A Guide to the Strategic Foundation Portfolio with Alternatives

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1 August 2016 A Guide to the Strategic Foundation Portfolio with Alternatives The PNC Institutional Advisory Solutions (IAS) Investment Strategy Team has developed a new Strategic Foundation Portfolio with Alternatives (Foundation Portfolio) based on specific investment objectives. This report discusses the new portfolio and key elements of its development. While every institutional client portfolio is customized to meet the needs of the particular client, we have built a series of new, so-called strategic portfolios that will serve as a baseline for client portfolios with similar objectives and provide a starting point for discussions with prospective clients. This paper outlines the recommended Foundation Portfolio along with key elements of its development. The portfolio has been developed to address the specific challenges faced by foundations with respect to liquidity needs, spending levels, and the fairly high rates of return required to achieve these objectives. Additionally, we decided to develop this new baseline portfolio based on specific investment objectives deemed to be representative of canonical foundation client needs. Foundation Client Profile The profile outlined in this paper is unlikely to precisely describe any one foundation client. Each client has unique, and often rather complex, needs that we must disregard to some degree for the purpose of developing a baseline portfolio applicable to a meaningful subset of our clients. Nonetheless, we believe it is important to establish baseline portfolios reflecting well-defined, albeit somewhat simplified, investment objectives as a starting point for addressing more complex situations. We start by defining, at a high level, a foundation. Chartered Financial Analyst (CFA) curriculum provides the following description of a foundation: 1 Grant-making institution funded by gifts and investment assets in order to support philanthropic goals and can be classified into four types: independent (most common), company-sponsored, operating, and community. Private non-operating/charitable foundations simply disburse funds to other charitable organizations. We have also chosen to follow the recommended guidelines from CFA Institute with regard to the creation of an investment policy statement 2 for this exercise. The Foundation Portfolio is being developed for a hypothetical independent foundation which meets the following criteria: The foundation is a U.S.-domiciled taxexempt entity whose asset value and spending needs are dollar denominated. The investment portfolio is expected to provide the sole source of revenue and income to support grant-making needs and the operating budget, as the institution does not engage in fundraising campaigns. Little or no alternative funding sources are available to bridge a potential shortfall in expected returns, though it may be possible to cut expenses and/or distributions will eventually adjust to lower asset levels should a lower return environment persist. Risk profile: fairly high due to lack of defined liabilities/obligations (grants are typically variable/discretionary in nature) and a long time horizon. Return objective: o will need to achieve a minimum compounded (nominal) return objective 1 Foundations and Endowments, Portfolio Management, CFA Institute, 2014 Level 3 Curriculum, p Elements of an Investment Policy Statement for Institutional Investors, CFA Institute (May 2010).

2 of 7.42% = (1.05)(1.003)(1.02), which includes the legally required 5% annual distribution, investment management fees and overhead expenses of 30 basis points, and 2% inflation, based on the rolling three-year average asset value of the portfolio; and o organization desires, but is not required, to maintain and/or grow the purchasing power of the principal over the long term. Time horizon: has an indefinitely long investment time horizon reflecting the expectation that the portfolio will last into perpetuity. Liquidity needs: a portion of the annual grant-making and operating budget is held in a cash reserve outside of the investment portfolio in order to maintain adequate liquidity for distributions, typically once or twice per year (June/December), while normal/ongoing expenses such as excise taxes, fees, co-trustee fees, and so forth, can be covered by income flow (all paid on quarterly cycle). Tax concerns: o excise taxes can be in the 1-2% range; and o any investments that might generate unrelated business taxable income should be avoided (for example, master limited partnerships). Unique circumstances: o the organization has sufficient size, scope, experience, and resources to qualify for and maintain an allocation to alternative investments; and o there are no concentrated positions that need to be considered in managing this portfolio. Composition and Development of the Portfolio Based on these assumptions, the primary focus/objective was to construct a portfolio capable of funding a real stream of spending with the potential for modest growth of real wealth net of this spending. High Level Allocations We begin by laying out the asset allocation of the Foundation Portfolio at a high level. As seen in Table 1, public equities comprise the majority of the portfolio at 60%, including publicly traded real estate investment trusts (REITs), followed by a 30% allocation to alternatives, and just 10% to public fixed income. Table 1 Asset Allocation of Foundation Portfolio Foundation Public Equities 60.00% U.S % International 24.00% REITs 2.00% Public Fixed Income 10.00% Short Taxable 10.00% Alternatives 30.00% Hedge Funds 6.00% Private Equity 12.00% Private Debt 6.00% Real Estate: Private 6.00% Cash 0.00% The sizable equity position reflects the need for significant long-term growth potential in the portfolio. In addition, it is supported by the notion that because they tend to mean-revert, equities help stabilize long-run portfolio returns. 3 The rather small fixed income allocation consists of short taxable bonds only a highly liquid, relatively stable asset class that can provide an offset to the large illiquid alternatives allocations. We view the 3 Christopher D. Piros, Plus Ça Change, Plus C Est La Meme Chose, Investments & Wealth Monitor (March/April 2015): 5. 2

