Endowment and Foundation Investment Return in Today’s Volatile Investment Environment
By Kristen Derryberry, Assurance Manager
The stock market has seen unpredictable and vigorous changes in prices and therefore returns in the past 10 years. It is necessary for some movement within the market in order to sell commodities, however a volatile market represents the most risk to investors. The markets have still not recovered from the lowest point in recent history in 2009. While 2014 saw increased returns, 2015 reminded investors the environment is still volatile. The lower investment returns are forcing endowment and foundation fiduciaries to question the current impact and perpetual existence of their investments. Endowments and foundations typically rely on returns to support their annual spending.
Risk vs Return
Most endowment and foundation investment policies take a conservative risk approach to investing, which in a volatile market may yield minimal or negative returns, not enough to cover distributions for spending or maintain the value of the portfolio. To counter the volatility in the market endowments and foundations are reconsidering their acceptable level of risk. Investments with higher returns are often investments with higher risk.
Endowments and foundations are responding to the lower returns by taking additional risk through alternative investment options including real estate, commodities, expanded markets (private equity and debt), hedge funds, and other individual strategies. Many of these options have higher returns even in a volatile market, but also have higher risk. Effective diversification can provide the additional benefit of increasing long-term portfolio return.
Although some alternative asset classes such as private equity and real estate have outperformed other in recent history, smaller endowments and foundations may not have the in house resources to participate directly. Endowments and foundations choosing to seek these alternative asset classes need to do their fiduciary homework. An outside advisor should be carefully considered for those smaller organizations. And make sure to perform due diligence.
Most endowments and foundations are focused on protecting the assets and returns to support their purpose. The life of the assets should be considered when determining a spending rate, and the life of endowment assets may be longer than those of foundations. Lives of endowments should be looked at from at least 30 years, and the investment performance over that life must support the spending. The spending rate must support the organization and sustain the assets regardless of short-term investment performance. Small adjustments, even a modest .5% decrease, can create a significant future impact.
In Bank of America’s U.S. Trust whitepaper, The Endowment Challenge, they recommend a sustainable spending rate that doesn’t put the portfolio value at undue risk of permanent loss in conjunction with a long-term asset allocation strategy. Many organizations base their spending rate on the current market value of the portfolio. Given market volatility and the long-term nature of the charitable mission, it may make more sense to average (or “smooth”) that market value over a period of three to five years. By applying the spending rate to the lower “smoothed” amount, the organization meets it’s stated spending rate but at a lower value, thereby preserving principal for the future.
With the volatility in the market, fiduciaries must consider how they are managing their endowments and foundations to sustain the assets to support the spending. The endowments and foundations may have to diversify their portfolios with alternative investments that have a higher risk to achieve greater returns.