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Investment To-Do’s in Today’s Environment

Strategies for achieving gains despite the low-return climate.

By Louis R. Morrell

In the past few years, there has been much speculation about corporate profits. Thanks to falling interest rates and high consumer demand, profits received a notable boost. In turn, because corporate profits drive stock prices, investors benefited from above-average returns in the capital markets. However, these positive factors are fading fast, and it is now widely expected that stock market returns will revert to longer-term performance in which corporate profits rise in line with economic growth. Since 2000, corporate earnings growth (adjusted for inflation) has averaged near 6 percent, more than twice the rate of growth in the economy. This profit growth rate is the highest for the postwar era. Meanwhile, the Federal Reserve continues to raise interest rates, which indicates that corporate revenue and income are sure to fall.

The bottom line? Investors may not attain the double-digit returns of the recent past. The U.S. economy is headed for a late-cycle expansion. Inflation is beginning to rise and pressure on the dollar continues to increase as foreign central banks are losing interest in the U.S. dollar. This will result in higher interest rates ahead, perhaps 5.5 percent or higher on the 10-year U.S. Treasury note. Thus, many believe that lower returns await investors.

Regardless of economic indicators, a general objective of investing is to attain returns consistent with risk tolerance—that is, the level of risk that an investor is willing to assume. An investor should never undertake more risk than is necessary to achieve desired returns nor try to attain returns that require more risk than necessary. The issue of risk is particularly critical for those of us who manage institutional investments. Unlike private investors, we must answer to a variety of stakeholders with differing goals and objectives for our funds. Each institution must establish an investment policy that fits its needs, but there are valuable strategies and principles that we share. Wake Forest University, for example, recently implemented tactical changes to its investment allocation and management that may work for other institutions (see sidebar, “The Wake Forest Way”).

Careful consideration of today’s evolving economic factors will help us better serve investors and our institutions. Institutions can establish and maintain asset allocations based on realistic expectations by looking ahead at the global market.

Thinking Beyond U.S. Borders

It is no longer realistic to consider the U.S. economy in a box. Rather, as informed investors, we must bear in mind another important dynamic: globalization. Capital, output, and goods flow freely around the world seeking the best risk-adjusted return or the lowest cost of production. The United States represents approximately one-half of world market capitalization and acts as a major driver of new investment capital and a top purchaser of goods. Several serious factors now influence our economy:

  • a growing budget deficit,
  • an expanding trade deficit,
  • the future of Social Security funding resolution,
  • high consumer debt levels,
  • a low personal savings rate,
  • high energy prices,
  • the lack of new tax stimulus,
  • rising interest rates, and
  • accelerating inflation.

Because conditions in the United States are important to the financial condition of the world at a time when growth is shifting toward Asia, investors need to maintain a global perspective in making decisions.One challenge of today’s economy is that the aforementioned conditions may not disappear soon—in particular, the U.S. trade deficit. Foreign investors with massive U.S. dollars holdings assume that the debt will ultimately be repaid and that repayment will be made in terms of currency with reasonable economic value; otherwise there is a risk that the dollar could collapse.

This country faces another set of global challenges: a dollar that is declining in value, the loss of high-paying jobs to overseas employers, and excess debt at both the consumer and the national level. If foreign countries begin to dump our debt, interest rates will rise beyond the control of the Federal Reserve and inflation will result. The effects on the stock market could be significant because foreign investors would surely reduce their U.S. holdings to avoid losses. Meanwhile, many U.S. companies are carrying very large cash balances. How that money is used—capital spending, dividends, share buybacks, more labor, or mergers and acquisitions—will be a major factor in economic growth, corporate earnings, and stock market returns. These factors will shape the U.S. economy of tomorrow and are important considerations for institutional investors as we establish asset allocations.

