Is Spending Policy the Other “Free Lunch” in Investing?

December 8, 2022 |
2 minute read
|

We believe spending policy not only should influence strategic asset allocation but should be thought of as the other "free lunch" of long-term endowment investing alongside diversification.

In 1952, Nobel Prize laureate Harry Markowitz famously said, “diversification is the only free lunch in investing.” What he meant was that when building a portfolio, allocating to asset classes with differing risk and return characteristics can lead to a portfolio with a reduced level of risk without sacrificing returns. And while this principle still holds true today, those benefits are perhaps not as powerful as they once were.

As our Chief Executive Officer and Chief Investment Officer Mark Anson likes to joke, free lunch today is more like a free breakfast or even a Starbucks cup of coffee given the overall rise in correlations between asset classes that we've seen over the past decade (see Figure IV below). Higher correlations tend to erode those diversification benefits.

img-figure-vi

So, where can we get our additional risk-mitigating calories? We believe it is through the spending policy. This is because for most institutions, the biggest risk is not necessarily a drawdown of the endowment pool but rather a drawdown of the distribution used to support the institution. Therefore, we would argue that the spending risk metrics are the most important risks to mitigate.

Below, we have defined three of these key metrics.

Spending Volatility: The standard deviation (or dispersion relative to the mean) of the annual spend.

Reasonable goal: ensure this metric is lower than the investment volatility of the portfolio, which would mean that the spending formula is effectively mitigating the volatility generated by taking risk in the endowment.

Negative Spend: A calculation of the percentage of years in which spending in dollars for year x is less than spending in dollars for year x-1 (i.e., spending in dollars declines year over year).

Reasonable goal: limit the number of negative spending years to maintain consistent and growing support from the endowment.

Annual Spending Drawdown: The average and max percentage of decline in spend dollars, year over year, during these negative spending years.

Reasonable goal: minimize the annual spending drawdown to avoid sizable budget shortfalls that could cause operational stress for the institution.

Selecting an investment plan based solely on maximizing return per unit of risk (pick your favorite risk metric: volatility, drawdown, etc.) while ignoring the spending policy’s ability to mitigate some of that investment risk is an oversight we see all too often. We would argue that if a spending policy that decouples from the endowment market value is implemented, this may allow the portfolio the freedom to increase its allocation to growth assets without the commensurate increase in the risk that matters most, the distribution. So, does this result in the free lunch that we have been searching for?

Interested in seeing the full analysis?  Take a deep dive into our whitepaper “Endowment Spending Policy: Often Overlooked but Critical to Long-Term Success.”

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Rachel Stavola Clivaz

Author

Rachel Stavola Clivaz

Director

Rachel Stavola Clivaz

Author

Anthony Peretore

Managing Director

Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

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Disclaimer

Certain information contained herein has been obtained from or is based on third-party sources and, although believed to be reliable, has not been independently verified. Such information is as of the date indicated, if indicated, may not be complete, is subject to change and has not necessarily been updated. No representation or warranty, express or implied, is or will be given by The Common Fund for Nonprofit Organizations, any of its affiliates or any of its or their affiliates, trustees, directors, officers, employees or advisers (collectively referred to herein as “Commonfund”) or any other person as to the accuracy or completeness of the information in any third-party materials. Accordingly, Commonfund shall not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement in, or omission from, such third-party materials, and any such liability is expressly disclaimed.

All rights to the trademarks, copyrights, logos and other intellectual property listed herein belong to their respective owners and the use of such logos hereof does not imply an affiliation with, or endorsement by, the owners of such trademarks, copyrights, logos and other intellectual property.

To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated herein. Forecasts of experts inevitably differ. Views attributed to third-parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Market and investment views of third-parties presented herein do not necessarily reflect the views of Commonfund, any manager retained by Commonfund to manage any investments for Commonfund (each, a “Manager”) or any fund managed by any Commonfund entity (each, a “Fund”). Accordingly, the views presented herein may not be relied upon as an indication of trading intent on behalf of Commonfund, any Manager or any Fund.

Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Fund. Such statements are also not intended as recommendations by any Commonfund entity or any Commonfund employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information or statements. Past performance is not indicative of future results. For more information please refer to Important Disclosures.