Of the many questions that vex those running non–profit investment programs as we approach 2017, top of the list is a question that’s been on the agenda ever since interest rates got so low:
how are we going to earn the returns we’re counting on?
It hasn’t gotten any easier
Although the ten–year Treasury yield is above its summer lows, it remains meagre by the standards of history. This tells us that investment markets are not offering much return for those who are unwilling to take risk. Non–profit organizations typically target something like inflation–plus–5% for their investment programs, and there’s a lot of work to be done if that’s to be achieved.
Over the years, Russell Investments has published several papers asking “Are 5% distributions an achievable hurdle for foundations? Were they ever?” and the latest in that series has just come out. Unsurprisingly, the authors (Mary Beth Lato and Steve Murray) find that the hurdle has not become easier in recent years and that “we don’t believe it is going to get any easier over the next ten years.”
They find that a foundation earning a 60% equity/40% bond return over 1900-2015, and spending 5% of its assets each year, would have seen its asset base increase (in real terms) in 52% of five-year periods and seen it fall in 48%. Specifically, they point out that, based on “lower yields and a lower forward-looking equity risk premium… mean that the high returns of the past are not expected to repeat themselves in the future.” Indeed, based on Russell Investments’ current market outlook, the 52% success rate experienced in the past falls sharply: “on a forward-looking basis, [the] probability of success is only 20%.”
Where can the extra return come from?
Since equities tend to deliver better returns than bonds over the long run, one way to increase the odds of achieving the targeted 5% real return is to tilt the asset allocation more toward equities. The obvious drawback with that approach, the authors note, is that “the higher the probability for success, the greater the potential for losses.” With a heavier bias to equity markets, the downturns will be sharper and more painful.
So instead of loading up on equity risk, many non–profit organizations are looking beyond the listed equity and bond markets for other sources of return. In short, don’t “overlook investment strategies that may offer incremental returns, take risks for which you do not expect to get paid, or ignore implementation efficiency.” The list of potential strategies to consider may include real assets and alternative investments, dynamic management to take advantage of fluctuating market valuations, traditional active management, factor exposures (smart beta), and more.
The more diversified the program, the more challenging it can be to manage, which explains another trend we expect to continue into 2017: the growth in the multi–asset approach and outsourced CIO (OCIO) . Rob Balkema, a senior portfolio manager at Russell Investments, has described recently how, for all but the largest institutions, “it’s impossible to effectively select, track and manage separate exposures to the full range of return opportunities (e.g., exposures such as global infrastructure, global REITS, commodities, global high yield, bank loans, emerging market debt, volatility and currency.”1 But getting exposure to what he calls “the things in-between” is a key step in building a true multi‐asset portfolio, and one of the advantages of the approach.
At the end of the day, though, there’s no secret short cut to success for non–profit organizations faced with reduced return expectations across a wide range of asset classes. The five to ten year return outlook is as challenging as it’s been in a long time.
¹Balkema, R. and L. Fuhlbrugge (2016) “The evolution of multi–asset” Russell Communiqué (Third Quarter)