It looks like 2012 may be another difficult year for not-for-profits' investment portfolios. Volatility threatens to stay up; yields, down. Many private foundations (PFs) and endowments face a potential struggle to make their distribution requirements and keep their portfolios' values intact.

In our firm's conversations with trustees, chief investment officers, treasurers, investment committees and board members, many are asking: “What can our organizations do to better position our portfolios?”

In all economic environments, a not-for-profit's investment effectiveness and the expectations of its stakeholders begin with its investment policy (IP) statement. The IP statement, effectively, is the board of directors' marching orders for its investment managers. One might argue that the IP statement ultimately helps determine the fate of the PF or endowment.

That's why it's important to “enable” the IP statement with language that guides, but doesn't constrict, appropriate time horizons and an appreciation of risk.¹ Investors working on behalf of PFs and endowments will be better able to avoid risks, catch tactical opportunities generated in turbulent markets and, ultimately, achieve the not-for-profit's long-term objectives. Importantly, such a policy also could better frame expectations. An emphasis on risk metrics can give policymakers and stakeholders a clearer idea of the tradeoff between the pitfalls in reaching for returns and the shortfalls inherent in playing it safe.

And, since many companies review and amend their IP statements at the end of the calendar year or the beginning of a new year, now is a particularly good time to consider enabling your not-for-profit's IP statement.

A New Approach

Our firm contends that the conventional approaches to constructing IP statements no longer suffice. Many IP statements are simply tone setters, focused on expressing the aspirations and mission of the institution. We believe that a greater level of analytics is needed, given the complexities of the investment landscape and the fact that most institutions have moved from traditional U.S. stocks and bonds to portfolios that are far more sophisticated and diverse.

Even when conventional policy statements are more concrete, they tend to hamper success by including clauses that are too restrictive, setting inappropriate time horizons and neglecting to acknowledge risks that could undermine returns.

Instead, Anthony Werley, chief strategist for the J.P. Morgan Endowments & Foundations Group, proposes that not-for-profits consider adopting an “enabling policy” that:

• has horizons relevant to investments rather than an institution's lifespan;
• looks forward rather than backward;
• is flexible enough to capture opportunity; and
• gives measures of expected investment risk the same level of prominence as expected investment return.

Rethinking Time Horizons

The starting point for a constructive IP statement is an appropriate investment timeframe for the assets that support a not-for-profit's mission. By precisely identifying a strategic timeframe, which we define as a forward-looking 10-to-15 year interval, the IP statement can shape more focused risk and return expectations. Referring to this interval when setting strategic asset allocations is sufficient to capture the economic and financial market conditions likely to influence portfolio performance and determine a portfolio's contribution to an institution's operating objectives.

Many IP statements seek to support an institution's desire to operate in perpetuity and intend its IP to support that goal for as long as the organization exists. While this concept implies the construction of a portfolio with a maturity long enough to take meaningful risk for the benefit of asset compounding, institutional life spans generally aren't relevant to investment success.

Basing an asset allocation on excessively long time periods (30 years or more) can be misleading, as looking at such time spans offers no guarantee of approximating average returns. For example, basing an asset allocation on the 13.7 percent 30-year annual return for the U.S. large cap equity market during the 1970s through the 1990s would have proven woefully inadequate to prepare for the 1 percent annual decline in equities during the recent decade.

Rather than tacitly matching the investment time horizon with the institution's, an IP statement should be more explicit about the timeframe over which it's to be measured and adjusted as global economic and investment market conditions change.

Looking Forward

Many IP statements also tend to base their strategic asset allocations solely on historical data. This can be deeply problematic.

