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Bridging the gap between hurdle rates and muted return expectations
Addressing the challenge posed by muted return expectations
For much of the past decade, the endowment and foundation community has expressed concerns about the challenge of meeting their spending requirements while maintaining funding levels in an environment of low yields and muted return expectations. The 2019 NACUBO-TIAA Study of Endowments that analyzes the financial, investment and governance policies and practices of the nation’s endowed institutions for higher education, shined a bright light on the challenges institutions face in fulfilling this mandate.
The report, which looked at the endowment performance and investment management practices of higher-education institutions for the fiscal year ending June 30, 2019, found that the average annual effective spending rate for institutions with more than $500 million (which we refer to hereafter as large institutions) was 4.5%. With expected inflation of 2.1% and fees that typically range from 50 to 150 basis points, it is easy to see how 7.5% has become the standard hurdle rate for endowments and foundations. Unfortunately, the median return for large institutions in FY2019 was only 5.5%, and only 14% of large institutions that reported their returns in the survey exceeded the 7.5% hurdle rate in FY2019.
For most endowments and foundations, the challenges of bridging this 200-basis point gap have become even more daunting since the NACUBO survey was conducted. The COVID-19 pandemic, along with waves of social unrest and political uncertainty, have injected huge jolts of volatility into global markets — and created new headwinds for endowment and foundation investment offices to navigate related to donor contributions, the costs of operating safely during a pandemic and other financial pressure. In what was already an environment defined by muted long-term return expectations, unprecedented stimulus efforts have pushed interest rates even lower, significantly expanded public debt burdens and arguably heightened the risk of inflation.
The silver lining is that endowments and foundations have many investment policy-related levers that they could potentially pull related to risk budgeting, liquidity management and rebalancing to help close this gap. Implementing these changes while accounting for the constraints and realities that endowments and foundations face, however, may require new approaches to portfolio construction and management.
In this Q&A, Nathan Shetty, head of Nuveen’s Multi-Asset Team, looks at how endowments and foundations can optimize their approaches to portfolio construction, capitalize on current opportunities and enhance their ability to fulfill their spending goals. Nathan shares his views on:
Reassessing expected returns given today’s capital markets assumptions
Key findings from NACUBO 2019
Return targets vs. actual return: Of the large institutions that reported having a stated return target in 2019, the median targeted return was 7.5%. The median actual return in 2019, however, was only 5.5%. Even institutions that generated 80th-percentile returns fell short of the median target.
Average asset allocation and projected returns: Large institutions allocated roughly three-quarters of their total portfolios to equities, including 41.5% in what is classified as marketable alternatives, private equity and venture capital. Within the fixed income allocation, about half was allocated to U.S. bonds and less than 1% was allocated to non-U.S. strategies. Within real assets, the vast majority was allocated to private real estate and private energy and mining. Nuveen used its capital markets assumptions as of September 2020 to generate the projected annualized returns and volatility of a portfolio with this allocation over the next five years.
To what degree should endowments and foundations adjust their long-term capital markets projections because of the COVID-19 pandemic?The key variable driving capital markets assumptions is interest rates. This is the starting point for any discussion about capital markets assumptions, regardless of how long the pandemic lasts. Interest rates are embedded in and contribute to every asset class’s expected return, and nominal interest rates are a direct reflection of real economic growth and inflation expectations.
That being said, even though central banks’ stimulus efforts related to COVID-19 have put additional downward pressure on interest rates, the pandemic’s impact on long-term capital markets assumptions will likely be minimal in the bigger picture. Even if the pandemic had not occurred, it is unlikely that the global economy would have generated enough growth to spur a return to 10-year bond rates in the 4%–5% range, like what we saw in the decade before the Global Financial Crisis (GFC).
