approach increasingly embraced by leading institutional investors and asset managers offers a way to gain greater clarity of the market risk in a portfolio. Most investors have a general understanding of the broad types of risk associated with specific asset classes, notes Anthony Werley, chief investment officer, J.P. Morgan Endowments & Foundations Group. However, this doesn t provide enough market context to help determine whether a portfolio s implementation is truly aligned with the risk-return objectives set out in an investment policy. To be useful in making this judgment, he says, an allocation framework can provide a simple, comprehensive description of risk drivers across the entirety of the portfolio, regardless of asset class description

3 or investment vehicle. Only this level of transparency gives investors the information they need to have thoughtful discussions about opportunities and tradeoffs, to separate market risks (beta) from true manager skills (alpha), and to make fully informed decisions around portfolio implementation. Factor allocations differ from asset allocations in that risks are aggregated by market exposures, not by asset classes or management format. This framework compels an investor to consider: What s the summary of market risk in a portfolio once it s populated with traditional active managers, hedge funds, derivative structures and passive management vehicles? While vehicles and strategies may differ, diverse asset classes and strategies often share many of the same risks. For example, an equity long-biased hedge fund strategy (hedge funds tactically adjust their market exposure by investing long and short) may have equity market exposure similar to that of a traditional long-only equity portfolio. Event-driven hedge fund strategies, such as merger arbitrage and distressed debt, have a meaningful level of equity market exposure that likewise should be aggregated as part of the total equity risk of a portfolio. Consider, too, the traditional equity and fixed income management universe, in which a growing number of managers are benchmark agnostic or indifferent to adhering tightly to it. The pattern of risktaking within a widetracking-error traditional portfolio is less transparent than in benchmark-defined strategies, and the former Key Investment Challenges Endowments and foundations are under increased pressure to meet their target payouts Generating consistent portfolio returns in today s equity markets and low-for-long U.S. interest rate environment requires unique portfolio construction considerations to meet non-profit entities required distribution streams and administrative costs Consistent distribution rate necessary to maintain spending requirements Traditional allocations relying exclusively on equity and core fixed income beta may be inadequate to meet distributing organization s return requirements based upon J.P. Morgan Nominal Equilibrium Assumptions Portfolio Operating Requirements Total Rate of Expenses** Inflation Estimate*** Excess 0.25% 3.00% Operating Requirement* 8.25% Real value maintenance in light of potential future inflation Sample Distribution 5.00% To help meet these challenges, we advocate full portfolio diversification that spreads risk across credit, alternatives and equity * Amount necessary to generate rate of return in excess of distribution rate, inflation and expenses ** The expense estimate represents an assumption for expenditures, other than investment-related activities. (Source: J.P. Morgan, 2008/2009 Association of Small Foundations Survey (indicates median expenses generally range between 0.13 percent and 0.50 percent for foundations over $5 million)) *** J.P. Morgan Nominal Equilibrium Assumption for Inflation (Note: Bureau of Labor and Statistics; average headline inflation since 2000 = 3.00 percent) J.P. Morgan Endowments & Foundations Group

