In an environment of continued inflation uncertainty, what tools can investors use to improve performance? One potentially very powerful tool is the one most often overlooked: diversification.
While the prospect is tantalising, it is impossible to flip a switch to get inflation back down to levels we saw three years ago. Those days are over, and while there have been promising signs of normalisation, some of the underlying forces that drove inflation higher are still present and can be expected to endure.
Organisations of all types have been forced to adapt to higher costs including the endowment and foundation sector. Operating costs in particular have increased for endowments and foundations (“E&Fs"), putting a strain on margins as well as the funding necessary to support their missions. Adding to the strain is volatility in the value of investment portfolios. With CPI+ performance targets, many organisations are facing the challenge of beating higher inflation-adjusted return hurdles.
Grantees of E&F generosity are also impacted, as they face the same challenges in their operating costs and, in many cases, find themselves even more reliant on funding. Nobody in the value chain is spared. In an environment of continued inflation uncertainty, what tools can investors utilise to try to improve performance? A, potentially, very effective tool is the one most often overlooked: diversification.
Many smaller E&F organisations have maintained a primarily domestic stock and bond mix for their portfolios, and while this mix has certainly worked well for the most part over the past decades, it may not be enough to weather future inflationary headwinds.
Geographic diversification, particularly in equities, is certainly important, but investments in alternative assets (real assets, hedge funds and private assets) should be a consideration for those institutions that have under-utilised this asset class. As an example, a strategy like private real assets (e.g. real estate, infrastructure, energy, timber, farmland) can benefit a portfolio in two different ways. First, these assets are not valued on a daily basis, so shorter-term effects from inflation surprises may not impact the intrinsic value of this part of the portfolio in the same way that public market investments would be impacted. Second, private real assets are often tied to investments that move in tandem with inflation. Because some real estate strategies are reliant on cash flows from leased property, owners may have the flexibility to adjust rents in alignment with rising costs, driving incremental cash flow and increasing the value of properties accordingly. This diversification strategy allows investors some measure of protection against an increase in inflation, while supporting the potential for longer-term portfolio return expectations.
How can E&Fs manage expectations associated with further diversifying their portfolio?
We recommend stress and scenario testing to identify the potential value-add, especially in consideration of current market dynamics. Stress and scenario testing can better quantify the portfolio impact, and in the process help set expectations with key decision-makers and stakeholders. You certainly cannot plan for everything, but you can understand how the portfolio should react in different environments, including best- and worst-case scenarios.
We also suggest a review of spending policies, consideration of any flexibility to adjust spending. Some policies provide more “hard and fast” rules depending on previous period market values, whereas others are “softer” in terms of how much spending can occur.
Rising inflation and subsequent market performance over recent years has resulted in spending policies reducing dollars granted to organisations. That said, some institutions with greater spending flexibility have actually increased their dollars granted during this time, reasoning that it is now that they can have the biggest impact for grantees in need.
All environments carry uncertainty, and periods of inflation are no different. However, investors have options to provide a measure of portfolio protection to try mitigate the knock-on impacts on investment performance and the organisation’s mission. It begins with level-setting how portfolios are positioned and how cash is distributed, both of which impact how the organisation sets itself up for success over the long-term. Diversification provides the foundations to robust defences, ensuring that the portfolio contains assets that can perform even in the most difficult of conditions.