Endowments and foundations are facing an environment of rich equity valuations, ultra-low fixed-income yields, and newly awakened inflation, coupled with concerns on environmental and societal problems.
These issues pose serious questions for endowments and foundations about how they are going to meet their spending obligations fulfilling their philanthropic mission, whilst addressing some of the biggest challenges in sustainable investing from climate change to creating a fair and equitable society.
In our annual top considerations in 2022, we highlight the range of challenges and opportunities we believe endowments and foundations should be thinking about in 2022, and crucially how you can look to protect and position your investment assets.
While economies have been recovering from the effects of the pandemic, monetary and fiscal stimulus packages still remain in place. However, central banks are expected to taper activity such as quantitative easing through 2022.
Meanwhile, monetary authorities also seem to be shifting their attention to job creation in an effort to stimulate economic growth. This focus may be challenged as inflation rises.
On top of this, increasing tribalism in politics places a question mark over future fiscal policy.
For traditional portfolios, heavy in assets that do well in stable, low inflationary environments, adding more inflation-sensitive assets can improve forward-looking portfolio robustness. Examples include real assets such as property and infrastructure, as well as select equities and commodities.
As the most populous country in the world, China has outgrown most major economies over the past 20 years – and is likely to do so for some time to come. However, China is also significantly underrepresented in standard benchmarks and many investors’ equity portfolios.
In addition, exposure to China in emerging market equity indices is, for historical reasons, heavily tilted toward its offshore equities. This overlooks the likelihood that the future dynamics of China’s economy will be increasingly reflected in its onshore equity market, often referred as China A-shares.
China A-shares offer the prospect of low correlation with other equity markets, an abundance of alpha opportunities, and exposure to higher economic growth rates. The Chinese government has been proactive in improving access to A-shares for overseas investors in recent years. That said, this new market comes with political and ESG risks that investors need to measure and manage.
Given China’s importance to the global economy, consider a blend of onshore and offshore listed equity exposure. There are also significant alpha opportunities for active managers arising from uncertainties relating to trade, regulation, and politics.
We believe that an impact-oriented approach, when executed well, can generate returns competitive with broad markets alongside making a positive non-financial contribution to society. Investors should consider an impact investing allocation with an explicit intention and objective to deliver positive, meaningful, and measurable social or environmental outcomes in underserved areas, alongside a financial return.
There are instances where certain impact investors may wish to sacrifice returns willingly in order to generate a highly specific impact. Work still needs to be done on encouraging firms to embrace diversity and inclusion practices, which can foster staff retention and build robust internal decision-making, particularly in the financial industry.
Private markets, particularly venture capital, are great ways to generate impact. Listed equity trading simply transfers share ownership rights between buyers and sellers, although it can lower the cost of capital. Private market investors typically provide new financing directly, and can have a greater impact through initiating new projects and allowing investors to influence companies’ practices more directly.
Climate change is a global, multi-industry problem that we believe requires a ‘total portfolio’ response. Highly emitting and highly difficult to transition assets involve risks that are unlikely to reward investors over the long term. As the saying goes, there are no bad assets, only bad prices. With that in mind, we have to ask, is the price right?
Assess your exposures to climate risk that are ‘grey,’ ‘green’ and ‘in between’. What we call grey assets involve high levels of carbon emissions and a high climate transition risk, which describes the negative effect on companies of a shift to renewable energy low emissions. Green assets involve low or no emissions and low climate transition risk. Of course, there is a lot of ‘in between’ assets. Exercise ‘decarbonization at the right price’ (DARP) .
As with any major trend, the climate transition will not happen in a straight line, and nor will price recognition. Flexibility built into your strategic climate transition plan will be very helpful.
The pandemic accelerated the adoption of new technology and technology-enabled services across multiple aspects of society, allowing businesses and global commercial activity to continue while many aspects of normal life were at a standstill. Innovations such as video conferencing and greater automation were driven by the necessity of surviving the global pandemic. This has in turn led to many new opportunities for companies and investors.
Consider private market investments or specialist funds that can target technology companies that are unlisted or at an early stage of development. While carrying higher risk, they are often also poised to capitalize on growing opportunities to streamline systems, processes, or supply chains.
Low absolute interest rates and tight credit spreads have resulted in negative real yields for a high percentage of the bond universe. Interest rate risk offers little compensation, while leaving portfolios exposed to inflation. However, high valuations in public credit markets have been slow to leak into the private credit market, which is also less exposed to potential financial market volatility, due to its higher exposure to floating rates and pricing that lags listed equivalents.
In addition, the traditional role of bonds as a natural diversifier for equities no longer applies: prices for both fell sharply at the height of the pandemic-induced volatility in early 2020.
Consider allocating to private debt and other lower-beta strategies to diversify rate and credit exposure in your portfolio. These assets can provide higher total returns than those implied by very low traditional public fixed income yields.
Traditional beta exposures such as equities, and especially bonds, look pricey, given the expectation that central banks will start to reduce policy support. Below the surface, equity markets have winners and losers driven by long-term market themes. With bond yields so low and inflation a concern, the ability of fixed income duration to act as a cushion for equity markets is on shaky ground.
Consider a diversified set of exposures to equities, focused on a few key long-term themes. Downside protection is often expensive, so strategies that provide steady returns regardless of market direction could have merit.
A mix of high-conviction downside protection strategies can be warranted, as individual strategies are unlikely to perform in every type of downside event. Historically, such a blend has worked well for investors. However, contractual approaches, such as options strategies, are subject to credit risk, often have counterintuitive pay-outs, and come with a cost of carry. A mixed approach can be beneficial but is highly governance-intensive.
Private pools of assets are playing an ever greater role in financing markets. We are seeing the technology-led democratization of finance, but as some financing activity moves underground, the risk of bubbles increases. Most notably, cryptocurrencies such as Bitcoin are becoming more mainstream, driving the growth of the decentralized finance system (DeFi) – a parallel financial services system native to the internet, run largely autonomously, providing services to holders of cryptocurrencies.
Consider hedge fund and private debt opportunities focused on specialty finance. In addition, venture capital can offer opportunities in new, often highly scalable platforms. Explore options for accepting and selling cryptocurrencies, which may be received as gifts to your organization.
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