Erika Murphy
New year, same markets? In the first quarter of 2024, market conditions seem to have carried over 2023’s upward momentum, supported by solid economic fundamentals and an anticipated easing of monetary policy after a flurry of interest rate hikes to combat record inflation.
This may be an uncommon take, but in my view, there is minimal distress right now. In public markets, we are seeing attractive valuations in some pockets. China, small caps and value remain areas of economic uncertainty, but we are observing consensus estimates stabilizing, and we are hearing from some of our underlying security selection managers that markets have already priced in much of the downside risk. Surprises to the downside could increase volatility if expectations are not met.
For endowments and foundations specifically, portfolios typically have aggressive investment objectives—which, in turn, means they are equally exposed to sizable volatility.
So, what can E&Fs do to navigate this prospective ‘sea of uncertainty’ this year?
I regularly speak to these institutional organizations as a portfolio manager on a team that manages multi-asset-class portfolios on behalf of E&Fs. Here are a few investment considerations when it comes to navigating those waters for E&F portfolio management in 2024.
- Allocate Cash Opportunistically
For our E&F client portfolios, we typically focus strategic asset allocation on asset classes that can capture a risk premium, such as equities, bonds and alternatives. We favor these asset classes because they also offer an opportunity to capture additional security selection alpha.
Cash, however, does not capture either. Although cash does have appeal given its high current return and limited drawdown profile, we do not expect these levels of return to persist. In addition, we do not expect cash returns will be able to offset both inflation and nonprofit spending rates over the long term.
For these reasons, E&Fs can consider tapping cash opportunistically, rather than in a policy benchmark. For example, some E&F client portfolios may hold more cash later in the economic cycle and during recessions—but they likely do not want to be forced to hold that cash exposure in early-cycle environments, when it could be deployed to higher-returning asset classes.
- ‘Stress Test’ for Liquidity
Should E&Fs need to source additional liquidity—either to offset rising costs due to inflation or to supplement budgets in a weaker economy—it is important to have a liquidity plan in place.
Create a ‘stress test’-type questionnaire for your team to help inform a liquidity plan in an environment that seems clouded with uncertainty. It is key to understand that things may not go entirely according to plan, but having a sense of your source of funds in advance can help streamline decision making in periods of stress.
Some questions may include:
- How much liquidity might be required to fund capital calls?
- Which allocations are subject to lockups or could be subject to a gate? How might this impact your allocations?
- Which allocations are most critical to achieving your return objectives? and
- How can you source liquidity to keep the combined exposure close to your strategic target in periods of dislocation?
The answers to these questions can help create a baseline to meet your liquidity needs. However, the planning does not end there. Be mindful of time periods that may have more stress than historical averages (think of the Great Recession), resulting in private asset distributions that fall below the mean.
Thanks to innovative minds in the private markets, there are new levers to pull to access liquidity from private exposure. One strategy is through evergreen private structures, which provide access to private assets but do not require capital calls or have a traditional fixed lifespan. These fund structures typically leverage the secondary markets to invest in mature private assets, such as higher-quality buyouts, for example, and provide some ongoing liquidity to investors in the fund.
- Dust Off the Inflation Playbook
Inflation headlines have been pervasive over the last few years, for obvious reasons. In the 20 years prior to 2021, U.S. inflation averaged only about 2% (measured using year-end annual headline Consumer Price Index inflation). If we put this into a historical context, we have just lived through an unusually long period of low inflation. It is no wonder it has been a focal point for businesses, in political discourse, at the dinner table and seemingly everywhere else.
Our asset allocation research team believes secular inflation will average approximately 3% going forward, materially higher than over the past 20 years, which may require some updates to E&Fs’ strategic asset allocations. Our research shows that the real wealth of a 70% stocks/30% bonds portfolio starts to erode when inflation nears or exceeds 3%, as the investment portfolio’s returns are insufficient to offset 5% annual spending and higher inflation levels.
What are some ways E&Fs can better preserve real spending power amidst inflationary headwinds?
Worthy considerations might include building in flexibility to opportunistically own a variety of inflation-related public assets, including commodities, commodity-related equities and Treasury Inflation-Protected Securities. Proceed with caution with these assets, as a “set it and forget it” approach to these inflation-hedging allocations is not advised. Asset selection and sizing of inflation hedges should vary depending on the level of inflation, inflation’s rate of change and the level of economic growth.
Building out more strategic allocations to private assets, including private equity, private credit, private infrastructure and private real estate, have also historically demonstrated a positive correlation to inflation and may be helpful in preserving the real wealth of E&Fs.
In periods of uncertainty, it is important to anticipate where your blinds spots may be—perhaps in sharp drawdowns, less liquid allocations or rising inflation—and then build in flexibility to adapt to market dislocations, respond to liquidity needs and position your portfolio to take advantage of opportunities when they present themselves.
Erika Murphy, CFA, CAIA, is a portfolio manager in the Global Institutional Solutions group at Fidelity Investments.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS Stoxx or its affiliates.
Tags: Endowments, endowments and foundations, Foundations, uncertainty