Multi-Asset / Wealth Management

Endowments and Foundations: Should a Windfall Change Your Investment Policy?

By Brian D. Wodar February 21, 2014

Board members at Uptown Community Foundation (UCF) faced an enviable dilemma: what to do when an unexpected bequest boosted UCF’s capital from $10 million to $12.5 million. One board member welcomed the chance to reduce portfolio volatility by cutting the stock allocation. Another had the opposite view: with increased financial strength, why not take on greater equity exposure?

While UCF is fictional, its quandary is not unusual. Here’s how we would give a board faced with this situation a rational basis for reconsidering its asset allocation. Using our Wealth Forecasting System, we would analyze how various alternatives are likely to play out over time.

Before the bequest, UCF was sustainably spending 4.5% a year and raising $200,000 a year; it had a moderate asset allocation of 60% global equities and 40% bonds. The foundation was on track to grow its portfolio’s value over time, in median markets. The bequest made the picture even rosier.

If the foundation shifted from a 60/40 stock/bond mix to a more preservation-oriented 40/60 allocation, the nominal portfolio value would still rise, but more slowly (Display 1). In fact, it would rise so slowly that over time it would lag the level UCF would have reached without a bequest.

If the board took the opposite tack and stepped up the allocation to stocks to 80%, we project the portfolio would grow to nearly $45 million in 30 years. But this growth would come at the price of increased market risk. The larger the allocation to equities, the greater the risk of a 20% loss from a market peak to a subsequent market trough. Over the next 30 years, the odds of such a large loss would rise from just 14% with a 40/60 mix to 44% with a 60/40 mix and 75% with an 80/20 mix (Display 2). Most boards we’ve met would find the 80/20 mix too risky.

We also show boards what might happen under very unfavorable conditions—high inflation and dismal market returns. In the bottom 10% of our Monte Carlo trials, the portfolio value would decline regardless of which asset allocation they chose. Over time, truly disappointing market returns would be equally disastrous to all the investment policies studied here, including the most conservative.

Thus, both reducing and increasing the equity allocation will increase risk: the risk of permanent depletion of capital on the one hand, and the risk of a steep investment loss on the other. While different boards might reach different conclusions, maintaining the moderate asset allocation will often strike a good balance between these risks.

Adding hedge funds, non-US bonds, inflation-linked bonds, and real assets (such as real estate and commodities) is another way to improve the portfolio risk/reward trade-off that we believe merits consideration.

The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Endowments and Foundations: Should a Windfall Change Your Investment Policy?
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