Priorities for Endowment, Foundation Investment Committees

The start of the year is a good time for such committees to review their institution’s investment strategy, evaluating what worked and what didn’t in the previous year, according to Mercer. It is also a good point at which to consider potential changes to this strategy.

Heading into 2014, Mercer research indicates the investment landscape is changing. With the Federal Reserve (Fed) beginning tapering QE3 in January 2014, market volatility may increase, offering new market opportunities and risks. The challenge for investment committees will be how to balance spending with the need to maintain purchasing power, and how to anticipate and respond to environmental, social and governance (ESG) issues.

Keeping this in mind, Mercer has identified the following priorities for investment committees to consider:

1. Continue to Diversify

Since the financial crisis, a U.S.-oriented portfolio of stocks and bonds has been difficult to beat. Investments in overseas stock and bond markets and alternative investments have generally hurt returns compared to simpler portfolios, harkening back to the second half of the 1990s. However, U.S. assets appear increasingly expensive. Diversification should yield better results in the future.

2. Prepare for the End of Fed Accommodation

It’s like anticipating the next bad weather system. One knows it’s coming, but it’s impossible to anticipate exactly when and how bad it will be. Weaning the economy and investors off of unprecedented easy money will be a challenge. What could go wrong? What could go right? How do investors prepare for the end of the party?

3. Ask If Now Is the Time to Play It Safe

Large-cap quality stocks, generally seen as multinational, industry leaders with strong balance sheets and market positions, are expected to protect against sharp market declines. As a result of their defensive nature, these stocks have lagged their riskier brethren over the past several years, including small-cap stocks, but they have generally yielded superior risk-adjusted returns over the long-term. With the U.S. economic growth appearing to improve, the investment committee should review investment strategy and actively decide to favor quality or lean towards riskier stocks.

4. Be Ready If Emerging Markets Re-emerge

As growth in China appears to slow and a number of other economies deal with sizeable macro imbalances, many observers have become pessimistic about the outlook for emerging markets. Performance has severely lagged developed markets of late, and as a result valuations are relatively attractive. Evaluate whether now is the time to increase investments in emerging markets or if such a step is way too early. In any event, discuss action steps if this sector appears ready to rebound.

5. Evaluate the Appetite for Tail Risk and Whether to Hedge or Embrace It

The potential for large investment losses appeals to no one and protecting against them through tail risk insurance tends to be expensive, particularly when it is desired the most. Tail risk is an extreme shock to financial markets that shows up as infrequent observations in the far left tail of a return distribution. It is technically defined as an investment that moves more than three standard deviations from the mean of a normal distribution of investment returns. Endowments and foundations with long investment horizons are arguably among the most able to bear tail risk. So, should tail risk hedging be considered? Is so, what should be the approach? When other investors are willing to overpay for tail risk insurance, does it make sense to sell it?

6. Analyze Whether Private Equity’s Expected Payoff Fits the Committee’s Patience Horizon

Private equity is the Holy Grail of expected returns. Meeting a lofty return goal in a low expected return environment forces committees to think about private equity. Given the powerful penalty imposed by the j-curve and the potentially distant payoff horizon, discuss whether the investment committee is comfortable with an asset class that may not bear fruit until long after most members have rolled off the committee.

7. Assess Whether Inflation Protection Is Desirable

Inflation continues to be benign as slackness in the U.S. economy has offset exceptionally easy monetary policy. One inflation hedge, natural resource-oriented investments, has generally posted disappointing returns in recent years. However, the Fed’s bloated balance sheet combined with stronger growth could lead to unexpected inflation in the future, although the timing is uncertain. This issue is especially important for institutions with inflation-sensitive liabilities. Assess the likelihood of renewed inflation and whether this is an issue for the portfolio.

8. Consider the Intersection of Risk and Moral Hazard

All investors will indicate that risk is a key factor in the management of their portfolios. Misalignment of measurement standards and risk definitions often result in an overwhelming dominance of statistical policy criteria as investment committees make decisions that impact the portfolio. Often investment committees actually express their risk tolerance through decisions in response to extreme market activity or underperformance. Because risk is not effectively defined and monitored, ad-hoc responses to risk can be damaging to the long-term objectives of many nonprofit investors. Now is the time to review whether the existing definition of risk and risk measurement standards has eroded the true role of risk management in portfolio design, and instead resulted in the entire focus landing squarely on the relative portfolio return.

9. Evaluate Spending Rates and Rules

Returns have been great for five years, but many observers expect a low return environment over the next five to 10 years given low interest rates and elevated equity valuations. Meanwhile, many institutions foresee unattractive demographics over the next decade. Committees may need to look at increasing spending at the very time future return forecasts would suggest cutting spending. This makes it important to freshly evaluate the institution’s spending rule and rate. An updated spending rule may help lower spending dollar volatility while preserving long-term spending plans.

10. Establish a Framework to Consider Stakeholder Issues in the Portfolio

Historically, these discussions have focused on divestment, such as calls against apartheid, Sudan, and more recently, fossil fuels. However, environmental, social and governance (ESG) issues may also reveal investment risks and opportunities to be discussed beyond divestment. Mercer suggests that investment committees establish a policy to periodically review material sustainability issues and stakeholder requests, even if it means that action is not always taken. Establishing this framework now may make it easier to respond to issues in the future.