If you start with a $100 million portfolio, for example, and assume that you're going to compound at 11.6 percent because you're using the historical rates of return for a diversified portfolio of stocks, bonds and commodities, you would, after five years, expect to have $174 million. And yet, the actual results for that asset allocation over the five-year period from 2000 through 2004 would have been only $112 million, more than 50 percent below your worst expectations.²

Looking five years further out for a 10-year timeframe, you would have expected that same $100 million portfolio to have grown to $303 million. Even the lower, 5 percent probability end of the expected range would have been $191 million. In fact, the true return number would have been $132 million, well below your worst expectations.³

“We, therefore, are quite concerned about the idea of having historical averages guide the direction of the document even if they're not explicitly stated,” says Werley. He continues:

Instead, we want to be much more explicit in the investment policy document about the unique environment that we foresee over the next five or 10 years. The trends we identify, whether it's de-leveraging or global in-balancing, as well as our capital market assumptions, certainly should have something to say in terms of how you guide a portfolio.⁴

Of course, there's no crystal ball. We wouldn't suggest that anyone's 10-year forecast will be perfect. But it's clear that there's great utility in having an informed and well-considered forward-looking viewpoint shape asset allocations.

Capturing Opportunities

After the baseline strategic asset allocation is set, the IP statement typically specifies a band around each allocation so that tactical changes can be made to take advantage of specific opportunities. Many institutions feel most comfortable with asset allocation variance bands of +/-5 percent.

But narrow bands around volatile asset classes would compel investors to round up equity exposure in a protracted market decline or round down exposure in a relentless rally. For instance, during the equity market plunge of 2008, tight bands would have led a portfolio to continually buy into equities to maintain exposure regardless of the determined descent in stock prices.

Even in normal economic and financial market cycles, there are many opportunities for enhancing return or reducing risk through judicious tactical changes to portfolio exposures, which a tightly constrained policy band might preclude.

Our firm believes that both portfolio governance and performance could be better served by setting allocation variance bands sufficiently broad to accommodate either historical levels of volatility or volatility levels we expect to see. Using J.P. Morgan's capital market assumptions (as of Jan. 1, 2011), the odds are roughly 50-50 of not breaching 5 percent policy bands over the next five years. In the context of recent history and future expectations, widening the bands to account for meaningful market volatility simply makes sense.

How wide should those bands be? In the last four years, equity volatility has been roughly 23 percent on an annualized basis; during 2008, the annualized volatility was 60 percent. We certainly don't think bands should expand that far. But, Werley says, “the bands should reflect the volatility regime; so if you had a 40 percent equity target, at least 10 percent around those bands could make sense.”⁵

Increasing Flexibility

Within reason, an IP statement should seek to enable more than it restricts. Our firm doesn't advocate relaxing portfolio discipline or disregarding an institution's preferences for, by way of example, constraints on the use of leverage or asset class diversification requirements.

But high-level guidance may unintentionally handcuff portfolio managers, preventing them from using a fuller set of tools to increase returns or reduce volatility, let alone exploit investment opportunities that arise from market dislocations. For instance, an IP statement may mandate that all real estate exposure be attained through real estate investment trusts, while failing to acknowledge the exposure that can be achieved across core real estate without the volatility of the equity market.

The extreme markets of 2008 are replete with examples of the unintended impact of policy guidelines on investment performance. Futures managers and commodity trading advisors who could have provided vital diversification often found themselves constrained by overly explicit guidelines on leverage and transparency.

Within the commodity asset class, gold, which has frequently exhibited counter-cyclical qualities, saw its price rise by 5.8 percent in 2008 when the S&P 500 fell 37 percent (see “Worth Its Weight,” p. 60). But, despite its portfolio diversification benefits, many IP statements' commodity diversification guidelines or single commodity prohibitions would have precluded investing in gold.

Along the same lines, macro hedge fund strategies have been rather successful as portfolio diversifiers. Too often, though, an IP statement isn't flexible enough to allow portfolio managers to unbundle more focused strategies, such as macro, from the broader hedge fund asset class, in order to solely invest in them.

Recognizing Risk

Return-focused policy objectives are the natural starting point for organizing investment policy. But it seems just as important to have IP statement guidance regarding risk parameters that are acceptable to the organization. After all, yearly volatility, drawdowns and black swans all directly impact returns.

Articulating a not-for-profit's risk tolerance also has the benefit of informing stakeholders of just how variable any given year's returns may be. Some advance knowledge of the magnitude of risk inherent in a portfolio may assist in deciding between having the fortitude to maintain the course during unforeseen events and bailing out to lower portfolio risk precisely when risk should be increased.