3 role of the short taxable fixed income position as effectively quasi-cash and have included it to help a foundation using this strategic asset allocation framework meet its short-term liquidity needs even during periods of extended market stress (when also potentially dealing with multiyear lockups from the allocations to alternatives) without having to reduce public equity exposure at inopportune times (that is, selling stocks when they are down for cyclically driven reasons rather than fundamental ones). The allocation to inherently illiquid asset classes/strategies hedge funds, private equity, private debt, and private real estate was limited to 30%, since we do not subscribe to the so-called Yale Model, where allocations to private equity and other alternative investments can easily exceed 50% of the total portfolio. The IAS Investment Strategy Team performed extensive simulation analysis based on explicit modeling of the structural characteristics that make these assets illiquid, including subscription/redemption periods and capital commitment/drawdown/distribution processes. The analysis showed that with a combined targeted allocation of no more than 20-30% to these classes, the portfolio is unlikely to experience either explicit liquidity problems or excessive drift in portfolio weights, provided a significant portion of the allocation is directed to funds which allow the investor reasonable control over the timing of investment and redemption (for example, hedge funds). However, the risk of such problems rises rapidly for larger allocations. Worth noting, we have deliberately excluded an allocation to natural resources and/or real return investments, that is, oil and Treasury Inflation- Protected Securities (TIPS), for a couple of reasons. There is no solid basis for believing that a long position in natural resources (specifically commodities) earns a persistently positive and significant risk premium. Depending on the specific asset and environment, the risk premium may actually accrue to the short position. An exception to this is timber, which does typically generate a positive economic return over time and may be viewed as a component of a private real estate and/or REIT allocation. Active trading strategies involving both long and short positions, that is, Commodity Trading Advisors, may be viewed as falling within our hedge fund allocation. Although natural resources tend to be positively correlated with short-term inflation, there is scant evidence they provide reliable protection of purchasing power over long horizons. Detail of Public Equity Allocations Table 2 highlights the public equity allocations at a more granular level. As indicated, 36% of the portfolio is allocated to domestic equity, with the balance, or 24%, allocated to international. This represents a significant home country bias relative to market capitalization weights, which would be closer to 50%/50% of total Table 2 Public Equity Allocations Foundation Total Public Equity 60.00% U.S % Large Cap 13.75% S&P 500 Growth 4.00% S&P % S&P 500 Value 5.25% Mid Cap 12.75% S&P 400 Growth 3.50% S&P % S&P 400 Value 4.75% Small Cap 7.50% S&P 600 Growth 2.00% S&P % S&P 600 Value 3.00% REITs 2.00% International 24.00% Developed Large Cap 10.25% MSCI WxUS Growth 3.25% MSCI World Ex Us 3.50% MSCI WxUS Value 3.50% Developed Small Cap 5.25% MSCI WxUS SC Growth 1.50% MSCI WxUS SC 1.50% MSCI WxUS SC Value 2.25% Emerging/Frontier Markets 8.50% 3

