Greenhouse Effect

August 17, 2014 |
2 minute read
|

Investment returns of less well-diversified portfolios have flourished in the accommodative market environment created by central banks. But what will happen when rates rise?

In the last five years, as world markets have recovered from the global financial crisis, institutional portfolio returns have generally been strong. While many factors have played a part in this scenario, historically low interest rates and accommodative monetary policies on the part of the Federal Reserve and the European Central Bank—an artificial environment like that of a greenhouse—are among the main causes for the high equity market returns of the last few years.

Yet, even in this period of good returns, the crucial question facing fiduciaries is: How should we prepare our portfolio for the day when accommodative monetary policies end and rates begin to rise?

Some hints may lie in the accompanying table.

InsightFall14_SharpeRatios

The data shown are from colleges and universities, but similar information is available for private foundations.

Historically, large endowments have usually outperformed smaller endowments. Much of their success can be attributed to the key tenets of the so-called “endowment model,” an investment approach characterized by a long-term horizon, a highly diversified portfolio with a bias toward equity and a willingness to accept illiquidity in expectation of higher returns over the long term.

Over the past few years, however, smaller, less well-diversified endowments have outperformed or produced returns very similar to those of their larger counterparts.

If, however, we examine return figures that have been adjusted for risk, we obtain a different perspective on the investment environment in the years FY2006–2013. The Sharpe ratio, named for Nobel laureate William F. Sharpe, is a measure of risk-adjusted performance. It shows the quality of returns—specifically, how much return was earned for each unit of risk (as measured by portfolio volatility).

The higher the Sharpe ratio the better, meaning that more return was achieved per unit of risk.

From FY2006 (July 1–June 30) through FY2008, larger endowments registered the highest Sharpe ratios. The pattern reversed—dramatically—in FY2009. In that fiscal year, smaller endowments outperformed. Although the Sharpe ratio favored larger endowments in the fiscal years 2010 through 2013, the spread from largest to smallest was negligible.

In the very accommodative monetary and interest rate environment of that period, risk became to some extent suppressed, making it easier for less diversified portfolios—those with large allocations to traditional stocks and bonds—to ride the rising market. More diversified portfolios saw their performance advantage diminish in relative terms.

Hedge fund strategies were particularly challenged in this environment, proving, in the minds of some, that a 60/40 domestic stock and bond allocation would work for the long term. Most frustrating to advocates of a more diversified portfolio, the five-year track record of this simpler allocation seemed to bear this argument out.

As the Fed begins to withdraw its support the question arises, What will happen in a normalized environment? With the Fed’s bond buying program expected to end soon, higher interest rates may well follow.

This could have major implications for smaller and mid-sized endowments, with their relatively high allocations to medium- and long-term fixed income investments that could suffer capital losses in an interest rate reversal.

Furthermore, because they are less diversified and have fewer sources of return, they are subject to higher volatility. 

As fiduciaries review the evolving market environment, it may be time to consider whether an “all-weather” 60/40 stock and bond portfolio is sufficient for the chillier weather that may lie ahead.

Commonfund Institute

Author

Commonfund Institute

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.