The Wake Forest Way

The Wake Forest University system of incorporating alternatives into its asset mix illustrates the two-step investment process (see table). Once the strategic asset allocation process was completed in 1998, the investment policy committee made several critical decisions and key sub-allocation transfers. First, private equity was established by reducing global equities. Second, hedge fund investments were established by reducing global equities and multisector bonds. Finally, real estate and timberland were established as separate line allocations. The original allocation to global equities was reduced and the percentage was shifted to the private equity line. Similarly, hedge funds were established with money transferred from global equities and multisector bonds. These net changes were coordinated with the remaining unadjusted allocations and became the basis for the policy portfolio. Asset upper and lower bands were developed for each asset class with the exception of private equity and real assets to ensure constant diversification.
How we operate. Wake Forest follows what is known as a tactical asset allocation approach. All equity managers are now classified under the heading of global equities. We continue to hire global equity managers (with the exception of emerging markets) because we feel it is important that our managers have the flexibility to select companies for investment regardless of location. The university’s current outlook is relatively bearish on the U.S. equity market. As a result, all of our equity market neutral hedge fund managers have been terminated and replaced with long:short managers. Since, in effect, we do not feel that the market itself will be neutral, we do not want our hedge fund managers to be linked that way to the overall market. Thus they are given more freedom to seek enhanced return—whether short or long. Energy is another area where we are and have been bullish. Therefore, we have energy allocations in public equities, private equity, and hedge funds. We also invest in currencies as a separate asset class.
When it comes to manager selection, we analyze the following characteristics:

  • The tactical ability of the manager (for example, it is rare that we would hire a single-strategy manager).
  • A demonstrated performance record in a given strategy.
  • A reasonable asset level under management.
  • The number of successful parties invested with the managers.

Table: Wake Forest University Strategic Asset Allocation

The university remains concerned about inflation. For that reason we hold a relatively large position in inflation-protected bonds. Our attention to inflation, as well as the desire to outperform the equity markets with a non-correlated asset class, has led us to take a large position in an indexed commodity fund. Capital markets continue to be cyclical in nature and all investors should recognize and be prepared to deal with both high- and low-return environments.

 

Investing in a Global Economy

Given the current economic environment, as institutional investors we must adjust our strategies and expectations. In particular, we must either lower our return expectations or reconfigure our asset mixes to shift funds to those classes that offer greater returns—seeking such returns anywhere in the world. Not long ago, a well-positioned investor would maintain a portfolio that was carefully balanced between domestic and foreign investments so that when one market declined, the other would provide upside protection. The problem was that an investor had to constantly monitor each market and shift the funds accordingly. Today, it is more sensible to hire investment managers who are able to buy stocks and bonds irrespective of geographic location.

Just as portfolio management for global investments has changed, so have the types of assets. Global funds typically exclude emerging markets, which are treated as a separate asset class. Given the probable low return from conventional assets (stocks and bonds)—especially in this country—interest in alternative investments will continue to flourish. The concept known as modern portfolio theory dictates that investors include alternative assets to attain added diversification and higher return rates in a portfolio.

Investment managers need to plan carefully prior to adding any new asset classes to an institution’s portfolio. Two important points to consider: Do potential assets have a low correlation to those classes in the existing portfolio, or do such investments offer the opportunity for higher returns? Assuming traditional assets to mean stocks and bonds, most other assets are considered “alternative.” Many institutions are heavily invested in alternative assets, while others have been reluctant to take the plunge. When considering new assets, the decision is essentially a matter of which alternatives and in what weightings to include in a portfolio to achieve success in a low-return environment.

Keys to Investment Return

Some argue that as much as 90 percent of one’s investment return is related to asset allocation. Investment return can be linked to four major factors: execution, asset mix, rebalancing, and manager selection. While asset mix is important, it contributes approximately 45 percent to returns; rebalancing and manager selection make up 20 percent each; and execution accounts for 15 percent of returns. Consider these factors when making investment decisions, particularly when setting allocations to alternative assets (see box, "Investment Return Factors").

Rebalancing. This is critical for dealing with the current global environment. Relative value and strength are constantly changing around the world, making automatic rebalancing systems out of sync. Blindly adhering to a predetermined asset allocation target is no longer a prudent strategy because it ignores the realities of the investment environment. For example, if an asset class underperforms and drops significantly in value, an automatic rebalancing approach would assign more money to it based on two assumptions: the assets are cheap and the investment will increase in value to return to its prior level (reversion to the mean). The problem with such an approach is that there may be a valid reason for its low valuation, and it is quite possible that its price will continue to fall, leading to a series of new cash infusions and losses driven by automatic rebalancing. The whole strategy in such a rebalancing system is based on a backward direction, not on forward thinking. It also implies a disciplined approach that seems attractive on the surface.

