Risky Business

By Kristy LeGrande, CFA, MBA, Principal

Acclaimed investor Warren Buffet summed up risk when he said, “Risk comes from not knowing what you are doing.”  So, what is risk?  How do we measure and monitor it?  How can we protect against it?  How much risk should we take?  There are numerous types of risk in the investment world and it is crucial that investors understand these risks and take steps to monitor them. 

In an attempt to educate investors, below is a list of some of the main types of investment risk, and, importantly, how they can be prudently monitored. 

Type

Financial Risk

Definition

Risks from heavy use of leverage or unsustainable spending rate that could jeopardize corpus longevity.

Who Monitors and How is it Monitored?

Client. Monitors through financial statements, prudent decision making by Board of Directors/Investment Committee/Family Decision Makers. Innovest assists clients through education.

Type

Volatility

Definition

Return fluctuation for a given security, strategy, market or portfolio, i.e. the potential range of a change in the security’s value. Higher volatility means price can change dramatically over time in either direction while lower volatility implies less price fluctuation in either direction.

Who Monitors and How is it Monitored?

Investment Consultant. Addressed through prudent asset allocation using non-correlated assets to mitigate portfolio-level volatility. Monitors volatility at the portfolio level and fund level in quarterly reports and annual asset allocation study.

Type

Market Risk

Definition

The risk and impact of equity market moves on an investment and on the portfolio as a whole.

Who Monitors and How is it Monitored?

Investment Consultant.  Monitors through in-depth diligence and continual monitoring of each investment strategy as well as through careful portfolio construction, including the addition of diversifying, non-correlated investment strategies.

Type

Liquidity Risk

Definition

Inability to sell an investment quickly either due to terms of investment contract or thin market with limited or no buyers.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through a liquidity schedule for the entire portfolio that demonstrates the availability of invested assets over time based on specific terms of each investment.

Type

Inflation Risk

Definition

The damaging effect that rising inflation rates can have on future purchasing power and erosion of real return on invested assets.

Who Monitors and How is it Monitored?

Investment Consultant. Monitors through the portfolio return target, which is represented as the return in excess of inflation (CPI +) and tracked over time. Use of asset classes with above-inflation returns protects purchasing power.

Type

Downside Risk

Definition

Estimation of the amount of loss a portfolio could sustain as a result of a decline arising from factors that affect the market as a whole or asset classes in particular (recession, loss of confidence, geopolitical events, etc.)

Who Monitors and How is it Monitored?

Investment Consultant. Monitors potential downside risk at the portfolio level. Downside risk is reviewed and quantified annually in an asset allocation study.

Other risks for investors to be aware of when constructing and monitoring portfolios include:  tracking-error risk (an investment strategy’s deviation from its benchmark), key person risk (risk of the departure of an investment strategy’s key decision maker), headline risk (risk of adverse news stories impacting the price of individual securities, strategies, or asset classes), factor risk (risk of having intentional or unintentional factor exposures in the portfolio), interest rate risk (risk and impact of changes in interest rates), credit risk (risk related to the credit of a borrower), counterparty risk (possibility that the other party in an investment, credit, or trading transaction may default on the contractual obligation), maverick risk (risk associated with venturing outside investment best practices or engaging in overtly risky positioning or strategies, i.e. a highly concentrated portfolio), legal risk (potential financial loss due to a contract between two parties being considered unenforceable), geopolitical risk (chance that an investment's returns could suffer as a result of political changes or instability), currency/exchange rate risk (the possibility that currency depreciation will negatively affect the value of investments) and other macroeconomic risks.

Risk is unavoidable in the investment world.  It is crucial that investors determine their risk tolerances and are aware of the risks they are taking in their portfolios.  In addition, investors along with their advisors, must take steps to quantify risk when possible, understand the qualitative aspects of risk, and monitor risk on an ongoing basis.

About Innovest

For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.

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Nonprofit Spending in a Low Return Environment: 4 Potential Strategies and Solutions

Nonprofit Spending in a Low Return Environment: 4 Potential Strategies and Solutions

By: Sloan Smith, vice president, CAIA

For a majority of nonprofit organizations, establishing an adequate spending policy for their portfolios is an important decision. This policy plays a key role in designing the long-term expected rate of return of the portfolio and its strategic asset allocation. The IRS has required that private foundations spend 5% from the portfolios each year in order to keep their tax-exempt status. The 5% spending rule, along with the smoothing method of averaging the value of assets over multiple points in time, have been used as key guidelines for nonprofits and their spending policies. However, with equity valuations at historically high levels, coupled with diminishing yields from fixed income investments, many wonder if a 5% spending policy is suitable going forward. Many nonprofits are facing difficult decisions to avoid the depletion of their portfolios and long-term purchasing power.

