Back to the Basics
Put away your crystal ball and follow these six fundamental steps of prudent and effective investment management.
The history of the investment markets is one of up and down cycles. The reasons for these fluctuations are generally apparent in hindsight, but rarely predicted accurately.
The past three years have been very difficult for virtually all investors. The values of foundation, personal and retirement plan assets nosedived, primarily due to the prolonged decline in the value of U.S. and foreign stocks. Foundations have reacted by reducing their grants budgets, seeking ways to cut costs and, in many cases, adding to the ranks of the unemployed.
Many foundation managers feel they must do something, often shifting investment funds to asset classes that have performed best in the recent past. Other managers are so concerned that any decision in this market environment is likely to be wrong that they maintain the status quo and wait for the recovery to occur. But what's the most prudent move for a foundation manager?
Over the long term, the biggest errors are often at the policy level, not the asset management level. So, to be prudent and effective, foundation managers must critically examine their investment processes, policies, practices and strategies to make sure they're consistent with spending policies and return objectives and that their assets are exposed to no more risk than necessary to achieve their objectives. These six steps are key to achieving those goals.
Step 1: Set a Spending Policy, and so, the Return Objective
You need to know what you're going to spend before you can determine what you need to earn. (See "The Point of Low Return," below, for how spending, growth aspirations, investment costsconsultant fees, custody fees and manager feesand inflation affect the return requirement.)
Portfolio Protection against Risk Overexposure. Spending policy should drive the return objective. Maximizing returns is not a suitable return objective because it would expose the portfolio to an unacceptable level of risk.
The portfolios of some foundations have gravitated toward asset mixes that are not aligned with their spending policies and return objectives. That's because good market performance and expectations of continuing good market performance were so strong in the 1990s that many investors felt little reason to rebalance. They allowed their allocations to some asset classes to drift beyond their established maximums, needlessly exposing portfolios to riskier asset classes when the markets turned downward.
Foundations that have not recently examined their asset allocations and rebalanced their portfolios may be overexposed to certain asset classes and underexposed to others at this very time. This can have a major impact on their portfolio returns and risk exposure.
Step 2: Develop an Asset Allocation Strategy
Asset allocation is the plan of diversification. It dictates how much of the foundation's endowment will be invested in which asset classesstocks, bonds, foreign stocks, real estate, etc.
A number of studies indicate that asset allocation is the key determinant of risk and returnpossibly accounting for up to 90 percent of the total investment return, while investment manager or individual security selection may account for less than 10 percent.
The goal of asset allocation is to identify efficient portfolioscombinations of investment assets that have the greatest probability of achieving the return objective with the least risk of any portfolio likely to achieve an equivalent return.
Investment consultants determine efficient portfolios with the aid of optimization models. Model inputs include the foundation's return objective, expected asset class returns over the investment time horizon, measures of the extent to which asset classes have similar or differing patterns of return (correlation coefficients) and measures of the year to year variability of returns (standard deviation). Model inputs rely heavily on historical data and relationships.
Laws of Linkage. It is important to remember that spending policy, the return objective and asset allocation are intrinsically linked:
(See "Sample Asset Allocation," below, which shows the target allocation, the permitted allocation range and the expected return for each asset class as well as the return that the portfolio is expected to generate.)
Asset Basket No-Nos. Failure to adopt an effective asset allocation and stick with it over the investment timeline can have a high cost.
Many endowment funds that incurred excessive losses over the past several years were under-diversifiedtoo many eggs in too few baskets. Studies show that adding just one asset class can significantly reduce volatility and stabilize returns. However, effective allocation is not achieved by simply having more asset classes. The asset classes must have different patterns of return and not be subject to the same forces. For example, the same forces that have affected the U.S. equities markets have similarly affected venture capital and private equity.
Some foundations err by adopting investment policies that provide for adequate diversification, but then allocate so little to some of the authorized asset classes that the portfolio does not benefit. It's difficult to envision how an allocation of much less than 10 percent to any asset class can have much of an impact on the overall return.
Other foundations err by departing from their asset allocation plan instead of sticking with it over their stated investment time horizon. For example, some foundations are shifting assets from stocks to bonds because bonds have been outperforming stocks. However, many investment professionals feel that such shifts are ill advised. They believe that bonds are at a high and, with interest rates at historic lows, bonds may be quite risky.
Step 3: Base Investment Moves on Long-term Data
Other foundations seemingly continue to make good moves at the wrong time. They shift funds from poor performing asset classes to asset classes that have been experiencing good performance just as the tide begins to turn.
Investors that chase after returns often end up moving from one asset class to another after the greater part of the return has occurred.