“By establishing risk benchmarks, we can raise the standard to which the portfolio is managed,” Werley observes. He states:

Risk guidance implies an awareness of historical levels of asset class volatility or, better still, measures of forward-looking volatility, either of which is essential in framing reasonable expectations. An IP statement that addresses, directly or indirectly, all aspects of portfolio risk from annual volatility and drawdown to liquidity and other risk measures can align return expectations with the magnitude and breadth of risk taken in order to reach the desired return objective.⁶

Historical statistics show the worst drawdown during the last five years was 33 percent. Our forward-looking projections based on a 10-to-15 year strategic timeframe tell us that there's a 5 percent likelihood of a roughly 10 percent drawdown in any one year and a 1 percent likelihood of a 16 percent drawdown in any one year. (See “What's the Risk?” this page.) As long as the market is dominated by risk and has so much to say about what the compound return will be, J.P. Morgan believes that the investment committee, the managers themselves and the stakeholders should be informed about risk, as well as return expectations.

Enabling PFs and Endowments

In our opinion, an enabling approach to portfolio construction, within the confines of sound policy guidance, makes sense no matter what the environment for investing may be. It's essential when we anticipate modest returns and outsized risk.

Now, more than ever, PFs and endowments should have their IP statements go beyond an expression of goals and missions. At a minimum, not-for-profits may want to consider adding an appendix or amendment to provide greater analytical detail to help frame expectations. Measures of expected investment risk — annual standard deviation, drawdown potential and other gauges of illiquidity and volatility — should be given the same level of prominence in an IP statement as measures of expected investment return.

Ultimately, a better IP statement is about generating better performance. But equally as important, a good IP statement is about shaping expectations for everybody involved, including the beneficiaries.

Clients often ask: “How often should we revisit our IP statement?” J.P. Morgan reviews all of its forward-looking assumptions every year. If a PF or endowment reviews its managers, advisors and assessments annually, then perhaps it should review its IP statement annually as well. Certainly, such a review should occur whenever an institution is re-adjusting its asset allocation, when there's a significant shift in its time horizon or if there's a major policy change. However often that review takes place, though, it's critical that IP statements be fully enabled so they can help PFs and endowments produce the funds that will help achieve their missions.

— The views expressed in this article are provided for educational purposes only and are based on information believed to be reliable. Neither J.P. Morgan nor any of its affiliates bear any responsibility for any direct or consequential losses arising from its use.

Endnotes

1. Not covered in this article is our thinking on the importance of calculating the probability of maintaining spending/purchasing power and converting that into a usable number — what we call “portfolio spending break-even probabilities.” That and several other topics are articulated in a white paper, “Investment Policy Statements for the Current Environment” (J.P. Morgan, October 2011), authored by Anthony Werley, with contributions by Suzanne Wuebben and Jason Warner. That white paper, as well as a sample investment policy statement that J.P. Morgan developed in conjunction with the law firm of Simpson Thacher & Bartlett LLP, is available from J.P. Morgan by emailing efg.qa@jpmorgan.com.
2. Based on an asset allocation of 60 percent stocks, 10 percent commodities and 30 percent bonds. U.S. stocks are represented by the S&P 500 Total Return Index, commodities by the GSCI Spot Index and U.S. bonds by the Barclays Capital Aggregate Bond Index after January 1976 and Ibbotson U.S. Intermediate Government Bond Index before January 1976. Sample allocation assumes monthly rebalancing and no fees or taxes. It's not possible to invest directly in an index. Past performance is no guarantee of future results. Information derived from Bloomberg, Ibbotson and J.P. Morgan.
3. Ibid.
4. J.P. Morgan “Rethinking Investment Policy Statements for the Current Environment,” Webcast and Conference Call featuring Monica Issar and Anthony Werley, New York, Oct. 18, 2011.
5. Ibid.
6. Ibid.

---

Monica Issar is the head of the J.P. Morgan Endowments & Foundations Group, based in New York

SPOT LIGHT

Water Colors

“Delta Water” (48 in. by 72 in.) by Wayne Thiebaud, sold at the Christie's Post-War Contemporary Evening Sale on Nov. 8, 2011 in New York for $2,994,500. Thiebaud is often included on the list of great pop artists because of his early interest in items of mass culture. However, his later choice of more traditional subjects, such as landscapes, suggests he may be historically miscast.