In the last several decades nonprofit institutions had few significant challenges attaining a 5% or greater real return, which is the nominal rate of return minus inflation.  Due to the relatively strong performance of the markets, a 5% real return could be achieved through a diversified portfolio comprised of stocks and bonds. However, with interest rates near multi-decade historical lows, the yield on the fixed income portion of a portfolio has contributed less and less toward a 5% real return.  Therefore, it is important that nonprofit organizations review their spending policies, long-term expected return targets, and strategic allocations to determine if their current spending policy makes sense. If an institution wishes to maintain the purchasing power of the portfolio and make ongoing portfolio distributions, then four choices need to be considered:

  1. Increase the risk in the portfolio in order to generate higher returns

    By allocating more toward riskier assets, a nonprofit could potentially increase the portfolio’s long-term expected return. - This decision would likely force the portfolio to have more exposure to equities and less to fixed income. Even though adding more equities can enhance the expected return, the portfolio would experience a greater volatility, steeper drawdowns, and potentially increased year-to-year fluctuations in the dollar amounts distributed from the portfolio. While the option of increasing the portfolio’s risk/reward profile is straightforward, periods of poor returns are likely to test an organization’s patience and resolve to maintain the course of action.

     

  2. Add more illiquid allocations to the portfolio

    Enhancing portfolio returns while potentially reducing total portfolio risk could come from incorporating more alternative and illiquid asset classes, such as hedge funds, private equity, direct real estate, reinsurance, and illiquid credit. The total allocation to illiquid investments needs to be carefully assessed, as such commitments may have little to no ability to contribute cash flow to the portfolio’s distributions.  In order to meet the 5% spending policy, cash may need to come primarily from equities and fixed income, which could make it more challenging to rebalance the portfolio’s asset allocation in a timely manner.

     

  3. Reassess and potentially reduce the spending policy

    This option may seem challenging at first, considering the nonprofit’s donors may have contributed with the expectation that the portfolio would make perpetual distributions at a certain percentage of the portfolio’s value.  However, the portfolio’s distributions may not keep up with inflation if the distribution percentage rate is too high.  Research has shown that a lower spending policy may be a strong solution going forward.  For example, decreasing the annual spending from 5% to 4%, and assuming a total return of close to 6%, after 42 years the portfolio would distribute more in dollars, as compared to portfolio with a 5% spending rate.[1] By reducing the spending rate, more assets would be left in the portfolio to grow every year, leading to a larger long-term portfolio values and eventually higher payouts.

     

  4. Add more capital to the portfolio through fundraising

    The significant appreciation in risk assets since the 2008-2009 bear market has provided an opportunity for nonprofits to enhance their fundraising efforts.  It is a great time to improve development, marketing, and communication programs to strengthen relationships with all donors, thereby leading to increased contributions. Successful fundraising increases the ability of the portfolio to maintain the spending power of its distributions.

     

    There is no single right approach for nonprofit organizations to address their spending dilemma.  Some nonprofit entities may be willing to adopt a higher risk change certain aspects of their portfolio.  However, there may be others who cannot due to the restrictive nature of their spending policies and their heavy reliance on portfolio payouts to support their organizations.  In the end, lower expected returns would make it difficult for nonprofits to satisfy their spending policy, especially if it is 5% or higher. Therefore, it is important that nonprofit organizations and their investment committees review these choices and determine which solutions may be best. Prudent long-term planning can have significant and lasting benefits to organizations and the causes they support. 

About Innovest

For more than 20 years, Innovest has provided excellent client service as well as forward-looking, innovative investment solutions for endowments and foundations, retirement plans, and families. We are an independent provider of investment-related consulting services and work on a fee-only basis.

Chart 1: Average Annual Effective Spending Rates for Fiscal Year 2014 and 2015 [2]

Chart from Nonprofit spending in low return environments.png

[1] https://www.plantemoran.com/explore-our-thinking/insight/2016/09/nfp-spending-policy-paper

[2] 2015 NACUBO-Commonfund Study

Source: Innovest