Investment Return Factors
  • Execution is quite broad and relates to how things are done and by whom. It includes the investment committee, responsibilities of various parties in the investment process, decision making, information flow, and performance measurement. These items should be reflected in the investment policy.
  • Asset mix is basically the strategic asset allocation and includes return expectations, correlations, and risk components. Investing in the right asset classes with proper diversification is critical.
  • Rebalancing involves the ability of the investor to cope with the ever-changing environment. It could also be considered the dynamic nature of the asset mix.
  • Manager selection involves how the managers are selected, evaluated, and even terminated.

In contrast, a tactical asset allocation approach is based on what is likely to happen in the future. A weakened U.S. dollar could prompt investors to allocate additional funds to non-U.S. equities, especially those with currencies that are expected to strengthen against the dollar. Rising inflation could lead to an asset shift toward inflation-protected securities, shorter duration bonds, and commodities. Investors must maintain a reasonable degree of diversification, but forward-thinking strategies mean that rebalancing would not be automatic.

Organizing an effective investment committee. What is the key to a productive investment committee? Basic education. For example, there might be an emphasis on alternative investments, what they are, their intended goals, and the risks and rewards that such investments offer. In fact, it can be helpful to assign an entire committee meeting to learning about alternative assets. From such a meeting, a special policy as well as a sub-strategy should be developed. Some institutions may want to form a subcommittee to engineer these guidelines. Other institutions may benefit from enlisting the assistance of a consultant.

Because there are so many different alternative investment possibilities, it can be very helpful to start with a broad list and then establish a priority list. Such narrowing can be accomplished by identifying a subset of strategies in which the committee has a keen interest. The process should take into account both return and risk factors. When working with an investment policy committee, it is a mistake to assume that all members understand why alternative assets should be incorporated into a mix. The same general approach would apply to other asset classes.

Choosing assets. Once alternative asset investments have been identified and vetted with the committee, coordinate alternative investment classes with the current strategic asset allocation. Begin by conducting a traditional strategic asset allocation exercise, excluding alternative assets. The underlying belief with this approach is that alternative investments are not a separate asset class but that they represent a series of investment strategies. This could be considered phase one. Once the exercise is complete and the investor has calculated the asset mix based on projected returns and standard deviations, the next phase of planning is to add alternative assets. At some point, you must decide whether an alternative asset class will be considered separately or as part of another class. For example, the committee may wish to allocate assets to energy. Alternative asset investments in energy can be classified as a separate allocation line in the strategic asset allocation or as part of a private equity allocation, a hedge fund allocation, or as a subset of a broader equity classification. Similarly, timber could be invested through public equity or in a private partnership.

Among institutional investors, a developing belief is that new types of assets (e.g., energy, timberland, real estate, commodities, and currency) should be continually held as part of the asset mix of the portfolio. While such an asset may become a fixture of the portfolio, the size of the allocation is constantly monitored and altered. Make each allocation to alternative assets either to reduce risk or enhance return. An investor may wish to offset a high risk:high return strategy with an asset class in another part of the portfolio. One possibility is a type of alternative investment known as an absolute return strategy, which has a low-risk profile that enables it to produce a positive return in virtually all periods.

With interest in alternative assets growing, the sub-allocation process can be challenging. Hedge funds are currently suffering from something known as return compression, a result of major investment inflows. Generally, there is a performance lag following too much money chasing high returns. From 1999 to 2002, hedge funds outperformed the S&P 500 by an amazing 15.4 percent annually. More recently, the reverse has happened. So while many investors are in “performance mode,” hedge funds may be about to enter “protection mode.” This is more in line with the original intent of hedge funds, which was to reduce volatility in a portfolio.

Planning for the Unknown

Alternative assets are on the rise and will likely continue to gain in popularity because they offer exceptional opportunities to institutional investors in dealing with a volatile and fundamentally low-return world. Investment allocations alone do not guarantee success, however. The critical elements in attaining investment success depend on a few major factors:

  • Acceptance of the strategy by the investment committee.
  • The ability to effectively incorporate alternative assets in the strategic asset allocation.
  • The ability to select sub-strategies most appropriate for the changing investment environment.
  • The ability to identify managers who are able to meet investment objectives.

The world of investing continues to be a challenge, especially with the global shift of economic power. While we have faced some of the elements of today’s economic environment in the past, there is no roadmap for what’s to come. Successful investors will be those who look ahead, incorporate tactical asset allocation approaches, and think globally.

Author Bio Louis R. Morrell is vice president for investments and treasurer, Wake Forest University, Winston-Salem, North Carolina.
E-mail lmorrell@wfu.edu