Avoid abrupt shifts in asset allocation; in general, they're not warranted. Inputs to optimization models are based on data from both good and bad market years, thus your allocation plan should already allow for the cyclical nature of the investment markets.
Finally, don't delete individual asset classes from your portfolio without revising the entire asset allocation. This is because each asset class has a unique role that is integral to the overall allocation strategy. Understand the characteristics and the role served by each asset class in which you're investing. Give strategies and policies time to work; the best performing asset classes vary over time, and inflection points are nearly impossible to predict.
Step 4: Establish Investment Policies and Guidelines
Make sure your investment policies and guidelines identify those responsible for policy, implementation and oversight. Document your foundation's spending policy, investment objectives, asset allocation strategy and management plan. As well, indicate how (or if) consultants and managers will be used. Establish guidelines regarding liquidity, security quality, economic sector weightings, maximum holdings of individual securities, the use of social screens and proxy voting.
Perhaps most importantly, adopt a rebalancing policy.
A good investment policy should explain why the foundation is investing, its investment objectives, its plan for achieving the objectives and identify those responsible for policy, management and monitoringall helpful guidance when outcomes are not as planned.
The Who's Who List. The most common policy error is failing to identify those responsible for essential investment management and oversight functions, such as keeping policies current, asset allocation, rebalancing and monitoring manager and overall portfolio performance. Sometimes, actions that should be taken aren't, because the various players aren't sure who should be taking the lead. Finally, good policies, particularly with respect to allocation and rebalancing, can insulate the portfolio from the often detrimental impacts of ad hoc decisions that are based on bias.
Step 5: Monitor Manager and Portfolio Performance
Regularly evaluate manager and portfolio performance to ensure that investment objectives are achieved and managers are exceeding their performance benchmarks on an after-fee basis. Also monitor costs, because reducing them may be the best way to improve net investment returns.
Keep a Watchful Eye. Virtually all foundations monitor their investment returns in relation to the performance benchmarks they have established, which are generally based on readily available market indices. Yet, many foundations fail to compare their investment returns to their return objective, and are unable to answer the crucial questionWas the return objective achieved?
Manager returns should be compared to benchmarks on an after-fee basis. There is little reason to engage managers if they are unable to beat index returns over a reasonable time period. Otherwise, invest in an index fund.
Managers who change their approach, discipline or style, and those who move outside the asset class that they were hired to manage, pose a risk to your overall investment planaltering the asset allocation and plan of diversification. Significant deviation from benchmark returns may be indicative of significant sector bets, style changes or asset class drift.
Bare-Bones Investing. To improve investment performance, reduce investment costs. Using index or mutual funds for more-efficient asset classes can sometimes reduce costs, while sliding scale fee structures and consolidating similar funds under one manager might reduce management fees. Custody and consultant fees can often be negotiated. As well, directed commission programs and securities lending programs might help to offset costs.
Step 6: Regularly Rebalance the Portfolio
Rebalancing is perhaps the single greatest risk management tool for your portfolio. It's a policy mechanism for buying low and selling high, and entails shifting funds from asset classes that are above their range maximums to asset classes that are below their range minimums. Thus, a portion of the gains in good performing asset classes is "harvested" (i.e., sold "high") and reinvested in asset classes that are lagging (bought "low").
Selling best-performing assets classes to buy more underperforming assets may feel counterintuitive, but this strategy ensures that your portfolio participates in market up trends, while avoiding the full impact of corrections after an asset class has "run up" in value.
Rebalancing is necessary. Over time, the actual asset allocation diverges from your set policy ranges, simply because returns among the asset classes will differ. A good rebalancing policy will dictate when the portfolio will be rebalanced and whether it will be rebalanced back to the target allocation or some point within the allocation range. You can also rebalance on an ongoing basis by withdrawing funds for operations and grants from asset classes that are at the high end of their range.
The Laws of Gravity. What goes up will eventually come downassets that fall in value will eventually attract buyers and rebound in investors' favor. Successful investing requires patience and adherence to time-proven policies and processes. Realize trends are just thatthey do not continue forever.
*At a minimum, private foundations are required to distribute 5 percent of the average value of their investment assets, less the tax on net investment income, by the end of the succeeding tax year. Other grantmakers, such as community foundations, often consider 5 percent to be their minimum payout level, as well. Foundations may choose to pay out more than 5 percent, depending on such factors as program objectives and opportunities, the expectation of future endowment gifts and whether the foundation's existence is perpetual or time-limited. Qualifying distributions (payout) consist of grants, program and general administration costs, direct charitable expenses, the cost of assets acquired for charitable use and program-related investments. Investment-related costs are not included in payout.
Illustration by Paine Proffitt
Jeffrey R. Leighton, CPA, is a financial and management consultant based in Lafayette, California.