Originally published on The Foundation and Endowment Report
By Mark Dixon
Like Wall Street’s “Fearless Girl” statue staring down the “Charging Bull,” endowments and foundations should resist being swept up by the momentum of markets.
The fiscal year ended 6/30/17 will likely be a very successful one for endowment portfolios. Both domestic and international stock markets performed extremely well during the last year, with the S&P 500 up nearly 18 percent and the MSCI ACWI ex-US index up more than 20 percent. This will likely prompt many investment committee members at endowments and foundations to wonder if now might be a good time to put a larger portion of their funds into equities to further boost gains. After all, many endowments may have already hit their annual performance targets for the year.
The temptation to try and make hay while the sun shines is understandable, after a couple of miserable years. During the fiscal year ended 6/30/16, U.S. endowments on average lost 0.7 percent, following limp 2015 returns of 2.8 percent, according to Wilshire Trust Universe Comparison Service. Many endowments target returns of 5 percent plus an assumed rate of inflation (perhaps 2 percent) — which would require a long term return of a little more than 7 percent — but with the current interest rate environment, and stock market valuations, achieving a 7 percent return over the next decade will likely require a higher level of risk than historically was the case. As shown in the chart below, while in 1995 it may have been reasonable to expect a 7 percent return from a portfolio that was fully invested in cash and bonds, and in 2005 a portfolio that was invested almost 60 percent in bonds, lower bond yields and higher stock market valuations today would seem to indicate that this 7 percent bogey might only be reached over the next 10 years with a portfolio that is invested in all equities.
So, while it may be tempting to increase risk levels to attempt to achieve a higher level of return, it’s critical to assess the overall needs of the organization to determine if higher risk levels can be tolerated. It’s highly likely that, in the long run, stocks will outperform bonds, and bonds will outperform cash. That equation rarely changes over 10 year periods. But it is also a certainty that stocks lead to a much higher level of volatility within a portfolio. At times like these, it’s crucial for committees to review portfolio allocations and their appetite for risk. Logic suggests that funds that have enjoyed strong gains on their equities are now over-weighted in stocks and should rebalance, taking profits rather than doubling down, and adding allocations to bonds where gains have been more modest. Rebalancing ultimately reinforces the buy low/sell high discipline and is a simple step for a long-term, strategic investor. Managers of smaller endowments should review whether the contents of their portfolio remain in line with their goals, taking action to reduce or increase risk as appropriate.
That said, there are some opportunities within equities that look intriguing. For example, while U.S. stocks were 57.5 percent higher than their 2007 peaks as of May 2017, international equities were still selling 23 to 27 percent lower than their 2007 peaks. This 86 percent performance difference over 10 years is huge by historical standards. Attractive relative valuations, improving economic fundamentals, and accommodative monetary policy should be supportive of international equities in the years ahead. If you believe in the reversion to the mean tendencies of investment markets, then having a healthy allocation to international equities make sense in today’s environment.
Investment committees of endowments should remember the wisdom of Warren Buffett: “Be fearful when others are greedy and … be greedy only when others are fearful.” While we are all happy to see stock markets reaching all-time highs, and the economy doing so well, increases in risk levels are typically most beneficial to portfolios after big market pullbacks, rather than 8 years into a bull market. That’s not to say that higher allocations to stocks will not provide higher returns in the long run, but rather to say that the best opportunities for higher returns in the long run do not tend to present themselves at this stage of the market cycle. Therefore, for most investors, the best strategy is to stick to the long-term plan, and rebalance portfolios, which is the most disciplined way to sell high and buy low.
Mark Dixon is the Institutional Investment Consulting Practice Leader at Plante Moran Financial Advisors in Detroit.