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Endowments Look to Total-Return Approach Amid Low Rates

November 16, 2017

Absolute-returnThe extended low-rate environment has had a considerable impact on almost all institutional investors, but perhaps none more so than endowments and foundations, which often struggle with distribution requirements and spending needs in excess of realized returns. A recent NACUBO-Commonfund benchmarking study found that endowments produced average returns of -1.9 percent in 2016. And while performance has improved significantly in 2017, in an era in which interest rates are near historic lows and yield remains difficult to find, endowments and foundations are rethinking whether they should adopt a "total return" approach as part of their underlying investment strategies.

A survey and accompanying white paper published earlier this year by Fiduciary Trust Company and Associated Grant Makers demonstrated the extent to which the low-rate environment is affecting nonprofits across nearly all traditional activities — from spending and grantmaking to fundraising and board governance. Among the fundraising institutions polled, for instance, an overwhelming majority (over 80 percent) have stepped up their fundraising efforts, while more than two out of every five grantmaking institutions have reduced their grantmaking activities or are weighing such a decision. Moreover, nearly half of the public charities responding to the survey said they had considered reducing or have reduced spending. To be sure, such tactics can help bridge the gap during periods in which returns suffer, but at what expense to the charitable or grantmaking missions of the organizations in question? And then there's the fact that a significant number of respondents, roughly one in five, have broadened their investment universe to allow for riskier investments in pursuit of higher returns, in many cases (we assume) without proper regard for downside risks.

Thanks in part to the pressures that accompany a low-rate environment, the value of a "total return" approach has again come to the fore. According to the same survey, half of the more than two hundred and thirty respondents indicated that their organizations have either already adopted a total-return approach or are considering such a move. Total-return strategies can come with short-term risks, but broadly diversified portfolios generally offer reduced volatility from year to year and, as a result, provide institutional investors with more control, consistency, and visibility as it relates to their distributions and related planning.

For those who may not be familiar with the term, "total return" refers to the value that amasses in a portfolio over a given period of time and combines interest and dividend income with capital appreciation from both realized and unrealized gains. In the past, by statute or by design, many organizations may have employed investment programs that limited distributions to income from bond interest or equity dividends.

Interest and awareness in a "total return" approach, however, is by no means a novel idea; it actually goes back to the late 1960s when former Ford Foundation president McGeorge Bundy commissioned two studies that analyzed the lackluster investment performance of university endowments common at the time. The second of the two studies, "Managing Educational Endowments," by Robert R. Barker, attributed the poor returns to an overemphasis on avoiding losses and maximizing current income.

Barker's research was groundbreaking in that it made a case for nonprofits to apply Modern Portfolio Theory, which itself was introduced by Harry Markowitz in the 1950s, to the management of their endowments. But the Barker study also set the stage for changes to the fiduciary standard, allowing boards to assess the "prudence" of a given investment strategy at the portfolio level versus analyzing each commitment independently and apart from other investments. Recognizing the extent to which loss aversion was affecting performance, the research also advocated for the delegation of investment management to qualified professionals who are best able to optimize performance while managing risk.

In addition to the improved consistency and better command over distributions, a total-return approach also can lead to superior investment management decision-making and, potentially, higher overall distributions. By re-assessing asset allocations and rebalancing exposures as valuations and market conditions change, a total-return approach also imposes far more discipline than a mere focus on income generation at the expense of other risks or investment opportunities.

While it may seem counterintuitive, organizations that eschew a total-return philosophy may be placing undue hardship on their endowments and grant recipients. It should be noted that statutes such as UPMIFA (Uniform Prudent Management of Institutional Funds Act) or private foundation rules under the Internal Revenue Code may allow boards of tax-exempt organizations to consider the total return of an investment portfolio and also the circumstances dictating the prudence of diversification.

Mittelman_mullaney_for_philantopicDespite President Trump's nomination of a new Federal Reserve chair and investor expectations about future rate hikes, it is likely that the absolute level of rates will remain depressed for some time. What this means for nonprofits is that the same challenges that have complicated income-focused investment strategies over the past two years will likely remain in place until new catalysts emerge or as monetary policy changes. Against this backdrop, for many nonprofit investors there is not only more that can be done but more that should be done to meet the fiduciary duties that govern most trustee and board positions. A total-return approach isn’t just a solution for periods marked by low rates; it’s an antidote which can help ensure that portfolios retain a prudent level of diversification aimed at both augmenting long-term performance and managing risk.

Joel Mittelman is a vice president and head of endowments and foundations at Fiduciary Trust. Stacy K. Mullaney is chief fiduciary officer at Fiduciary Trust.

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