Hedging Against Inflation by Diversifying Investment Income
December 14, 2012 Mark Hrywna
When E.F. Hutton spoke, everyone stopped to listen. At least that’s what the iconic 1980s television ad campaign would have you believe. Everyone’s looking for investment advice and charities are no different. Some of the nation’s largest nonprofits are complex businesses, generating income from donations but also via fundraising events, program service revenue or membership fees, as well as investment income.
The Leukemia and Lymphoma Society is among the nation’s largest charities when it comes to generating revenue through fundraising events. The White Plains, N.Y.-based charity had total revenue of more than $283 million last year, with almost $155 million from fundraising events. Investment income made up a fraction of total revenue, just shy of $11 million, but it was nearly double the 2011 total of almost $6 million.
The implementation of a new asset allocations and the strong market recovery at that time drove the majority of the increase in investment returns, said J.R. Miller, vice president, finance. LLS has been using a consultant since the early 1990s, helping the investment committee select managers, monitor performance and decide on an appropriate asset allocation.
Going to a smaller governing structure — from 100 members on the national board to fewer than 30 — changed the board’s composition, with more sophistication and knowledge about investments. The move also changed the composition of the investment committee. The committee is made up of four board members and two people who are not on the board but have backgrounds in investments, Miller said.
A new investment consultant was hired in April 2008. “Partly because we don’t have the expertise on staff or willingness to hire a chief investment officer, we prefer to have an individual consultant who does not have any conflicts of interest recommending any funds that they might be benefiting from, as an organization or themselves,” said Miller.
“As we built our portfolio, members of the board felt preservation of capital was the main driver for the philosophy of the portfolio. So for quite a long time, it was really a conservative allocation with about 75 percent in fixed income, even through the decline,” said Miller. At the same time, consultants also said it’s risky to be so heavily weighted in bonds for capital preservation, he said.
Miller credits the new consultants, as well as the new skill sets of investment committee members, that “took us to a different place, in terms of investing more in hedge fund of funds, absolute return funds, and getting out of the bonds.” LLS had been invested nearly 75 percent in fixed income at the end of fiscal year 2009 (June), and during the following year reallocated 20 percent of its fixed income portfolio into absolute return (fund of hedge funds) and 5 percent into real return strategies.
The society’s federal Form 990 shows the change in asset allocation, with $115 million in the gross sale of assets in 2010, compared with less than $60 million in 2011. The net gain was less than $1 million in 2010, compared with $7.85 million.
The sales were more than just general maintenance, as LLS liquidated many of its individual bonds and fixed income securities, Miller said, opting for a PIMCO fund for bonds, and also replaced one of its hedge funds. “We probably turned over most of the portfolio,” he said. Other assets were listed at a market value of almost $47 million in 2010, and in 2011 it was better than $51.55 million.
The investment committee reviews asset allocations at its spring meeting, where it determines the allocation. “That asset allocation drives our decision, how much we need in large cap, international, absolute return hedge funds, fixed income — that drives our decision from that standpoint,” said Miller.
During quarterly meetings, the committee examines the performance of managers and whether any should be replaced or put on a watch list, which could mean changes to asset allocations. For instance, this year the committee determined it had a hole in asset allocation in terms of inflation strategy, so it carved out 6 percent of its portfolio, hired a manager and added a Treasury Inflation Protected Securities (TIPS) fund. “We have mixture of funds from that perspective,” said Miller. The committee also added an emerging markets portion to its portfolio.
Other nonprofits have shifted investments to address short-term needs, such as creating a reserve fund. NPR (National Public Radio) liquidated about $50 million last year that had been invested with a 10-year horizon to create an operational reserve that would be invested over a much shorter timeframe. With the shorter timeframe comes less risk — as well as less return — but the funds created a safety blanket for operational purposes, as well as an innovation fund to tap into beyond daily operations and access money for investment, said CFO Debbie Cowan. NPR has been focusing on digital transformation in recent years, including some “hefty investments,” she said. The long-term investment portfolio had about $85 million and even after the liquidation is back to about $40 million, she said.
Mary Jane Bobyock, director of nonprofit advice at SEI, in Oaks, Pa., said many clients and prospects are setting aside anywhere from one to three years of spending for long-term vehicles without having to worry about near-term distributions.
“Very often, clients and prospects we’re talking to the last couple of quarters are looking to increasing yield, worried about the fixed income environment,” said Bobyock.
It’s a matter of being a little more liquid, allowing the endowment to have less fixed income exposure, Bobyock said, and feeling more comfortable going to more high yield, like emerging market debt and alternative investments that may provide opportunity for higher yield over the longer term.
SEI’s 2012 Nonprofit Research Management Panel cited market volatility (85 percent), liquidity/spending needs (83 percent) and inflation protection (79 percent) as the most common investment strategies that charities see as having high or extremely high impact. Almost two-thirds of participants in the survey said that to combat market volatility, they increased portfolio diversification via new asset classes while 38 percent said they increased their allocation to inflation protection products.
The financial crisis in 2008 changed the way some nonprofits think about their endowments and the purpose of their endowments, said Wesley French. “Nonprofits are taking that question of what’s the purpose of the endowment, and simplifying the asset allocation modeling,” said French, a co-founder of Atlanta, Ga.-based investor advisory firm French Wolf & Farr. He also serves on the boards of the Atlanta History Center, Agnes Scott College and The Wesley Woods Foundation.
Charities are saying they need a certain amount of assets that are growth, some that hedge against deflation or a significant downdraft in the economy, and some to hedge against inflation. “That possibility is picking up not insignificantly in the future,” he said, in addition to charities worrying about excess liquidity.
Bobyock said they’re seeing an increase in inflation hedge type assets. “Things like commodities are now second, whereas before fund of hedge funds were,” she said, in addition to increases in hard assets like timber and farmland as endowments think about inflationary hedges. Growth in commodities, where there had been a lot of interest a couple years ago with explosive economic growth in China, might be slowing since China has put the brakes on its economy and is seeing a slowdown.
“Generally you’re going to see some strategic allocation to inflation protection assets,” said Bobyock, with an allocation that might range from 5 to 15 percent. “It’s not a huge amount of the portfolio at this point but there are other ways to imbed protection in the product,” she said. E