Mercer’s endowment and foundation (E&F) experts have assessed the likely challenges of 2015 and have identified the key priorities of focus for trustees, boards, and investment committees.
“Equity markets have provided generous returns for several years, but as we look forward to 2015 there continue to be many challenges to meeting nonprofit objectives,” said Kim Wood, Mercer Senior Partner and leader of Mercer Investments’ non-profit client segment. “To help endowments and foundations think through these issues, Mercer has identified 10 priorities for endowments and foundations in the year ahead, encompassing both nearer-term market-related risks and longer-term governance-focused enhancements.”
1) Got change for a dollar? Assess the impact of a stronger US dollar on non-US investments held within a long-term diversified nonprofit portfolio.
A strong US dollar has many implications. These include a relatively stronger US economy, an attractive interest rate environment, political or economic upheaval in other parts of the world, and relatively lower inflation for US consumers. Weakening foreign currencies versus the dollar mean lower non-US returns for US investors. Globally traded commodities, such as oil, typically fall in price as the dollar rises in value. While Mercer still believes international equities are attractive due to their compelling valuations relative to the US, E&Fs could consider hedging their currency exposure, and if that is appropriate seek advice on how best to do so.
2) Will this “J” curve ever curve? Address the place of private equity, given the committee’s patience and time horizon through multiple market cycles.
Many E&Fs target 8%–8.5% long-term returns to meet the current and future needs of their organizations. With yields at very low levels and expected stock returns muted from recent market strength, E&Fs continue to consider private equity investing to meet their long-term objectives. However, if the organization’s private equity portfolio has not yet reached its 10th birthday, or if the committee is yet to embark on the private equity journey, the committee and board may not be able to fully envision its positive impact to the overall portfolio. Compounding this is the recent very strong market for public securities. For success, Mercer believes E&Fs must ensure they have the resources, either internally or externally, to expend the time and energy necessary to maintain a fully developed private equity program. Committees and boards also must prepare themselves — and, critically, future committees and boards — for the appropriate evaluation of a private equity program that extends over multiple years and cycles.
3) Will emerging markets emerge or stay submerged? Assess the nature of your emerging markets exposure.
Returns from emerging markets have lagged developed markets in three of the last four years, even though in many cases those countries’ growth has exceeded that of the developed world. The prospect of rising US interest rates competing for capital has investors worried about the implications for growth advancing in emerging markets. At the same time, investors are encouraged by the progress in economies where reforms are being instituted. Entering 2015, Mercer believes emerging market stocks offer an attractive long-term return premium, and their inexpensive valuations relative to the developed world offers further potential upside. E&F investment committees should evaluate their staying power through this uncertainty and confirm their confidence in their managers. Given this period of greater risk and expected divergence across economies, we favor actively-managed over passive strategies in emerging markets, possibly emphasizing managers with the willingness and ability to access opportunities not on the radar of more diversified strategies (e.g., smaller names and smaller markets).
4) Tail risk or “tail risk me not”? Address downside risk by reducing equity exposure or using other less expensive forms of protection.
The final quarter of 2014 has been characterized by a return of volatility, which had been noticeably absent from US markets for much of the past couple of years. As many E&Fs have benefited significantly from the long bull market recovery, thoughts have turned to protecting those gains in the event of a significant tail risk event. Given their very long investment horizons, Mercer cautions that E&Fs should consider whether purchasing tail risk insurance is worth the cost. Mercer believes committees and boards concerned over downside risk should evaluate options such as simply reducing their equity exposure or using less expensive forms of protection, such as low volatility / quality equities.
5) Policing Policy: Thoroughly assess the committee’s governance model.
When pressed to articulate their biggest concerns about the portfolios they oversee, committees usually reference their unique spending requirements and return objectives. However, investment committees generally spend less time on these issues and more time reviewing relative trailing performance and peer comparisons.
Among the questions the committee should consider are: Has the committee explicitly reached consensus on its top priorities for the portfolio and its definition of risk? Are these beliefs captured in the Investment Policy Statement? Is the committee well equipped to manage the various tasks influencing portfolio management? Does the decision-making structure create a framework for long-term management while giving flexibility for short-term needs and opportunities? Should any components of the investment program be outsourced?
6) Friend or foe? Prepare for potential changes in global central bank accommodation.
Significant accommodation by central banks around the world has helped support a securities market recovery the world over. The US is strongly signaling its exit from quantitative easing (QE), while the European Central Bank and the Bank of Japan appear to be embracing the notion with renewed vigor. QE programs cause ripple effects throughout global financial markets, creating challenges and opportunities for long-term investors. E&Fs should consider potential changes in global central bank accommodation as a factor in long-term portfolio design.
7) Evolution vs. Revolution: Take opportunities to benefit from innovation.
Most E&Fs want cutting-edge ideas in their portfolios in the hope of driving strong returns that exceed their goals and their peers. Innovation, among themes and strategies, is paramount to the nonprofit investment thesis. At the same time, markets have become increasingly short-term oriented, making it difficult to embrace investment strategies that may extend well past the tenure of the current investment committee.
Not only should investment committees consider the best ideas for innovative, niche, or opportunistic investments today, but they should also attempt to identify the areas that will be vital 10 years from now so that portfolios are positioned to reap benefits down the road. This can take the form of evaluating maverick risk that may take some time to play out. It also takes the form of evaluating long-cycle opportunities, such as global scarcity, while managing short-term risk and return objectives.
8) Delivering impact from “impact investing”: Embrace sustainable growth principles and “impact investing” as factors influencing long-term portfolio success.
Portfolio resiliency and growth are influenced by diverse factors, including those caused by social and environmental trends, governance failures, and changes in policy and regulation. Identifying the risks and opportunities associated with these factors can improve downside protection, align the portfolio with the organization’s mission, and enhance long-term returns.
9) Keeping up with the Joneses’: Address benchmarking and performance evaluation criteria to ensure they support portfolio and organizational objectives.
E&Fs evaluate their portfolio performance across a variety of complex, and sometimes incongruent objectives. Often, committees are under pressure to demonstrate performance over short time horizons, and with little measurement of the risk required to generate those returns. Mercer believes performance evaluation should assist in meeting the organizational objectives by tying benchmarks to the risk profile and mission of the organization. As E&Fs prepare for their 2015 annual investment policy statement review, Mercer urges committees to evaluate the role and objectives of policy benchmarks, and consider a “suite” of benchmarks to measure the key risk and return factors. Ensuring that the organization’s definitions of risk are accounted for in benchmark selection, and applying the right combination of benchmarking tools to assess the many facets of portfolio return, can improve decision making around portfolio results.
10) The Goldilocks Solution: Assess whether your asset allocation is sufficiently diversified given the investment committee’s objectives and risk tolerance.
The past five years have been very good for equity markets, particularly in the US. As the Fed looks to tighten policy and with the world still plagued by macro problems, volatility could return to global equity markets. Meanwhile, the bull market has driven valuations to lofty levels, portending significantly lower returns in the future than those experienced in the recent past. Mercer urges an analysis through a risk factor-based framework that emphasizes diversification across a number of return drivers. While it is not possible to build an asset allocation that performs well in all scenarios, portfolios should be tested against downside environments, such as an extended period of weak economic growth or an inflation surprise. The goal should be to build portfolios that are robust in a variety of macro environments.
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