Understanding investment opportunities and approaches
Since the global financial crisis (GFC), the investment market has changed dramatically, with the result that many ‘go-to’ investment opportunities for a not-for-profit (NFP) are now offering considerably lower returns. Which is why it’s important that NFPs question whether the return target set by their Investment Policy Statement remains appropriate to their goals.
Today, in Australia, shares can be expensive, interest rates are at historic lows and term deposits are offering meagre returns. In response, NFP investors are pushing out into more risky vehicles, such as mixtures of stocks and bonds – so-called ‘hybrids’. Although these asset groups can indeed generate good returns in the long term, they also carry a greater possibility of generating negative returns if things don’t go well – an outcome that may not be appropriate for a NFP organisation.
In this environment, NFPs should take a long hard look at both their investment policy goals – and the investment strategies chosen to meet them.
No guarantee of hitting your targets
In a highly volatile investment environment, investors don’t get the same returns year-in, year-out. One year, they can do worse than the target. The next, they can do better. The graph goes up and down, but it trends upwards.
Imagine an NFP with an investment policy target of 3% higher than the Consumer Price Index. In a pre-GFC market, the board might have reasonably decided the best investment strategy to achieve that is 80% in equities and 20% in cash. But, according to Head of Solution Development, at Macquarie Wealth Management, James Greenrod, the problem with this approach is that, in the current market, the chance of achieving this target in the first year could be as little as 50%.
It’s now widely accepted that asset allocation is the greatest contributing factor in determining portfolio returns and risk over time.
“NFPs need to understand that their return expectations must be adjusted to the timelines around funding requirements. If you’re not going to use the money for 20 years, then that 80:20 (equities:cash) split might still be warranted. But, if you have the funds earmarked for a project next year – or even in five years – then market volatility means you may be running an unacceptably high risk of losing that money.”
He says that, over time, the risk range narrows. “In seven years, the probability of doing worse than target might drop to 30%. But you still have to assess whether you’re prepared to take that risk. What will you do if you end up in that 30%? Are you prepared to cancel or postpone the project the funds are intended for? How will you explain that to your stakeholders? Would you be better off taking less risk and potential making less money, but gaining more certainty that the funds will be there when your NFP needs them?”
Greenrod contends that, to make this type of call from a well-informed base, NFP boards need to look at the range of possible outcomes for a particular portfolio.
“Before they make investment decisions, it’s vital that boards understand what the best and worst possible cases are and how meaningful the difference might be in a bad run. It may be that, in a volatile market, a particular strategy could result in the NFP being down by a million dollars. In that case, the board will almost certainly choose a less risky investment strategy.”
He points out that the volatility effect also means that, sometimes, boards can be too conservative with investment strategies.
“We occasionally come across NFPs that are essentially building a long-term war chest, where their strategy is too conservative. They have enough time to weather the volatility and they really could be more aggressive without taking inappropriate risks with fund-raising proceeds.”
Challenges for investment sub-committees
He says that many NFP investment sub-committees are struggling with these issues – for a couple of reasons.
“Firstly, some NFPs don’t necessarily know what they’re going to be spending on in the future – that makes it really hard to decide what you do today. How much risk you take depends on what and when you’re going to spend. Sub-committees need to push for hard and fast decisions around that funding timeline.
“Secondly, because investment sub-committees report to the board every quarter, they have a tendency to take the short-term view. No one wants to be the bearer of bad news. But, in today’s market, you can almost guarantee that, in some quarters, you’re going to be reporting negative returns. Boards and committees need to reset their expectations: volatility is an investment fact of life. They need to keep their eye on the long-term goal and accept that markets will go up and down. Otherwise, you’ll get a nervous committee making changes to what was actually a perfectly sound investment strategy.”
Annual reviews essential
Increased volatility also makes it more important to have an annual review. As Greenrod explains, even if NFP boards make the right decision at the beginning of the year, in 12 months’ time the situation will be different.
“A year later the return you get will be lower or higher than you expected. What do you do then? Even if your goals haven’t changed, you’re one year into your time horizon, your asset liability situation will certainly have changed – and your fund raising efforts may have changed too.
“If you made more than you were expecting, do you take on more risk, because the downside potential doesn’t bother you as much? Or, do you lock in the excess return that you weren’t expecting to get – effectively taking less risk?
He says, at such times, people often ‘go with their gut’ when making investment decisions – sometimes with unfortunate results.
“We find NFP boards have a tendency to double down when things are going well. Equally, when things are going poorly, their instinct is to exit markets and sit on the side lines. Often both of those reactions are the opposite of what the organisation needs.”
Greenrod empathises with NFP decision makers when markets are going against them.
“If markets are falling, it’s very stressful to keep going with your investment strategy, especially when the board has to report to other stakeholders. It’s hard enough making these decisions with your own money – doing it with someone else’s to support a worthy cause is doubly difficult. This is why you need a scientific, rational basis for making the call.”
Pitfalls of traditional investment strategies
He says NFP boards and investment sub-committees need to be aware of all the potential emotional biases when it comes to deciding on their portfolio mix.
“It’s now widely accepted that asset allocation is the greatest contributing factor in determining portfolio returns and risk over time. To get the allocation to different investment markets right, we have to put our feelings to one side and rely on the data.”
This means looking beyond historical performance.
“When building a portfolio, NFP boards need to consider future expectations as well as historical information.”
He concedes that forecasting is notoriously difficult, even for professionals with access to statistical methodologies and analytics. But says that data is at least emotionally neutral.
“We can have very strong feelings about what we think is going to happen – based on what we read in the papers, or whether we like or dislike a brand. Those factors make us take certain actions more definitively than we should.”
Even if NFP boards make the right decision at the beginning of the year, in 12 months’ time the situation will be different.
Greenrod notes two particular biases most likely to cloud judgement in NFP investment strategies:
- Home bias – Australians tend to take a much larger position on the local share market because they are more familiar with home-grown companies. This so-called ‘exposure effect’ predicts that investors value stocks more simply because they are exposed to them more frequently. This bias towards the ASX effectively hitches NFP fortunes to the banks, which form an unusually high percentage of our local share market index. In a post-GFC era, this is a serious case of putting your eggs in one, not particularly safe basket.
- Franking credit bias – In some circumstances, the home bias may not merely be due to the exposure effect, but the preferential tax treatment given to domestic stocks. It seems perfectly sensible for investors to hold ‘more’ domestic equity in their portfolio to maximise after-tax returns. At issue is the fact that investors typically over-estimate how much more that should be. As a basic rule of thumb, if franking credits are available, they usually justify Australian investors to increase their domestic equities allocation by 20-30%. However, allocations above 60% are risky because investors don’t get the benefit of diversification. Excessive exposure to domestic equities leads to higher volatility, which can significantly erode the value of a portfolio over the long run – leaving it worse off than it would have been with a more diversified approach.
NFPs need realistic, diverse portfolios across multiple asset classes
To prevent bias and emotion from clouding investment decisions – and ensure they have an investment portfolio tailored to organisational needs – NFP boards need to get their advisors to model different portfolios with different benchmarks and different levels of risk. This should be repeated every year at review time to ensure the portfolio continues to be aligned with organisational goals.
“This type of modelling will provide the board with a realistic probability of outcomes for differing risk profiles and asset allocations,” says Greenrod.
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