One of the simplest but most important investment axioms is that risk and return are inextricably linked. Institutions cannot earn the long-term returns needed to support their activities without taking risk.
The core risk for an endowment is that a market decline has a game-changing effect on its ability to meet portfolio and operating liquidity needs and maintain its competitive strategic position. The worst-case scenario is to sell endowment assets after they decline substantially, thereby turning temporary market declines into permanent, or generational, losses. An institution might end up selling assets at depressed prices because of economic circumstances, restrictions on assets or behavioral factors.
Many investors turn to diversification as a way to reduce this possibility, but in the worst of market downturns, rising correlations and higher concentrations of risk can erode diversification's benefits and increase the likelihood of severely negative returns. What else can investors do to coexist more comfortably with volatility? Plan ahead.
Contingency planning is the next line of defense after diversification. A contingency plan helps investors navigate through short-term stressful periods in order to capture long-term returns associated with more volatile, higher-returning assets. The goal should be to meet portfolio and operating liquidity needs without needing to sell off assets at depressed prices. Further, investors should consider to what degree they would like to have sufficient liquidity to rebalance assets at cheaper valuations and “upgrade” the manager roster as manager access expands.
Successful contingency plans follow four best practices:
• communicate with stakeholders;
• understand expected sources and uses of cash across the institution — not just the endowment — during a crisis;
• understand and seek to avoid behavioral risks; and
• protect against tail risks.
First, key stakeholders must have a shared understanding of the expected role of the endowment and understand why and how the institution has prepared for stressful periods. This shared understanding should be reinforced, revisited and revised over time as appropriate.
Second, the plan should focus on revenues, expenses and reserves, without ignoring the constraints on assets that can limit their investment (such as debt covenants) or their accessibility for spending purposes (such as donor restrictions). During a stressed environment, institutions may be able to fund their budgets from short-term sources like reserves as well as from other (non-endowment) revenue sources. Institutions might also consider their capacity for taking on taxable debt for working capital purposes. Finally, investors should also consider to what degree they can cut costs.
A third best practice is to avoid behavioral risk. This doesn't just happen naturally; you have to work at it. No one is immune from the classic symptoms: feeling more comfortable as markets rise and valuations increase, even though equity risks are actually rising, and getting more nervous when markets have fallen sharply and valuations are relatively cheap. To reduce the risk of this type of behavior, institutions should have strong policies (including a rebalancing policy) and strong practices (such as adherence to valuation-based investment principles), a common understanding of the rationale for strategic asset allocation and a commitment to following the contingency plan to the degree possible when times get tough.
Finally, a best-practice contingency plan includes protection against tail risk. A traditional, asset-allocation-based approach to managing this risk is to hold some of the portfolio in inflation-sensitive assets to protect against an inflation shock, and to hold bonds, most notably Treasuries, to protect against a deflation scare or a flight to quality. Of course these investments typically come with an opportunity cost in the form of decreased expected returns for the portfolio, making it more difficult to maintain purchasing power over the long term. Nonetheless, we still recommend this strategy. Such allocations should be viewed as catastrophe insurance — a way to help meet cash needs in a crisis without having to sell risky assets when they are down.
Derivatives also can be used to reduce dramatic portfolio declines and provide liquidity in times of stress. Before considering derivatives, investors must answer several fundamental questions. What risks does the institution wish to hedge against? How much defense is already inherent in the asset allocation? How will the strategy be implemented — direct hedges, such as equity puts, or indirect hedges that are less expensive but are not directly tied to equity risk? Is the reduced risk of short-term volatility worth the direct hedging cost, the opportunity cost in terms of forgone investment return, the risk that it will not work well (in the case of an indirect hedge), exchange risk and/or counterparty risk, and the operational complexity? Is this a one-time purchase of protection, or can rolling options be considered? How much of the tail does the institution want to cut off? And so on.
Behavioral risk becomes a big concern for investors implementing derivatives. We have seen far too many cases of investors rolling puts only to get tired of “throwing money away” on option premiums for nothing. That is usually about the time that risks are rising and the market ultimately experiences a sharp decline, resulting in the worst of all possible worlds in tail-risk management — spend the money when times are good and fail to get the payoff when it is needed. Having strong policies and practices in place and crystal-clear assignment of decision-making responsibility is crucial to mitigate this behavioral risk.
Although volatility is with us for good, there are strategies investors can use to cope. Diversification is helpful in reducing volatility most of the time, but during tail events, particularly when a common source lifts and then sinks all boats sharply, planning ahead by developing a contingency plan that is well understood and endorsed by key stakeholders, and that includes a strong process to mitigate behavioral risks and adequate protection against tail risks, can help steady the ship when a storm inevitably strikes.
