UBS Advisor to Foundations: Risk Up or Wither

(November 5, 2012) – In an environment with negative real interest rates, how can foundation investors meet their long-term goals?

Mostly, they can’t-or so says Michael Crook, an executive director and head of the Portfolio Advisory Group at UBS.

Crook, who is also an adjunct economics professor at Marymount Manhattan College, built a sophisticated returns model to test the relative success of different foundation portfolios over the next 20 years, and published the results for three quite divergent portfolios in a paper titled “Investment Policy for Private Foundations: Seeking Compliance and Survival in the New Normal.”

The verdict: Crook’s riskiest portfolio had the likeliest chance of succeeding in the long-term, but the probably was still only 48%. In this scenario, the mock portfolio is 37.7% global fixed income, 10.9% emerging market debt, and just 3.8% US equities. Some 26.6% of these mock assets go to developed markets outside of America. Of the riskiest assets in the model fund, Crook allocates 15.8% to emerging market equities and 5.1%, to commodities.

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Twenty years from now, Crook’s model indicates that the most conservative portfolio would have only a 12% chance of meeting its baseline goals, and a moderate portfolio would likely fare slightly better, at a one-in-three chance of 20-year success.

The author defines success using three common foundation investment policy objectives:

1. Distribute 5% of the net fair value of their assets per year.

2. Maintain at least a constant level of real (inflation-adjusted) charitable giving per year.

3. Do so in perpetuity.

So back, then, to the original question: What is a foundation CIO to do?

“It is clear that more-risky allocations have a much better chance of achieving the goals described than more-conservative portfolios. In fact, even a moderate portfolio is unlikely to be sufficient for meeting the general investment objectives of a foundation over the next 10 to 20 years with a high degree of certainty,” says Crook in his paper.

Either risk up, or drop expectations, Crook continues: “To the extent that a foundation’s trustees are uncomfortable targeting a portfolio risk level greater than what is generally considered to be moderate (portfolio #2), the objective of maintaining the inflation adjusted value of the corpus must be relaxed or removed. If trustees are focused on maintaining purchasing power at a 5% distribution level, additional contributions are likely to be necessary to make up the difference.”

Read Michael Crook’s entire paper here.

A whitepaper from Ross McLellan—who recently started a transition management consulting business following his departure from State Street—asserts that the industry practices have remained essentially unchanged for 15 years.

(November 4, 2012) – Ex-State Street transition management veteran Ross McLellan has published a whitepaper decrying the lack of change in the industry.

“In 1997 you could have bought [Apple] for $3.28 per share after they rehired their former CEO Steve Jobs,” McLellan writes in A New Approach to Transition Bidding. “Gas cost $1.22 per gallon. After 79 years of futility, Boston Red Sox fans wondered if the cause was worth it and the state of Illinois swore in a new first-term state senator, Barack Obama. Fast-forward to today and the world has changed dramatically. However, transition managers often provide, and are often asked to provide, the same template as they did fifteen years ago.”

This template, McLellan argues, fails to reflect large changes in execution venues, among other things. “While it would be overkill for a transition manager to properly account for all order routing prior to the start of the transition, it is extremely important to find out where transition managers are accessing liquidity from,” he writes.

As part of the solution, McLellan—who recently founded Harbor Analytics, which aims to consult with asset owners on transaction costs—argues that the industry “needs a bidding platform where differentiated trading practices are evaluated, providers have the ability to demonstrate their cost minimization strategies, and all information is verified by a third-party.” He also believes that third parties should conduct post-trade audits, and that liquidity sources should be outlined in a more robust manner.

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McLellan also calls for changes in the way costs are accounted for, noting that internal and external crossings are assumed to be free from implicit costs, which is not always accurate. “It is also our belief that transition managers should not be stuck with assuming the costs calculated by any one pre-trade model and retain the ability to allocate the expected cost by execution method,” he writes. “Transition managers should be provided an overview of the portfolio, with expected cost as calculated by a transparent model where all parties understand the inputs and let that manager estimate the cost based on their trading practices. Certain transition managers may employ different trading strategies that ultimately reduce costs.”

McLellan’s call for change—of which he is not alone in voicing—comes at a time of contention in the transition management business. The recent turmoil in this industry is well known, and started, by and large, when McLellan’s departure from State Street was revealed.