4 public equities. Aside from slavish adherence to market capitalization weights, we see no compelling reason for a bigger international allocation. Correlation among markets is quite high. With more than 20% already allocated to international stocks (and many U.S. managers holding some foreign stocks), the marginal diversification benefit beyond this level is likely to be small. The U.S. market is as diversified with respect to sectors and industries as the whole global market. International equities generally entail currency exposure, which adds volatility but is not necessarily adequately and reliably compensated and has not been shown to offer reliable purchasing power protection. Public Equity Breakdown (Percent of Total) Table 3 depicts the breakdown of public equities by both market capitalization (small, mid, and large) and style (growth, core, and value) categories. As shown in Table 3, the portfolio is overweight in small cap and mid cap compared to their fairly low market capitalization weights. These allocations allow us to more fully capture the well-known size factor, take advantage of the fact that mid cap stocks often exhibit stronger performance as large cap managers look for acquisition opportunities in relatively smaller firms, and, more generally, reduce reliance on mega-cap names that dominate the large cap universe. We have also introduced explicit allocations to Growth and Value styles with a moderate tilt toward Value. The tilt toward Value reflects the well-known empirical regularity that over time Value stocks tend to outperform Growth stocks on a riskadjusted basis. Performance and Risk/Return Characteristics of the Portfolio The next sections examine the performance and estimated risk/return characteristics of the Foundation Portfolio. Nominal Return Characteristics 4 The results of our analysis are shown in Table 4 (page 5). We believe this portfolio has the potential to generate a nominal expected return of 8.77% with volatility of approximately 16.17%. The expected return handily exceeds our estimates for the long-run return profiles of each individual category of public equities (both domestic and international), with a volatility measure falling Table 3 Public Equities by Market Capitalization and Style*** Size Style Approximate Foundation Market Cap U.S. Only* Large Cap 40.4% 89.6% Mid Cap 37.5% 7.3% Small Cap 22.1% 3.1% Total** Large Cap 40.0% 70.7% Mid Cap 21.3% 15.2% Small Cap 21.3% 14.1% Growth 23.8% Core 27.5% Value 34.6% *Relative to the S&P 500, S&P 400, and S&P 600 as a % share of market capitalization in the S&P 1500, as reported via FactSet. ** Relative to the Large, Mid, and Small Cap indexes comprising the MSCI AC World Index, as reported via FactSet. *** The size and style categories do not sum to 100% because we have excluded both REITs and Emerging Markets from the calculations. 4 The capital market assumptions used in this analysis are not the same rolling 10-year assumptions we publish at the end of each calendar year. Instead, we used more neutral return and volatility assumptions based on a very long horizon (30 years). 4

5 Table 4 Key Portfolio Characteristics Foundation Expected Return 8.77% Volatility 16.17% Skewness Kurtosis 6.40 somewhere in between the long-run estimated volatility of the S&P 500 and S&P 500 Value indexes an attractive outcome in our view. In terms of skewness, a measure of asymmetry, the Foundation portfolio has a moderate negative skew, 0.95, versus zero for a normal distribution. The usual interpretation of this statistic is that the left (downward) tail of the distribution is longer than the right (upward) tail. However, that intuitive notion can be misleading since the whole distribution must be considered, and even small changes in the distribution can flip the sign on this metric. We report it here for completeness, but we do not view it as very informative. Regarding kurtosis (the so-called peakedness of a distribution curve), the Foundation Portfolio has a positive value of 6.40 versus 3 for a normal distribution. This means the portfolio not only has fatter tails than a normal distribution but also has more outcomes concentrated in the center of the distribution. Thus, both very large and relatively small deviations from the mean are more likely than with a normal distribution while intermediate deviations from the expected value are less likely. These are logical results because we have tilted the asset allocation of the portfolio toward some historically more volatile asset classes in an effort to maximize return per unit of risk, but still achieve the high required rate of return. Likelihood of Losses, in Nominal Terms Table 5 depicts the probability and magnitude of losses at any time within the 30-year horizon (left column) and at the end of the 30-year horizon (right column). The proposed portfolio has a higher likelihood of suffering a given size loss both at the end of 30 years and at any time within the 30-year horizon than a portfolio comprising, say, 45% equity, 35% fixed income, and 20% alternatives (45/35/20 Portfolio). This is driven by the substantially higher allocations to both equity and alternatives (higher returns, higher volatilities) and correspondingly lower fixed income allocation differences necessary to achieve the higher required rates of return. It should be noted that the probabilities of loss shown in Table 5 are likely to be overstated, perhaps substantially, because they do not reflect the long-term stabilizing impact of mean-reversion. The expected return shown in Table 4 is not a compounded return. Hence, it should not be interpreted as the growth rate of the portfolio over multiperiod horizons. Using a well-known volatility adjustment, 5 we can approximate the expected nominal growth rate for the Foundation Portfolio as 7.5%. Based on this growth rate and allowing for 2% inflation, we expect the Foundation Portfolio to facilitate modest growth of real wealth net of targeted spending. Under these same assumptions, the 45/35/20 Portfolio referenced earlier would generate only 6.0% nominal growth not sufficient Table 5 Probability of Losses (in Nominal Terms) Any Time within End of 30-Year Horizon 30-Year Horizon Loss of Foundation Foundation 5.00% 70.95% 0.279% 10.00% 49.41% 0.227% 15.00% 33.70% 0.181% 20.00% 22.46% 0.142% 25.00% 14.57% 0.109% 5 The growth rate is approximately equal to the annual expected return minus one-half the annual variance. 5