Long-term growth, which is one of the key determinants of long-term interest rates, is a function of productivity and demographics; these two forces together provide the upper limit on economic growth. Worldwide demographics have been trending in the wrong direction for multiple decades. Demographic measures such as a declining proportion of the total population that is of working age, declining population growth rates and increased life expectancy all weigh on economic growth. These trends have been particularly pronounced in countries that are currently the biggest contributors to global GDP growth. Even in developing countries, population growth is slowing, albeit from higher levels than in the developed world.
On the other side of the equation, productivity gains have been muted globally since the GFC. Productivity gains in the 2010s were about half of what was seen in the previous decade. The United States has seen an increase in productivity in 2020, but this appears to be largely attributable to the decline in hours worked during the pandemic being larger than the loss in output. It remains to be seen whether the coronavirus-induced shock will have lasting effects in terms of increased productivity.
Putting it all together, I believe that despite the massive toll that the pandemic is taking on people around the world in terms of physical health, social interaction, and short-term economic stability, the pandemic’s effect on long-term capital markets assumptions is likely to be small. Many of the longer-term, secular trends that move the needle in capital markets were already in place before 2020. Of course, the pandemic could accelerate some of those preexisting trends, but the overall impact on capital markets likely will not be as great as people may think.
What is your outlook for inflation? How should endowments and foundations account for the unpredictable nature of inflation in their portfolios?Although there is little inflationary pressure in the short term because of high levels of unemployment, we do expect inflation to pick up in the medium to long term. The dampening effect of unemployment on inflation, however, is worth exploring more because it has been hotly debated by economists over the past several years. Before the pandemic, when U.S. unemployment had fallen to less than 4% yet inflation remained stubbornly low, many argued that this suggested that the Phillips Curve argument, which is underpinned by the idea that low unemployment is associated with higher inflation and vice versa, was no longer valid. If the Phillips Curve is indeed no longer valid, then the current slack in the labor market cannot serve as an argument that inflation will remain relatively subdued.
It is also important to note that inflationary pressures do not always just come from the demand side. Supply chain disruptions caused by the pandemic, as well as the trend of de-globalization and onshoring will lead to price increases. Current U.S. fiscal policy and monetary policy will likely lead to deprecation of the U.S. dollar. This, along with the Fed’s updated mandate for driving monetary policy, will be a catalyst for increased domestic inflation.
While I do not foresee a return to double-digit inflation, I do think that it will increase well above the 2.1% figure that many endowments are currently baking into their return targets. This is important because inflation is the most variable of the three components — spending, inflation and fees — that drive an endowment’s or foundation’s return target to maintain the portfolio’s real capital value.
From a portfolio construction perspective, it is important for institutions to realize that there are two primary ways to address the uncertainty, or stochastic risk, that inflation represents: You can look to hedge this risk by owning assets that are highly correlated to inflation in the short term, or you can look to generate returns that are greater than inflation over time, increasing the chance of positive real returns that can contribute to fees and spending. Given their long time horizons, I argue that endowments and foundations should focus more on dominating inflation rather than trying to keep pace with it. Asset classes that are well-suited for this role include infrastructure, bank loans and real assets, particularly private real assets.
Given the muted long-term return expectations, what levers are available to endowments and foundations to hit their hurdle rate?There are five primary levers institutions can pull to deal with the lower-for-longer environment: 1) taking more risk; 2) being more efficient in deploying risk by focusing on risk-factor exposure rather than asset allocation; 3) removing constraints such as limits on liquidity and leverage; 4) being more dynamic in their asset allocation; and 5) lowering their return expectations. This last lever may not be palatable given the institution’s spending needs or the grant-making mandate.
The challenge for endowments and foundations is determining which combination of these levers makes the most sense to use. This involves realizing that many of these levers are interconnected. For example, if an institution is more efficient in deploying risk, this allows the institution to remove constraints and be more dynamic in its asset allocation. Conversely, removing constraints and allocating more dynamically allows you to use risk more efficiently.
Taking more risk is the easiest lever for endowments and foundations to pull, and they have been aggressive in doing so over the past decade. This is reflected by the fact that allocations to private assets have nearly doubled since 2010. Much of this growth has been driven by using private equity as a substitute for public equity.
