This post is one in a series written by individuals who are presenting sessions at the BoardSource Leadership Forum taking place in Seattle, October 18-20. BoardSource thanks Russell Investments for its support of the conference and for sharing its expertise with our participants.
For at least 1,500 years, a legend has been told about Loch Ness in the majestic Scottish Highlands—that it is home to the Loch Ness monster, affectionately nicknamed Nessie. Since 1933 alone, more than 4,000 people have reported seeing “something” in this mysterious body of water. Eight different scientific expeditions have explored the loch and scanned the water using sonar, and each has picked up on the movements of a large, unexplained object—perhaps a giant, aquatic creature, or perhaps something else? One thing is clear: Scientists have been unable to prove or disprove the existence of Nessie, and so the legend lives on, inspiring believers to continue searching for her.
Nessie isn’t the only legend with ardent followers. In fact, in the investing realm, many believe that meeting CPI (consumer price index) + 5 percent in today’s market environment is an easily achievable goal. In truth, this spending target is far more elusive than we would like. Russell Investments’ team of investment strategists predicts that over the coming decade, a passively managed 60 percent equity, 40 percent fixed income portfolio generating market returns only has a 20 percent chance of returning enough income to hit a 5 percent spending target. And, according to the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, over that same ten-year time horizon, the inflation-adjusted growth of this traditional, passively managed portfolio will fall to 2.8 percent. This is a return that lies below what many nonprofits need to achieve their spending objectives without taking on excessive risk.
All of this means that boards and investment committees are now facing a new, harsh reality: They can no longer rely solely on market returns and strong manager selection to meet their return requirements.
So, what are the options? We believe boards and investment committees should work with their investment providers to harness market volatility in their favor. This will require them to come up with creative ways to generate returns that may not be available from the market alone, thereby increasing the likelihood of achieving their organization’s investing goals. One way investors can do this is through dynamic portfolio management. By dynamic management, we mean not only including actively managed strategies in the portfolio, but also actively adjusting targeted exposures to capture short-term opportunities, and mitigating risks to help ensure that short-term volatility doesn’t derail your long-term goals. This approach helps investors incorporate investment strategies that may offer incremental returns, reduce their exposure to uncompensated risk, and work to ensure that investment portfolios are implemented efficiently.
Boards and investment committees should also carefully consider the types of strategies they incorporate into their investment portfolios. Due to higher risk and return correlations across regions and the increased need for flexible navigation in a globalized financial marketplace, this means weighing the impact of economic cycles, geopolitics, and global macroeconomic policy on market movements. Take equities as an example. U.S. equities are relatively expensive, but not the right price they should be according to seasoned analysts—investor overconfidence in their potential growth is driving prices up, telling a very different story from what the analysts’ hard, pragmatic valuations are saying. We believe that because of this mismatch in expectations and reality regarding U.S. equities, now is the time for investors to begin adding geographic diversity to their portfolios in search of returns. Both European and Japanese equities have more attractive fundamental characteristics than U.S. equities—solid valuations in which market prices accurately reflect investor expectations, fading political risk, and central banks that are likely to continue with supportive monetary policies. Emerging markets are also attractive, reasonably cheap, and resilient to U.S. dollar strength and Fed interest-rate hikes. Nonprofit investors with a significant home-country bias should consider making adjustments to their equity exposures to pursue additional value.
Board and investment committee members will likely be utilizing these capital markets insights to help make strategic decisions to steer their organization’s investment program towards CPI + 5 percent. Once you have done this, it’s important to ensure that any service providers you’re working with are aligned with these decisions. It’s also the job of the board and investment committee to record these high-level investment decisions in their investment policy statement (IPS).
Our team will be exploring this topic in more detail at our session during the BoardSource Leadership Forum. Our nonprofit and portfolio management experts will be on hand to discuss practical ways to help boards meet the elusive CPI + 5 percent in today’s low-return environment. We’ll talk through capital market assumptions, investment strategies, and potential changes to your IPS to help set your organization up to achieve that elusive goal.
And maybe, just maybe, once we’ve finished putting together the best possible framework for your investment program, one of you can go on to apply your prodigious planning and exploratory skills to finding Nessie. As far as we’re concerned, we believe she’s out there.