4 may add to the portfolio s market estimation error factor. Estimating true market exposures (or redundancy of equity, fixed income or commodity risk) across the entire portfolio can be an important tool in both clarifying and managing portfolio risk. Manager Selection Top-performing managers can have an outsized impact on returns in a diversified portfolio. But vetting managers for performance alone isn t enough: Protecting assets from operational risk (the failure of ordinary business processes), fraud and other hidden risks is equally critical. The manager selection process is lengthy, complex and essential especially when it comes to alternative investments. Yet, too often, investors fail to take the time to look under the hood to gain a deep understanding of how well and how securely a fund manager is running its business. Is the cash really at the bank? Is the auditor legitimate? Is the investment mandate being closely followed? Are the risk controls adequate? Are the right people in the right positions? How are they incentivized? How does the fund perform in bull and bear markets? Countless tough questions must be asked and the answers closely studied. Some of this information will be gleaned in faceto-face meetings with the manager s core team; other insights will be derived through analytic modeling and analysis. Moreover, a deep level of scrutiny should continue throughout the life of the relationship: Ongoing monitoring and due diligence are essential to determine if selected managers are continuing to meet an organization s standards and objectives from beginning to end. Further, if a manager has been carefully selected, the presumption should be that the relationship will last three to five years. Every manager, even those in the top performance quartile, is likely to go through a cycle that includes periods of under and over performance. To hold the relationship for less than three years is to waste part of the risk budget (the opportunity to generate outperformance). Challenging Assumptions When it comes to assessing and managing risk, one size doesn t fit all. It differs from organization to organization. There s a time and place to factor long-term risks into portfolios, and the last two years have not been the right time to do it [when] a stimulus-fueled recovery in economic activity and risk-taking have been the dominant factors driving financial markets.... writes Michael Cembalest, J.P. Morgan s Chief Investment Officer, in an early April 2011 issue of his weekly Eye on the Market newsletter. Now, however, as inflation climbs back into the picture, as the interest rate environment begins to change and as the United States and other nations grapple with massive debt levels, the evolving economic picture may once again make it difficult for foundations and endowments to hit or exceed their payout and return targets. Organizations will need more of the right analytic tools as well as a proven way to stress test their portfolio allocations and assumptions to meet their commitments. As the investment policies of so many foundations and endowments promise: The Investment Committee has adopted a diversified approach to investment that balances its goals of maximizing return and preserving the Endowment s [or Foundation s] purchasing power. 5 In the last few years, with inflation virtually banished, it would have been possible to meet payout targets and cover expenses simply by selectively investing in high yield bonds, for example. Moving forward, the challenge grows ever more complex. Gathering Information Asset allocation, portfolio construction, manager selection, due diligence and risk management are the building blocks of a successful portfolio. However, sophisticated modeling capabilities and analytics are crucial, especially for foundations and endowments seeking to take advantage of opportunities created by volatility within the context of longer-term strategic allocations. (See Checklist of Issues, this page.) Further, having the ability to stress test portfolios and conduct

5 scenario simulations can add valuable perspective on portfolio risk. Given the complexities of today s global financial markets, the more informed an organization is the more truly those aligned with its unique needs, objectives and risk tolerance understand the likely outcome of its various investment options the more likely it is to make the right decisions. Te The views expressed herein are provided for educational purposes only based on information believed to be reliable. Neither J.P. Morgan nor any of its affiliates bear any responsibility for any direct or consequential losses arising from its use. Endnotes 1. Chronicle of Philanthropy, May 2, 2011, Endowment-Losses-Trigger/65292/. 2. Ibid. 3. Ibid. 4. J.P. Morgan Securities LLC. 5. Purdue University, Endowment Investment Policy, July 9, 2010 (for approval by the board of trustees) at and on the university website at business/invest/ (May 2, 2011). Checklist of Issues Consider these key questions to help evaluate investment policies RISK MANAGEMENT The 2008 market crisis heightened foundation and endowment scrutiny of risk management How did you fare? How has your investment advisor navigated these markets? How did this downturn affect your liquidity and your long-term philanthropic goals? Have you made or are you contemplating any policy or manager changes? SPENDING POLICY The 5 percent payout is an aggressive hurdle in the current investment environment Is the foundation s goal to be perpetual or to spend down? How are you managing the 5 percent payout? Do you use a three-year average for smoothing payouts? Do you have carry forwards you can apply to reduce current year spending? ACTIVE MANAGEMENT Portfolio construction must target an approximately 8.5 percent return to remain sustaining Are you considering inflation, expenses and payout requirements when constructing your portfolios? Are you meeting the 8.5 percent hurdle? Do you have systems in place to measure total return and evaluate performance versus benchmarks? Do you use one or many managers? GOVERNANCE Increased scrutiny of the non-profit sector Do board members understand conflicts of interest and jeopardizing investment considerations? Are they aware of self-dealing rules? Are taxes and records in good order? DISCRETION Investment discretion implies a strong fiduciary responsibility Who assumes investment discretion and accountability? Does the foundation have an investment advisory committee or an investment policy statement? What is your due diligence process for vetting investments and managers? Have you retained or delegated discretion? J.P. Morgan Endowments & Foundations Group Copyright 2011 by Penton Media, Inc.