Six key topics nonprofit organizations should consider in 2018

Transcription

1 Six key topics nonprofit organizations should consider in 2018

2 Nonprofit organizations operate in a complex and evolving financial world. As one of the world s largest investment managers, Vanguard has helped thousands of nonprofit organizations navigate their unique investing challenges. We ve identified six key topics for nonprofit organizations to consider in the coming year: Portfolio construction Benchmarking Committee bias Spending policy Investment stewardship and governance Outsourced CIO services

3 Portfolio construction After another year of strong performance in 2017, equity markets stand at all-time highs. But, as investors prepare themselves for the likelihood of more modest returns over the next decade, many nonprofit organizations are asking themselves whether their portfolios have them positioned to weather potential challenges like an equity market downturn and a muted return environment for bonds. At the same time, differences in market returns across geographic regions over the last decade have caused many investment committees to question whether they have the right allocations to U.S. and non-u.s. investments. Similarly, the allure of something different has created an impetus for committees to explore nontraditional investment strategies such as private equity, real estate, and commodities. While there s no magic solution that produces higher returns, there are important portfolio construction questions that investment committees should ponder as 2018 gets underway: Do we have an appropriate strategic asset allocation that aligns well with our long-term goals and objectives? Is our portfolio broadly diversified across the full scope of the equity and fixed income markets? What role might active management play in helping us weather an anticipated low-return environment? Does it make sense to consider investment options that are not highly correlated to the traditional equity and fixed income asset classes? Have we constructed our portfolio in a way that minimizes costs, ensuring that we retain as much of the market s return as possible? The start of 2018 is a good opportunity for investment committees to revisit the building blocks of portfolio construction and validate that their current approach sets them up for long-term success. While short-term, tactical approaches aren t likely to be consistently successful, a thoughtful, strategic approach to portfolio construction that aligns with your goals and objectives can help ensure that your organization remains on a path to investment success in the coming decade.

4 Benchmarking Evaluating your investment program s performance (i.e., benchmarking) is more easily said than done. Do you compare yourself to broad-based market indexes? If so, which indexes? Do you compare yourself to the returns of other nonprofit organizations? If so, do your organizational complexities and goals make you substantially different from your peers? What if you outperformed your index but underperformed your peers, or vice versa? Benchmarking should begin with consideration of the overall risk and return profile of your unique portfolio. Once the investment profile is established, an appropriate benchmark should be used to assess performance versus a strategic target allocation. A common approach among nonprofits is to also include a peer universe; however, identifying a peer group can be very challenging. Many nonprofits gauge their effectiveness against the performance of well-known endowments such as Harvard and Yale. These might not be true peers. Well-known endowments are very large and may have different investment models, risk-return profiles, or spending needs compared to most nonprofit portfolios. In the end, the best benchmark is one that takes into account the long-term goals of your investment program and the strategic asset allocation of your portfolio. Committee bias Traditional finance theories hold that markets are efficient and that investors tend to make rational decisions, unswayed by their emotions. The field of behavioral finance holds that financial theories should incorporate observed human behavior, which can lead investment committees to make suboptimal decisions. Behavioral finance research has uncovered a number of decision-making behaviors, or biases. Here are a few of the more common biases found in investing: Overconfidence Most investors overestimate their ability to outperform the market and place greater emphasis on their own forecasts versus other forecasts. Prospect theory Investors tend to dislike losses much more than they like gains of the same size. This bias, if left unchecked, can result in taking small gains and large losses in a portfolio. Home bias Investors tend to place a larger-than-average weighting in domestic securities of their home country. This is typically because the investor is more familiar with domestic products and services. Herd behavior Investors often mimic the actions of a larger group even though the individual would not necessarily make the same choice. This bias is based on the power of conformity as well as the belief that the group knows more than the individual. With these biases in mind, here are some steps that nonprofit organizations can take to offset suboptimal human tendencies: Adopt an investment policy statement This document formalizes the goals and objectives of the portfolio and can help prevent hasty decisions during periods of market volatility.