But if you are going to take on more risk, it is essential that you be more efficient in deploying that risk. We believe that doing so starts with taking a “risk factor-first” approach to portfolio construction. This approach is built on the idea that investors are compensated for owning risks, not asset classes. Institutions should start by decomposing their liabilities and then understanding what risks they want to own and in what proportion. While “spending + inflation + fees” works as a general construct for decomposing liability exposures, it is possible to build and manage against more elaborate, hybrid constructs around spending policy or return objectives. Once the liabilities have been properly decomposed, endowments and foundations should construct portfolios around getting exposure to those risk factors.
With this factors-first approach, the asset allocation becomes a byproduct of the portfolio construction, not vice versa. This approach is so beneficial because it allows you to remove arbitrary constraints related to liquidity and leverage and be more dynamic in allocating to areas of the market where risk is being rewarded richly at the time. This allows you to be more direct in matching the exposures that drive returns of the assets with the exposures that drive liabilities. Our current research illustrates how using this approach to stitch together public and private assets in a portfolio in a coherent way can lead to improved outcomes.
From a geographic perspective, where are you seeing the most attractive opportunities today?I am very constructive on emerging markets, both equity and debt. Emerging markets are particularly attractive for longer-term investors, such as endowments and foundations, that seek to extract the value risk premiums that exist outside of developed markets.
It is important to realize, however, that the dynamics in EM debt and EM equity are quite different. EM debt opportunities are very focused on Latin America and geared toward reflation of the real economy. As a result, EM debt is much more cyclically oriented. EM equity opportunities, on the other hand, are centered in Asia, including a significant amount of technology as well as economies that rely on energy and other cyclical imports. As a result, EM equity can be both defensive and growth-oriented. Owning both EM debt and EM equity in a portfolio creates a nice blend of risk exposures and allows you to access the EM risk premium in a diversified way.
Our positive view on emerging markets is clearly linked to our view on the depreciation of the U.S. dollar. This applies both implicitly and explicitly. The implicit dynamic is that weaker dollar environments benefit global growth and contribute to international risk assets outperforming domestic risk assets. The explicit dynamic centers on the positive contribution to return from currency translation assuming an unhedged equity position.
Deploying active risk efficiently to address the shortfall
Key findings from NACUBO 2019
Large institutions’ active vs. passive allocations: Across all major public equity and fixed income asset classes, large institutions allocated more to actively managed strategies than passive ones.
How can endowments and foundations use their risk budgets more efficiently to bridge the gap between their return requirements and their projected returns?While investors spend most of their attention on budgeting active risk, it is important to realize that there is a risk budget associated with a portfolio’s beta. And this beta risk budget will dominate an institution’s ability to meet its objectives. We think that a dynamic “risk factors-first” approach to budgeting beta exposure is essential to meeting longer-term objectives and managing the changing risk landscape.
When budgeting active risk, there are two dimensions to consider — pursuing alpha through active managers and tactical asset allocation (TAA), often referred to as “market timing” alpha. Often, institutions focus the vast majority of their risk budgets on active managers and overlook TAA or risk budgeting in the beta space as a source of incremental value. In an environment with muted return prospects, it is essential for institutions to use all available levers.
Let’s assume that a portfolio’s active managers deliver 3% tracking error with a 0.5 information ratio. This means that they are adding 1.5% of returns at the fund level from security selection before fees. If you are trying to generate returns of 7.5% in a low-rate environment, you will have to focus your efforts on capturing the other 6% more efficiently, which boils down to your strategic asset allocation (SAA) or TAA. You need to use every available lever to make up that gap, and TAA — or being more dynamic in your beta allocation — is an underutilized source of incremental value.
