After the devastating stock market declines of the past three years, many investors are now working with their advisors to rebalance their portfolios. Perhaps now is a good time to review how universities invest their endowment and why individuals should model their portfolios along these lines. Most institutional investment committees follow a code of fiduciary conduct which consists of:
- Setting an asset allocation policy based on how much they plan to spend ever year
- Diversification of the portfolio’s assets
- Hiring professional money managers
- Controlling expenses
- Monitoring the activities of the money managers
- Avoiding conflicts of interest
These steps are equally applicable to individual investors.
Most investment advisors use questionnaires to evaluate the risk tolerance of their clients in order to determine the asset allocation of a portfolio. While there is some controversy as to the exact magnitude of the asset allocation’s importance in affecting a portfolio’s return, baring an appropriate allocation given your objectives, the likelihood of achieving your goals is remote. The problem with traditional risk evaluation questionnaires is that they assume the portfolio will earn the same return year after year and that interest and inflation rates will remain stable. Unfortunately, for any given year in the future, we cannot accurately predict the rate of return on investments, inflation or interest rates. Consequently, assuming constant rates of return for these variables is a very risky assumption, since these rates will certainly vary from year to year.
Consider the following example. You have a $2 million well diversified investment portfolio and your assumption is that you will earn an average of 7% per year. Further, you will be withdrawing $150,000 per year for your retirement needs starting two years from now. You’d like to know whether you can continue to make this withdrawal adjusted for inflation until your death and not run out of money.
Earning 7% each year, your portfolio value will grow to $2,289,800 two years from now. But what if in Year 1 your portfolio earns -10% and in Year 2 it earns 24% (not unlikely given recent market volatility). In this case, your average return (arithmetic return) is still 7% over the two year period, but your portfolio value will grow to only $2,232,000 two years from now. Imagine the fluctuations in the portfolio’s rate of return between now and your life expectancy. It’s clear that by assuming an average rate of return on your investments over the time period, the portfolio may not be able to support your desired withdrawal over the long term.
Because we need to somehow account for future rates of return, inflation and interest rates, but cannot settle for estimated averages, “Monte Carlo” simulation has emerged as a valuable and essential tool for helping to determine an appropriate asset allocation.
Monte Carlo simulation is an iterative mathematical technique that estimates the probability of meeting specific goals in the future. By varying the factors that contribute to an asset allocation’s ultimate success including fluctuating rates of return on your investments, completion of the simulation reveals that in some trials your portfolio has succeeded in achieving your goals, and in others it has not. A large number of trials using randomly generated returns for different asset allocations will allow you to determine the statistical probability that your allocation will achieve your distribution requirement. For example, if the simulation runs 1000 trials, and in 650 of those trials you achieve your spending goal, then the probability of successfully achieving your goals is 65%. In other words, 35% of the time, you run out of money. At that point, it’s up to you to decide if you are comfortable with a 65% likelihood of achieving a spending goal. If not, then you need to consider how you might adjust your goals and/or asset allocation to improve your plan’s likelihood of success.
Rather than simply ask an investor how much down side return they can tolerate before moving to cash, we now have a much more robust mathematical tool to determine the asset allocation.
How did balanced portfolios manage to have positive returns in 2000-2002, given the devastating market in those years? The answer, as you might suspect, is they were properly diversified. Below is the Callan Periodic Table of Investment Returns for the years 1983-2002. It depicts the returns for various asset classes, a term describing a broad class of securities such as large cap or small cap stock, etc. The only asset classes that had positive returns in these years were fixed income, small cap value (growth and value are sub-indicators of investment styles) and hedge funds. Exposure to these three classes was sufficient to generate positive returns. A quick review of the Table suggests there is no way to use the history of the asset classes’ performance as a predictor on next year’s top class.
Interestingly, in 2002 institutional investors with in excess of $1 billion in their endowments allocated on average 32% of their portfolios to alternative investments such as hedge funds and private equity. Hedge funds are investment structures for managing a private, loosely regulated (although likely to become increasingly more regulated) investment pool that can invest in both cash and derivative markets on an unleveraged or leveraged basis. Many analysts believe poor performance in traditional asset classes will be the catalyst that drives more investors to these ‘absolute return’ strategies. When investing in these vehicles, investors should consider a fund of funds, a vehicle for diversified exposure to multiple hedge fund strategies within one investment. With generally low correlations to traditional investments, hedge funds can complement an investment strategy and improve performance. A typical fund of funds will provide exposure to 8 to 10 different investment strategies and anywhere from 20 to 50 managers.
Use Professional Money Managers
Many investors are increasingly becoming aware of the advantages of hiring private money managers over mutual funds. When you own a mutual fund, you actually don’t own stocks and bonds, rather you own shares of a fund which own the stocks and bonds. This is why at the end of the year, even if you’ve not made any withdrawals, you may still receive a 1099 with your distributable share of capital gains – note that losses cannot be distributed. The worst scenario occurred in 2000 when investors had depreciated portfolios but still had to pay taxes. This result can be eliminated by hiring a private money manger. In these so called ‘managed accounts’, you actually own the securities in the account yourself, don’t receive capital gains distributions when other investors using your manager make withdrawals, and importantly, you can book losses for tax purposes.
Your investment advisor should be able to provide an unbiased recommendation for which managers to use as opposed to using proprietary managers or funds of one particular firm. By researching all eligible managers in the country, they can put together the “best of breed”, a pool of managers that have excellent track records in their respective asset classes. The final portfolio might have anywhere from 7 to 15 managers and funds.
Monitor the Activities of Money Managers
The most common mistakes individuals make when selecting money mangers include: placing too much emphasis on recent performance, having unrealistic performance expectations, and importantly, hiring managers without taking ‘peer analysis’ into consideration. Institutional quality reporting available to an individual investor should include performance of the overall portfolio, performance of each asset class, each manager within each class, and the benchmark-specific performance for each manager. For example, a small cap value manager is compared to the Russell 2000 value index. We’d obviously like our manager to outperform their benchmark, after all, why hire an active manager when a passive benchmark does better? Most studies have shown that relatively few large cap managers outperform the S&P 500 consistently over time. As a consequence, you might consider indexing the ‘large cap core’ and hiring active managers for the other asset classes.
Only by reporting this level of detail can you identify outperformers and underperformers. Finally, a truly unbiased report will depict how each manager has performed relative to peers within the same investment style While it is important to know, as an example, how a small cap value manager did in comparison to the Russell 2000 value index, knowing how they did in comparison to virtually every small cap value manager in the country can be even more helpful. Without the conflict of proprietary relationships, your advisor will be in a position to fire a manager if they underperform their peer group.
Controlling Expenses: This requirement is not too difficult to achieve. Caveats would be to make sure operating expenses of mutual funds, trading costs of managed accounts and spreads on bonds (infrequently disclosed) are unearthed.
The Tufts University Endowment had a positive 18% return in 2002. It consisted of 20% Fixed Income, 27% Large Cap, 10% Small Cap, 10% International, 5% Private Equity and 28% Alternative Investments.* Individual investors can increasingly achieve this kind of allocation and receive institutional quality reporting through the growing array of truly independent investment advisory practices.
*Source: The National Association of College and University Business Officers
Edward Papier, CIMA CFP, is Senior Vice President of Lexington Advisors, an independent wealth management and investment advisory firm with offices in Boston, New York and Washington D.C.