It’s no secret that the final quarter of 2018 was a rough one for capital markets, as stocks experienced double-digit losses and most asset classes finished the year in negative territory. The downturn was swift and caught investors off guard, as most U.S. economic and other fundamental data remained largely positive.
While many are clamoring to figure out what will happen next in the markets — an unproductive venture in our opinion — we suggest that institutions managing investment portfolios take a more pragmatic approach and think about what lessons can be learned from the most recent market pullback.
Here are five questions that institutional investors can ask themselves as they look back on last quarter and plan for the years ahead.
1. Did last quarter significantly impact the overall financial performance of your organization?
Some organizations rely heavily on investment income or may have other revenue sources that are sensitive to market downturns.
In those instances, it often makes sense for investment portfolios to be positioned more conservatively, particularly when there is high sensitivity to economic downturns. By limiting the year-to-year volatility of returns, a portfolio can provide a more consistent and reliable revenue stream.
If your investment returns were detrimental to your financial results in 2018, it’s important to ensure that your investment strategy going forward is aligned with your organization’s goals and overall situation.
It’s important to ensure that your investment strategy is aligned with your organization’s goals and overall financial situation.
2. How will this affect the portfolio spending rate in 2019?
Many organizations, especially foundations or those with long-term endowments, count on their investment portfolios to provide some level of spending to cover grant-making, operations, or other expenses each year. Depending on how that spending is calculated, the market drawdown last quarter could have a significant impact on the dollar amount that’s provided.
3. Did the portfolio reach, or is it close to, a critical level?
While the Uniform Prudent Management of Institutional Fund Act permits fiduciaries to spend from “underwater” endowments, corpus values can be protected by specific donor restrictions and are often regarded by board members as thresholds that aren’t to be breached. In some situations, organizations strive to maintain a defined level of investment reserves on hand, either as part of a prudent risk management strategy or due to restrictions based on regulatory requirements or debt covenants.
Whatever the reason, portfolios that must maintain a certain asset level (e.g., corpus) should be modeled appropriately to estimate their potential for short-term losses. If the fund balance isn’t sufficient to allow for such portfolio volatility, a more conservative asset allocation approach may be necessary to reduce the probability of breaching that minimum threshold.
4. Does the IPS contain rebalancing guidelines?
As a result of last quarter’s market environment, many investment portfolios are likely near or at allocations that would warrant rebalancing today. Rebalancing is a time-tested and proven portfolio management tool that reinforces the concept of “buying low and selling high.” Unfortunately, it can also be easier to embrace in theory than in practice, particularly during periods of heightened volatility. A good IPS will address this issue by specifying how often a portfolio should be reviewed for rebalancing opportunities and outline rules for when rebalancing should be considered. If your rebalancing criteria are documented ahead of time, it’s much easier to stick to the plan in any market environment.
5. How did you and your board members react to the market volatility?
At the end of the day, we’re all human. No one enjoys watching portfolio values drop, even if it’s only a temporary setback in an otherwise successful long-term strategy. However, if you’re suddenly worried about the daily movements of the stock market, or wanting to hold cash “until things settle down,” it may be a sign that you’re uncomfortable with the level of risk in the portfolio. Bouts of volatility like that in the fourth quarter provide investors with the opportunity to reconfirm their overall risk tolerance, strategic asset allocation, and portfolio construction — all of which should typically be reviewed on an annual basis anyway. While we don’t advocate making portfolio changes based on short-term price swings, no investment strategy will be successful in the long run if you’re unable to stick with it through periods of distress.
If you’d like to discuss these issues or want help effectively managing your organization’s investments, please contact us today.