Endowments and foundations have bounced back from the market lows they faced in 2008 — but will they have to bounce back from 2016?
Non-profits have an opportunity to smooth the way now for whatever rough roads the next year will bring, according to Mercer, a New York-based talent, investment, health and retirement consultant.
“It’s still too early to tell if people will need to come back from 2015 and 2016,” says Travis Pruit, a senior consultant and U.S. proposition leader for Mercer’s endowment and foundation services. “At this point, we don’t see the same kinds of excesses that occurred before 2008 and it doesn’t feel like we’ve stumbled on one big risk, but any time you get volatility, people start to re-evaluate.”
Investment committees should establish their behavioral risk tolerance, or "comfort level," according to Mercer, because in a low-interest rate environment, conservative allocations heavy in fixed income can’t generate the 7 percent to 8 percent average return that an endowment or foundation typically relies on.
“This is a more challenging environment where basic returns will be lower; committees should be thinking about whether they need to be more aggressive or more cautious,” Pruit says. “We counsel clients to be mindful that we believe in globally diversified portfolios that spread out the risk and return factors. That also means we’ll own some things that aren’t market correlated.”
While the rest of the investment universe seems to be casting a critical eye at hedge funds and other liquid alternatives, Mercer believes there is still a place for them within the portfolios of endowments and foundations.
“We believe that hedge funds are an invaluable tool for non-profit investors,” Pruit says. “Bonds do okay when equity markets roll over, and high-quality bonds do well in an inflationary environment, but the greater allocation is better placed in hedge funds because the return potential is better.”
Investment committees should confirm the role of inflation-sensitive investments in the endowment or foundation portfolio, Pruit says.
“The concept of private debt seems to be gaining momentum among non-profit investors, “Pruit says. “Investors are separating the concept of liquidity from safety with fixed income, and that’s leading to greater allocation to things like private debt.”
Pruit says that investment committees should take extra time to conduct due diligence on investment opportunities like private debt and hedge funds. Endowments and foundations must first establish due diligence best practices, according to Mercer.
“A number of organizations are embracing alternatives that are less transparent and use different regulatory rules than traditional investments,” Pruit says. “There are many more things that could go awry with these investments; the level of control is a lot lower. Investment committees can’t process away every possible risk, but we think there’s more that they can do to protect themselves.”
Investment committees should attempt to realistically measure their liquidity needs and to design their portfolios accordingly. Pruit says that many non-profits aren’t taking advantage of their ability to access illiquidity premiums.
“From a liquidity planning standpoint, investors have to be able to meet the mission of the endowment or foundation, but they’re paying too high a price for liquidity,” Pruit says. “Do they really need 50, 60 or 70 percent of their portfolio liquid to sell tomorrow? In most cases, their annual cash need is 5-7 percent of their current asset base. These are perpetual pools of capital that are going to be around for a long time.”
Mercer has identified portfolio benchmarking as an area where many non-profit investors need to spend time and energy in 2016.
“Benchmarks are the primary quick look around portfolio expectations,” Pruit says. “We see a lot of endowments and foundations focusing on comparisons with their peers,” Pruit says. “There are too many variables between organizations, even those with similar goals and objectives have different personalities and biases.”
Investment committees most often use benchmarks to measure portfolio performance, which Pruit says is too simplistic.
“We think the most appropriate big-picture benchmark is an allocation-weighted correction of the underlying strategy, that way you can measure and consider the basic asset allocation that you’re following,” Pruit says. “The basic allocation is the best expression of what an investment committee is attempting to achieve, they should be critical of the underlying performance of their benchmark, not just how it compares to the performance of their investment portfolio.”
In 2016, most endowments and foundations are considering factors beyond return when deciding how to allocate their assets, according to Mercer.
Pruit says that socially responsible and other forms of investing that consider environmental, social and/or governance factors give committees a broader opportunity to align their goals with their organization.
“It’s more constructive to take a positive view of the opportunities that ESG investing offers as a practice,” Pruit says. “It should be more than just screening out the ‘bad players’ like fossil-fuel industries.”
Mercer’s analysis warns endowments and foundations that ESG factors like climate change may impact their long-term returns, so investment committees should consider adopting a strategic asset allocation that incorporates risks and opportunities presented by ESG factors.
“We think it’s important that you take into account the viability and sustainability of businesses over a long time period,” Pruit says. “Not just resource sustainability, but sustainability in light of a changing regulatory environment, we’ve reached a point where that’s going to be an important factor for long-term investing.”
Interest rate risk also vexes long-term investors like endowments and foundations. Loose monetary policy has some investment committees questioning their asset allocation, Mercer says.
“If all central banks were moving in the same direction, we’d have momentum in one direction or another,” Pruit says. “Divergence has raised volatility in the short term. Anytime things seem like they aren’t going to be as rosy, the questions from investment committees start coming — it’s all normal and common.”
Mercer also recommends that investment committees perform a governance "fire drill," crash-testing their response to market downturns to determine if they need to meet to address declines as they happen and to build consensus on how portfolios will be rebalanced in such an event.
“We’ve had two major downturns in the last 15 years. I don’t think you need to envision conditions that dire, but I’m a believer that the real risk is never the volatility or the drawdown or the performance of the active manager, but the investor’s reaction,” Pruit says. “We build strategic portfolios because we know that the market is eventually going to go down, and we also have these fire drills. As a kid, you have fire drills in school so if something actually happens, you’re prepared, not panicked. We think it’s a good exercise for investment committees, too.”
Mercer is a subsidiary of Marsh & McLennan Companies that works with more than 250 non-profit clients.