What role does tactical asset allocation play in reducing portfolio risk?Every decision that a tactical asset allocator makes is to either add return or reduce risk. The risk reduction component is especially important given where interest rates are today. The Great Moderation of the last few decades will not repeat itself, and it is extremely unlikely that long-term bonds will deliver the same level of returns that they did over the past 30 years. As a result, bonds’ ability to serve as a reliable return generator and a ballast against riskier assets in the portfolio may shift.
That means that you need to be more tactical in the short term in finding ballasts elsewhere based on how the market is pricing risks. This is exactly what TAA is designed to do. A purely static policy portfolio that is reevaluated every three to five years means that the total portfolio’s risk and return profile is at the mercy of how the market is pricing that risk at any given time. If you have a static allocation, you are stuck owning the changing risks.
TAA has evolved significantly from its first iterations. Early TAA practitioners simply tried to time decisions of allocating between bonds and equities. Today, managers have many more ways to deploy a more sophisticated approach to TAA. The rise of derivatives, more granularity in factor exposure, deeper analytical methods, and the increasing influence of macro factors because of central bank and governmental policy all contribute to the rise of the more advanced approach to TAA.
When it comes to risk budgeting in the alpha space, what asset classes are currently most conducive to active management?Given that fees are one of the three components of the 7.5% target return for endowments, it is easy to see why so much of the active risk decision centers on where fees are justified. But rather than thinking about where to deploy your risk budget on active managers, the more appropriate question is how to do so efficiently.
Certainly there are asset classes or sub-asset classes — such as fixed income because of its technical characteristics and complexity or EM equity because of its breadth — that provide active managers more opportunity to beat the benchmark. But even in the most efficient markets, there are active managers who are worth their weight in gold.
The key is finding managers, in any asset class, who can outperform in the context of the portfolio. Rather than focusing on finding managers who can beat a benchmark, institutions should focus on finding managers who deliver exposures that add incremental value and diversification relative to the rest of the portfolio — both the beta and the alpha allocations. This thinking aligns with the need to shift from benchmark-relative investing to a true outcome orientation. Traditional benchmark-relative management starts by setting the policy portfolio and then populates each market exposure with active managers, passive vehicles or some mixture of the two. This approach is inefficient because it does not concretely consider how an active manager under consideration interacts with the other active managers and the entirety of the underlying market exposures.
To answer the question of where fees for active managers are justified, institutions should spend their risk budgets on managers with high concentration and high active share. Conversely, institutions should guard against managers that, when you look beneath the hood, are actually running higher-risk, higher-beta strategies that do not offer security-selection alpha that is less correlated with the rest of the portfolio. Going even further, you need to understand what exposures an active manager is bringing to the portfolio and how those relate to the portfolio’s existing exposures.
Managing fees certainly is an important part of an institution’s active vs. passive decision making, but fees should not be the totality of that discussion. Remember, not every exposure can be captured passively. If an institution only thought about managing active fees, that might lead the institution to reduce its overall allocation to private asset classes or use all of its active budget in private asset classes, thus precluding the opportunity to use active managers that add significant value in public asset classes.
Taking a more holistic approach to illiquidity and rebalancing
Key findings from NACUBO 2019
Large institutions’ allocations to private asset classes: Private or illiquid asset classes accounted for about one-third of large endowments’ asset allocations in 2019. Private equity and venture capital represented the majority of this, while private real estate and private energy and mining also had sizeable allocations.
Given that endowments’ and foundations’ exposure to private asset classes has approximately doubled in the past decade, are you worried that these institutional investors are over-exposed to illiquids?
Because endowments and foundations essentially have an infinite investment time horizon, that suggests that they are ideally suited to capture the illiquidity premium in private asset classes. That is true to an extent, but you also have to think about the sequence of drawdowns relative to your liabilities and the resources you can draw on to meet those annual spending rules.
During the Global Financial Crisis (GFC), which was before endowments’ and foundations’ exposure to private asset classes surged, many of these investors were forced to sell private assets at extreme haircuts. They had to do this to generate liquidity, even though they had a very good idea that those asset values would quickly recover, which many of them did. This forced deleveraging is a very real threat when it comes to owning illiquid assets.