6 to cover inflation, in addition to the targeted 5.0% spending rate for foundations. Wealth Projections Chart 1 is based on an initial portfolio value of $1 million (for modeling purposes) and shows the median (50%) confidence level for real wealth net of spending over a 30-year horizon. The sawtooth pattern in the chart reflects an annual disbursement for grant making and so forth. The Foundation Portfolio is the dark red line, while the 45/35/20 Portfolio is shown in blue. Chart 2 shows the tulip of confidence bands for the Foundation Portfolio. Consider the green region labeled 5-25%. This means there is a 25% chance that wealth will be at or above the bottom of this region and a 5% chance that wealth will be above the top of this region. The bottom of the dark red band (equivalently the top of the orange band) is the median level of wealth corresponding to the dark red line in Chart 1. Chart 3 isolates the difference in outcomes for the Foundation Portfolio versus the 45/35/20 Portfolio by showing the differences between their respective 95%, 75%, 50%, 25%, and 5% confidence levels for wealth. Consider the green line in Chart 3 labeled 25%. This is simply the difference in wealth at the 25% Chart 1 Foundation Portfolio, Median Real Wealth Initial Wealth = $1 million confidence level (the bottom of the 5-25% region in Chart 2) for the Foundation Portfolio versus the 45/35/20 Portfolio. Since this green line lies entirely above zero, the 25% confidence level for the Foundation Portfolio is always above the 25% confidence level for the 45/35/20 Portfolio. At the 30-year horizon, the difference is roughly $872,820, or 87% of the initial $1 million, of real wealth for the foundation. We emphasize that these wealth charts reflect cash distributions that are tied to the value of assets. Thus, the fact that the Foundation Portfolio is likely Chart 2 Foundation Portfolio, Estimated Confidence Bands for Real Wealth Source: Windham Portfolio Advisor, PNC Chart 3 Confidence Levels for Real Wealth: Foundation Portfolio - 45/35/20 Portfolio Source: Windham Portfolio Advisor, PNC Source: Windham Portfolio Advisor, PNC 6

7 to grow real wealth faster than the 45/35/20 Portfolio means that it will also have distributed larger amounts to the sponsor along the way. Conclusion We believe the traditional/balanced asset allocation approach (60% stock/40% bond) is not sufficient to address the specific challenges of foundations regarding liquidity needs, spending levels, and fairly high required rates of return necessary to achieve these objectives. With this as the backdrop, the IAS Investment Strategy Team has conducted extensive analysis to design/develop a customized solution specifically for foundations, and this paper is the culmination of that research effort. Indeed, we think this Strategic Foundation Portfolio with Alternatives is an excellent solution capable of meeting and/or exceeding a typical foundation s long-run spending and return objectives with the potential to actually grow real wealth and distributions over a 30-year investment horizon. Amanda E. Agati, CFA Managing Director, Chief Institutional Investment Strategist The PNC Financial Services Group, Inc. ( PNC ) uses the marketing name PNC Institutional Advisory Solutions SM for discretionary investment management, trustee, and other related activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC does not provide investment advice to PNC Retirement Solutions and Vested Interest plan sponsors or participants. PNC Bank is not registered as a municipal advisor under the Dodd- Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. PNC Institutional Advisory Solutions is a service mark of The PNC Financial Services Group, Inc The PNC Financial Services Group, Inc. All rights reserved. 7