Meeting Endowment Objectives in a Low Return Environment

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1 Meeting Endowment Objectives in a Low Return Environment Greg Johnson, CFA Ryan O Quinn, CFA May 11, 2017

2 Our Background Full service, independent, institutional investment consulting firm Established in employees with more than 60 experienced investment professionals Independence Key differentiators Stability Client service Experience Value-add

3 Our Background We advise more than 260 clients Private and public foundations, education endowments, pension plans, health care, and insurance organizations Roughly $50 billion in client assets Comprehensive range of service offerings

4 Contradiction OPERATIONAL GOALS Low volatility LONG-TERM STRATEGIC GOALS High returns Predictable Very liquid Reliable Budget Real Growth

5 A Little History QUESTION How many of you are trying to spend roughly 5%, plus grow your endowment beyond inflation? SURVEYS SAY Most of you but the 5% is going down.

6 A Little History In order to earn 5% plus inflation (plus a little more?): Stocks earned 12.1% Bonds earned 5.0% Cash earned 5.6% Inflation 3% 60/40 stocks and bonds balanced portfolio earned 9.5% No problem!

7 A Little History In order to earn 5% plus inflation (plus a little more?): Stocks earned 10.5% Bonds earned 7.2% Cash earned 4.4% Inflation 2.5% 60/40 stocks and bonds balanced portfolio earned 9.4% Still not much of a problem.

8 A Little History In order to earn 5% plus inflation (plus a little more?): Stocks earned 7.1% Bonds earned 4.3% Cash earned 0.7% Inflation 2% 60/40 stocks and bonds balanced portfolio earned 6.2% (less if you diversified internationally) Now, we may have a problem.

9 Today 2017 Cash pays 0-1% Bonds pay 2-3% (unless you want a LOT of risk) Equities yield around 2% and have a lot of volatility. Even if the historic premium over cash is earned, the total return might be 6% (?) Inflation expected to run 2.0% over the next 10 years So, if not 60/40, what else?

10 What Else? OPTIONS ABOUND But keep in mind: Low risk = Low return

11 Aligning the Portfolio The endowment model or the model portfolio or the strategic solution for one organization may be very different than another. Even if both are just trying to earn 5% over inflation.

12 Aligning the Portfolio Model Portfolio Return objectives Risk tolerance Liquidity needs Bond indentures Spending restrictions Budget dependence Client Portfolio Governance

13 Aligning the Portfolio Expertise Know what you own and avoid mystery. Governance How often do the decision-makers change? Cash flows What are your needs? Volatility tolerance What would a 20% decline mean to you?

14 Building the Portfolio COMMON STARTING POINTS FOR PORTFOLIO CONSTRUCTION Start from cash at 0% expected return. Build risk/return incrementally. Start from 60/40. Chip away at allocations by diversifying into other choices. FACT: The term alternatives started here, as most other choices are considered alternatives to stocks and bonds.

15 Building the Portfolio Either way, the portfolio should end up in a place that best reflects the answers to the questions posed earlier. Risk of loss Need for liquidity Governance Comfort level Size

16 Building the Portfolio Once a portfolio of asset classes has been determined, the next layer of hard work begins. Understand fees Choose managers Evaluate short- and long-term performance

17 Long Term and Short Term HERE S THE QUESTION: How do we know when short term (which we are supposed to ignore) becomes long term (which should be our focus)?

18 Long Term and Short Term It is difficult to separate long- and short-term results. Virtually all asset classes look different over the last three calendar years when compared to long-term history. Asset Class 20-year Annualized Return Year Annualized Return Difference Domestic Equity (0.9) International Equity (8.9) Hedge Funds (7.4) U.S. Bonds (2.9) Private Equity (5.0) Real Estate (3.5) Commodities (15.9) Cash (2.8)

19 Long Term and Short Term 25 S&P 500 Index Rolling 10-Year Return

20 Long Term and Short Term Market timing is probably not part of the solution. S&P 500 Index Performance Excluding Best Days 10% 8% 25 Year Annualized Return 7.2% 6% 4% 4.2% 2% 1.4% 0% -2% -4% -2.3% 50 Best Days 25 Best Days 10 Best Days No Days Data as of March 31, 2017

21 Back to it: Aligning the Portfolio HOW DO YOU DESCRIBE YOURSELF? Many of you might say: Endowment Low cash needs Sophisticated investment committee Long-term investor Fee sensitive

22 The Portfolio SET REASONABLE EXPECTATIONS Equities near fair value Bonds with low yields Hedge funds trying to lower risk profile Private equity seeking high returns What is the recipe? What are the targets that achieve the difficult balance between reliable budget and real growth? Reliable Budget Real Growth

23 Portfolio Expectations Long-Term Asset Class Assumptions Expected Real Return Expected Volatility Domestic Equity 4-5% 15-20% International Equity 4-5% 20-25% Hedge Funds 4-5% 8-12% U.S. Bonds 1-2% 5-10% Private Equity 5-7% 25-30% Real Estate 4-5% 20-25% Commodities 2-4% 15-25%

24 Equity-Like Bond-Like Portfolio Expectations Equity 60/40 M1 M2 M3 Diversified Model Global Public Equity Global Private Equity Flexible Capital Long/Short and Absolute Return Real Assets Real Assets (RE/NR/TIPS/Commodities) Credit Core Bond Deflation/Dollar Hedge Sovereign Debt Total Statistical Output (%) 60/40 M1 M2 M3 Diversified Model Expected Real Return (Arithmetic) Expected Standard Deviation Expected Real Return (Geometric) Sharpe Ratio Historical Real Return (Arithmetic) Historical Standard Deviation Historical Real Return (Geometric) Notes: Expected return/risk using year Prime Buchholz asset class assumptions. Historical data based on index returns from January 1, 1988 through December 31, 2016.

25 Bond-Like Equity-Like Attributes of Sample Portfolio Diversified Model Global Public Equity 40.0 Equity Global Private Equity 10.0 Flexible Capital Long/Short and Absolute Return 20.0 Real Assets Real Assets (RE/NR/TIPS/Commodities) 15.0 Deflation/Dollar Hedge Sovereign Debt 15.0 Liquidity Cash (T-Bills) 0.0 Total Passive or active management? BUT WE STILL HAVE ALL THIS TO CONSIDER Private or public investing? Direct or funds of funds? Are there liquidity restrictions? What about management fees?

26 Things to Remember Goals can be conflicting, especially in today s environment. There should be a balance between operational and long-term strategic goals. Your organization is unique. One size does not fit all. 5% may no longer be the right target (too much risk to get there).

27 Thank you! Any questions?

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