Endowments and foundations should think very seriously about their tolerance for public market drawdowns and how that sequencing affects their ability to meet their liability obligations. This should inform the amount of private assets that endowments are able to own.
Another — and related — concern that I have about endowments’ and foundations’ exposure to private asset classes is that it limits your ability to be tactical in your asset allocation. As I said previously, TAA is an important and often-overlooked return generator. But it is very hard to be dynamic in your asset allocation if a large portion of your portfolio is tied up in illiquids. This is a hidden cost that needs to be incorporated into the net impact of the illiquidity premium that endowments and foundations seek to harvest.
Using derivatives can alleviate some of the roadblocks to TAA, risk management and factor drift. But deploying derivatives effectively requires additional expertise and infrastructure, and smaller institutions may not have the resources or staffing levels internally to properly implement derivatives.
One of the benefits of the risk factor-first investment approach is that you can decompose the exposures you are hoping to get from illiquids and replicate some of the underlying contributors in liquid assets. This allows you to essentially liquify that portion of your illiquid exposures that are not idiosyncratic or directly related to what you are trying to harness by going into illiquids. This frees you up to be more tactical in your asset allocation and more efficient in your risk allocation.
Are there any private asset classes that endowments and foundations are over- or under-exposed to?
This presumption, along with the cache that can come with investing in the higher-profile private equity and venture capital funds, has led some endowments and foundations to plow into private equity and venture capital without fully assessing whether they are being adequately compensated for the lockup, the risk and the significant dispersion of outcomes by vintage year and by manager.
Conversely, I think that private credit and private real assets are asset classes that endowments and foundations may want to consider owning more of. Private credit, in particular, could be attractive for many institutions because it gives them an opportunity to balance out some of the business cycle-related risks in their private equity portfolios by sitting higher up in the capital structure while often generating ongoing cash flows. Private real assets can help address many of the inflation risks that are baked into the hurdle rate if the institution wants to maintain its real capital base.
How can endowments and foundations improve their approach to portfolio rebalancing? What role does exposure to illiquids play in this?
It is important to realize that the decision of whether or not to rebalance is absolutely an active decision — executing the rebalance is a value trade and delaying the rebalance is a momentum trade. Using drift to express tactical views is a fine approach as long as institutions have a consistent method or process for making this decision and they have attribution mechanisms in place to account for how drift contributes to performance.
Given that rebalancing has such a significant impact, it is essential for the rebalancing protocol to be a thoughtful, coherent part of the investment policy statement and be fully aligned with the institution’s objectives. Standard rebalancing approaches do not account for changes in risk; this inherently puts the rebalancing policy out of alignment with the strategic asset allocation. A first step in incorporating risk into the rebalancing policy is to rebalance based on asset classes’ marginal contributions to tracking error risk rather than their absolutes weights.
Another major benefit of the factors-first approach is that it helps you see that not every asset class’s drift from the desired exposure has an equal impact on the total portfolio’s tracking error risk. For example, if a portfolio’s short-duration bond allocation drifted down 5% and its cash allocation drifted up 5%, those movements would have very little impact on the portfolio’s risk exposure. Conversely, if the short-term bond allocation drifted down 5% and the energy allocation drifted up 5%, that would have a much bigger impact on the portfolio’s total risk because of how volatile energy is.
More and more, we see institutions migrating away from calendar-based rebalancing policies. We feel that this is a positive development because it shows that institutions are being more thoughtful in using rebalancing to capitalize on shifting risk and return opportunities. To further capitalize on this opportunity, we recommend that endowments adjust how tight their trigger bands are to account for the relative volatility of each asset class. Endowments and foundations also need to realize that rebalancing is about the tradeoff in creating stability in the strategic allocation assumptions, the transaction costs of rebalancing and the potential for additional return, assuming that momentum is being rewarded.
