Investment Insights

A complex investment environment

Institutional investors, especially endowments and foundations, face an increasingly complex investment environment in today’s world. Navigating market volatility, potential regulatory risk, and geopolitical risks (to name a few), require endowments and foundations to not only manage their portfolios to meet long-term objectives but also to understand how potential changes/risks may impact their investment strategy from both a short-term and long-term perspective. Given the increased complexity and potential risks facing endowments and foundations, we believe this is a good time to focus on some of the basic investment principles at the core of the investment strategy for an endowment and foundation.

Asset allocation – balancing long-term return and short-term liquidity

Endowments and foundations face a dual mandate: preserving and growing capital over the long term while meeting short-term liquidity needs to fund operations, grants or distributions. Most endowments and foundations are meant to last into perpetuity, requiring investment strategies that preserve and grow capital over the long term. The long-term time horizon of endowments and foundations allows them the opportunity to take on more risk in their asset allocations than other institutional investment portfolios, but they cannot afford to completely ignore market volatility. Striking a balance between the dual mandate may be difficult at times, especially in a volatile environment. Each entity will be unique in terms of its risk and return objectives, and therefore, there is not a “one size fits all” approach. Focusing on the entity’s specific goals and objectives will help with identifying the appropriate long-term investment strategy.

The strategic asset allocation decision is an important decision for the long-term planning and growth of the assets. The idea of the strategic asset allocation is to build a portfolio that is broadly diversified and will meet the long-term return objective in a risk-controlled manner.

The long-term return assumption generally has two goals:

1. Support the annual spending rate, and;
2. Preserve the purchasing power of the entity (net of fees).

With these goals in mind, the long-term return assumption is usually in the 7-8% range. This may be adjusted if there are changes in spending policy or a lower (higher) expectation for inflation over the long term.

It is important for endowments and foundations to construct their asset allocation and investment policy in alignment with the spending policy. Spending policies often use smoothing techniques to avoid significant year-to-year variations in distributions, but if the portfolio suffers a sharp decline in a given year, the effective spending rate using smoothing may be significantly higher in that year than the stated spending rate. Endowments and foundations may look to short-term bond portfolios to manage the liquidity needs of the entity, which is a more appealing proposition in today’s interest rate environment than it was for the fifteen years following the Global Financial Crisis.

Another consideration is the balance between liquid and illiquid assets. Many endowments and foundations over the years have increased their exposure to alternatives (e.g., private equity, private credit) that are illiquid and are meant for investors with a long-term horizon. Determining the appropriate allocation to illiquid investments requires careful consideration of the tradeoff between liquidity and (potential) return enhancement. Recent news articles have noted that some large endowments are looking to sell portions of their private markets portfolios to raise cash or redeploy into other asset classes. During periods of market stress, some entities may be forced to sell assets that are experiencing a drawdown to meet their spending requirements or for capital calls of private investments. The asset allocation decision is complex and requires a thorough analysis of many aspects of the entity’s objectives and overall mission.

Proper risk management and governance

We take a holistic approach to risk management. This involves not only focusing on the various market-based risk exposures but also the governance structure and decision-making. A good governance structure may enhance investment results. Structured and rigorous processes should be followed in establishing an investment policy statement and its alignment with the spending policy, asset allocation and manager selection decisions, setting and monitoring investment manager guidelines, and in evaluating investment performance.

From a market perspective, understanding your risk exposure and stress testing your portfolio is very important in the overall decision-making process. Stress testing the portfolio may provide key decision makers with insight into how bad a situation can potentially be based on certain market conditions. One part of the stress testing is to analyze the liquidity under different market conditions. It is important to understand how liquid your portfolio is and how easily you can meet your liquidity needs if unforeseen market events occur.

Given the increased allocations to private markets over the years, endowments and foundations should also regularly update the stress cases for their private market pacing program. Over the last few years, investors have experienced slower distributions from private equity investments. This, coupled with market volatility, may have an impact on the liquid portion of the portfolio, the management of short-term liquidity needs and how much to commit to private market investments in the future. Including downside scenarios where there is a combination of market stress and/or increased liquidity needs will help manage the short and intermediate liquidity needs.

Reviewing and analyzing your investment strategy

Portfolio management for endowments and foundations is increasingly becoming more complex. Given the current market environment, we believe that this is an important time to review and analyze your investment strategy. Our focus is on one thing: our clients. We develop customized solutions based on each client’s specific risk and return objectives and tailor portfolios to align with the client’s mission and core values. Incorporating proper risk management and governance structure may increase the likelihood of your entity meeting its mission and long-term objectives.

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This material was created to provide information on the subjects covered, but should not be regarded as a complete analysis of these subjects. The information provided cannot take into account all the various factors that may affect your particular situation. The services of an appropriate professional should be sought regarding before acting upon any information or recommendation contained herein to discuss the suitability of the information/recommendation for your specific situation.

Investment advisory services are offered by Gallagher Fiduciary Advisors, LLC (“GFA”), an SEC registered investment advisor that provides retirement, investment advisory, discretionary and independent fiduciary services. Registration as an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the SEC. GFA is a limited liability company with Gallagher Benefit Services, Inc. as its single member. GFA may pay referral fees or other remuneration to employees of Arthur J. Gallagher & Co. or its affiliates or to independent contractors; such payments do not change our fee. Neither Arthur J. Gallagher & Co., GFA, their affiliates nor representatives provide accounting, legal or tax advice. GFA/Osaic CD (8138196)(exp072027)

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