When I chaired the investment committee for an endowment fund some years ago, I faced a conundrum that many investors struggle with today: dwindling yield.
The fund, responsible for providing scholarships and bursaries, saw its purchasing power eroding because the portfolio was invested almost entirely in fixed-income securities.
Faced with falling interest rates, the spending policy couldn’t adapt, even with modest capital gains. The headmaster wanted to expand the bursary program and something radical had to be done.
I connected with J. Peter Williamson, then a professor at the Amos Tuck School of Business at Dartmouth College and a consultant to the Commonfund, an organization created by a grant from the Ford Foundation that invests for endowment and not-for-profit organizations in North America and the U.K.
Professor Williamson, a Toronto native, introduced me to the Yale formula and emerging trends in endowment investing that, like pension plans, have long time horizons, but unlike pension plans, need to provide stable annual income. If your clients are in or approaching retirement, learn from endowment fund strategies that allow for more stable drawdowns and focus on risk in a way that’s different than pension and mutual funds.
The Yale formula
The Yale formula allows endowments to smooth spending. Starting with last year’s expenditure as the base, a 24-to-36-month moving average of returns is used to establish spending for future periods. Notably, the formula permits both income and capital gains to support funding requirements.
This contrasts with the more common practice of spending only interest and dividend income or a flat 4%-to-5% of the portfolio’s value. A modified version of this formula allowed the endowment with which I was involved to double funds available to worthy students by building in a growth component.
Having accommodated capital gains in spending models, the Commonfund and major North American endowment funds like Yale and Harvard began to pursue broad portfolio diversification that moved away from the traditional pension fund asset mix of 60% equities, 40% bonds.
The evolution of Harvard’s Policy Portfolio
Examine the “Evolution of the Harvard Policy Portfolio” (right). The fund made three important changes:
- It grew total real assets;
- It introduced absolute-return assets; and
- It reduced its fixed-income assets.
What can we learn?
Like large pension funds, endowments are diversifying away from traditional asset classes. Uncorrelated assets theoretically dampen volatility.
Harvard’s move from two asset classes in 1980 to twelve today is evidence: equities (domestic, foreign, emerging, private), absolute return, real assets (real estate, natural resources, publicly traded commodities), and fixed income (domestic, foreign, high-yield, inflation-indexed).
Where ETFs winHarvard and Commonfund endowments have beaten the standard 60% equity 40% bond benchmark by about 1.2% annually over 10 years, and 20 years for periods ending June 2012.
But one-year and three-year returns have lagged because hedge fund, foreign equity and commodity returns have been weak. Endowments must diversify carefully, because it was least effective when needed most between 2008 and 2009. Having more asset classes is not always better.
Endowments have dramatically reduced fixed-income weights to about 11% currently. That means domestic bond exposure is down 4% from 15% in 1995. Pension funds, by contrast, should theoretically be invested 100% in bonds because fixed-income instruments provide the best offset to their liabilities. As interest rates rise, both their assets and liabilities decline and vice versa. But since most defined-benefit plans are in deficit to funded projections, this strategy would only lock in shortfalls today — not a good idea.
Harvard’s low bond weight is worthy of note. A 1.61% yield from 10-year U.S. Treasury Bonds has a five-year average volatility (standard deviation) of 9.9%. That’s plenty of risk for not very much return.
Ten-year Government of Canada bonds yield 1.71% with 5%-to-6% volatility. High-yield and corporate bonds offer equity-like risk and return characteristics. Although corporate cash flows and balance sheets are improving, bonds are riskier than many investors appreciate right now.
Alternative sources of yield like dividend ETFs can substitute not only for bonds but also alternative equity with a stable stream of cash flow. Absolute return and private equity strategies, including infrastructure ETFs, are scarce, unproven and usually expensive. We will explore these ETFs in coming months.
A sustainable income policy combines more focus on growth with a spending policy to accommodate capital gains. Advisors should consider an endowment model for their income clients. If you want to use fixed-income securities, remember they’re riskier than they appear.
Final note
Professor Williamson passed away last summer, but his counsel and direction continue to help many students access better education. Thank you Professor!
High-yield ETFs trading in Canada
| High-Yield ETFs | Symbol | Expenses | Index Risk (SD) | Duration | Weighted Av. YTM |
|---|---|---|---|---|---|
| BMO High Yield Corporate Bond Hedged to CAD | ZHY | 0.55% | 17.6 | 4.26 yrs | 5.82% |
| iShares US High Yield Bond Index Fund | XHY | 0.60% | 16.6 | 3.98 yrs | 5.51% |
| Horizon Active High Yield Bond | HYI | 0.60% | NA | 5.7 yrs | 6.67% |
| PowerShares Fundamental High Yield Corporate Bond | PFH | 0.65% | NA | 3.69 yrs | 5.09% |
| iShares Advantaged US High Yield Bond + forward structure costs |
CHB | 0.55%+ | 17.6 | 4.27 yrs | 5.59% |