5 Diversify the investment committee Effective decision-making can be improved if the committee is diverse and individual members are encouraged to share their views rather than simply fall into line with an influential member of the committee. Rebalance A regular rebalancing schedule serves to keep the portfolio in line with its long-term objectives and helps the committee resist the temptation of being influenced by current market conditions. In 2018, we anticipate more nonprofit organizations employing an outsourced chief investment officer to further combat these biases and create a more efficient structure (see Outsourced CIO services below for greater detail). An effective outsourced CIO instills the discipline necessary to maintain a long-term strategy during periods of market or organizational uncertainty. Spending policy The global financial crisis began over ten years ago. Since 2009 the markets have experienced strong upward momentum. While we acknowledge that bull markets don t die of old age, it wouldn t be surprising to see a pullback in the months or years ahead. Vanguard s 2018 economic and market outlook makes the case for median return expectations for global equities in the 4% to 6% range and for global fixed income in the 2% to 3% range. These return expectations pose challenges when the Council on Foundations reports that the average spending rate for private foundations is nearly 6% annually. 1 It is critical for foundations to control what they can regarding spending and costs. If organizations can keep spending low perhaps 4% or even lower the compounding effect of these savings can result in larger corpus values and higher overall spending impact. Previous downturns have lasted anywhere from three months (1987 crash) to 30 months (global financial crisis), so it s important to have a plan in place for lean times. Committees should ask themselves: Can multi year grants be adjusted depending on market outcomes? Should we consider extended smoothing periods to reduce spending volatility? Are illiquid assets adequately reflecting market experience in rising and falling markets? Is a line of credit a better option than selling assets at depressed values? Has spending been frugal in good years? Are spenders and savers within the committee able to get on the same page in times of market duress? Does the organization have other revenue streams available? Are fundraising and donation initiatives maximized? Do we know what assets and liabilities can be included in determining our spending policy? Are we minimizing investment costs to maximize net return outcomes? 1 Source: 2016 Council on Foundations Commonfund Study of Investment of Endowments for Private and Community Foundations.

6 A little reflection and realism now can improve your ability to meet both short and long-term goals. Both spending and costs are two critical success factors within the control of the organization and the investment committee. The inevitable bump in the road for performance and the anticipated muted return environment should be wake-up calls to plan ahead for long-term success. Investment stewardship and governance Investing in public companies carries the heavy responsibility of holding management accountable for long-term value creation and running the company s day-to-day operations effectively. Companies and boards should similarly be focused on long-term shareholder value both through the sustainability of their strategy and operations, and by managing the risks most material to their long-term success. Well-governed companies perform better over the long term, and when portfolio companies perform well, your investments perform well, too. Are your investment dollars advocating for you? Are you partnering with an investment firm that takes a thoughtful and deliberate approach to investment stewardship? Vanguard s funds typically own the stock of companies for long periods and, in the case of index funds, are semi-permanent holders of companies. As a result, our emphasis on investment outcomes over the long term is unwavering. We focus on enduring themes and topics that drive long-term value, rather than short-term results. Acting as a voice for our investors, we work tirelessly to drive and monitor effective practices through: Advocating for a world in which the actions and values of public companies and investors are aligned to create value for all shareholders over the long term. Engaging with portfolio companies. Thoughtfully voting proxies at company shareholder meetings across our portfolios and around the globe. Outsourced CIO services Most nonprofits don t employ fulltime investment staff. Many committee members have other duties. An outsourced CIO (OCIO) can help a nonprofit investment committee address challenges like those discussed here. Vanguard has offered OCIO services to nonprofit organizations for over 20 years through Vanguard Institutional Advisory Services (VIAS TM ). Working with thousands of investment committees, we have seen the benefit an OCIO partnership can deliver. An organization can leverage the OCIO s expertise, scale, and investment methodology while freeing its investment committee members to focus their time and effort on their primary roles.

7 In order to create alpha for a client, we believe an OCIO must deliver: 1. An articulated strategy A clear and concise firm wide investment philosophy and approach that doesn t change if personnel leave the OCIO. 2. Operational scale To best support an organization, an OCIO needs expertise across investment management and research, as well as operational support staff. 3. Behavioral ballast An OCIO should provide governance and committee best practices to keep the committee focused on their objective during times of market volatility. 4. Cost maximization Every dollar spent on investing is a dollar less an organization has for its mission. An OCIO needs to show both what the committee is paying for and its return. The challenge ahead Nonprofits invest in a challenging environment. We believe nonprofit organizations can best advance their core missions by considering the six topics discussed here in 2018: Portfolio construction Benchmarking Committee bias Spending policy Investment stewardship and governance Outsourced CIO services If you would like more information on any of the topics covered in this commentary, please contact your Vanguard representative or call us at Acknowledgments Leo Corrigan, Jr. CFA, CFP; Nathan Erickson; Geoff Hall; Carol Misus, CFA; and Dan Voss, CFA made significant contributions to this commentary.

8 For more information about Vanguard funds, visit institutional.vanguard.com or call to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future returns. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer s ability to make payments. Investments in stocks or bonds issued by non-u.s. companies are subject to risks including country/regional risk and currency risk. Costs are one factor impacting total returns. There may be other material differences between products that must be considered prior to investing. Advice services offered through Vanguard Institutional Advisory Services are provided by Vanguard Advisers, Inc., a registered investment advisor. Connect with Vanguard > institutional.vanguard.com > P.O. Box 2900 Valley Forge, PA The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds. NPCMWP DOLU