By: Paula Romanchuk, CFA, Consultant
Is now the right time to take risk off the table? With bond yields so low, should a portfolio have a dedicated allocation to fixed income? These are just a couple of the common questions that we have heard at many recent client committee meetings. While these questions are sensible and quite practical, oftentimes committees can get bogged down in the details and lose sight of the overall purpose and long-term objectives of the asset pool. Also, in some cases those bigger-picture goals have yet to be established, which makes it even more challenging to determine an optimal asset allocation.
Stay Focused on the Future
A critical component of successful asset management is a regular review of the portfolio goals. This should be more comprehensive than the annual evaluation of portfolio risk and return targets. And while this is certainly an important step, we encourage committees to keep the longer-term vision the primary focus while marrying that with shorter-term objectives.
For example, suppose there is a foundation supporting a hospital system that has an upcoming project with a $5 million payment due in six months. The foundation’s goal is to live in perpetuity and support the hospital system with funding for large projects. A prudent decision might be to carve out the $5 million in assets and invest those in a conservative manner to ensure the preservation of that capital for timely payment. Without any other near-term capital needs, the rest of the portfolio should be managed with a longer-term view and presumably higher risk tolerance.
Alternative Investments
Another decision many committees face is whether to invest in alternatives, such as hedge funds and private equity. These asset classes are usually less liquid than traditional equity and fixed-income securities and not as well understood. Some committee members may be uncomfortable with the liquidity risk and inability to call capital if or when needed. That could be a valid concern; however, if projected cash needs are known and nominal, the portfolio could benefit from dedicated hedge fund and private equity allocations.
Committee members, as stewards of the assets, have an obligation to evaluate the merits of these investments and make informed decisions to ultimately achieve the portfolio objectives. It may be tempting to favor a conservatively positioned portfolio to limit downside risk and preserve capital while managing the portfolio, but this short-term view could prove costly over the long run. For asset pools with long-term investment horizons, compounding returns is a powerful and important concept. When portfolios are limited to only low-risk investments, in strong markets, slight near-term underperformance may seem negligible, but the magnitude of that underperformance can increase over a full market cycle.