What role does exposure to illiquids play in endowments’ and foundations’ approach to rebalancing?
Stale pricing, or long spans since a private asset was last marked to market, will eventually catch up with institutions and impede their ability to rebalance effectively. One way to counteract this is by anticipating the extent to which illiquids in the portfolio can be revalued through public proxies and then incorporating this into the rebalancing policy.
The early stages of the COVID-19 pandemic highlighted how important is it to think about liquidity when establishing a rebalancing policy, as well as how problematic using an arbitrary, rules-based approach can be. Back in the spring of 2020, institutions using calendar-based rebalancing would have been stuck executing trades at varying points of the Federal Reserve’s efforts to restore liquidity to fixed income markets.
Institutions with drift-based triggers faced a similar conundrum. Institutions that came into 2020 at typical ACWI/AGG portfolio targets would have hit the 5% drift mark around March 9, right at the height of the liquidity vacuum. If they were able to delay their rebalancing just a few weeks, they could have executed their rebalance when liquidity conditions were much more favorable. But, again, the decision to delay that rebalance would have been an active management decision. This all reinforces the need for institutions to be thoughtful in creating a rebalancing policy that aligns with their overall objectives and reflects the portfolio’s liquidity and factor exposures.
Turning ESG policies into actionable investment strategies
Key findings from NACUBO 2019
Numerous approaches to ESG: Endowments and foundations are using multiple approaches to address ESG and responsible investing. While the majority of large institutions reported meeting with third-party stakeholders regarding responsible investing in 2019 and nearly half include ESG in their investment policy statement, the majority have not taken more tactical steps such as joining an ESG network, appointing a chief sustainability officer, creating a proxy voting committee or including asset classes with ESG categories in their investment process.
How can endowments and foundations improve their ESG integration efforts?
To bridge this gap, I think that it is important to acknowledge that ESG investing is about more than just risk and return. The conversation needs to go beyond simply how incorporating ESG factors would affect the portfolio’s performance and instead start with how responsible investing — for however the endowment or foundation chooses to define it — should align with the organization’s larger mission.
Stakeholder communications are an integral part of these discussions as well. Endowments and foundations are part of society, and they serve a wide collection of stakeholders, including students, donors, faculty, university administrators, state and federal governments, and the local community. In addition to thinking about how you actually implement an ESG investment strategy, you need to spend just as much time thinking about how you will communicate those decisions with all of your stakeholders. And given the diversity of those stakeholder groups, that is no small task.
It is also important for investors to realize that many ESG factors are directly related to the current low-return environment. For example, I talked earlier about how global demographic trends are a headwind to economic growth. But improved gender equity could serve as a catalyst for improved productivity, thus countering some of the broader, unfavorable demographic trends. In terms of the environment, the conversion to cleaner energy could have both positive and negative effects on returns, and this impact will vary across sectors and regions. Certainly, investors need to factor these trends into their capital markets assumptions and investment analysis.
Has the COVID-19 pandemic changed endowments’ and foundations’ thinking regarding the role that ESG plays as a risk-mitigation tool?
But it is safe to say that the pandemic — as well as the social unrest related to racial inequality — has emphasized the importance of the social and governance aspects of ESG. In the previous decade, most of the attention in ESG was focused on climate change, carbon emissions and other environmental issues. Those certainly are still front and center for endowments, but 2020 reminded everyone how much the S and G matter.
The pandemic certainly has the potential to shape some long-term secular trends that are linked both directly and indirectly to ESG considerations. For example, in 2020 we have seen a sharp reversal of the urbanization trend as many people with means have been seeking less dense living conditions. If this urbanization reversal proves to be enduring, it will affect variables related to climate change. Similarly, work from home reduces dependence on city centers and transportation. It is also worth noting that rural areas tend to have higher fertility rates than urban areas, a dynamic that could help counter the larger trend of declining population growth.
About the NACUBO-TIAA study of endowments
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