Multi Asset Endowment Investment Strategy

Editor's Notes

• #10: The US economic expansion began in mid-2009. Now, 4 years later, we see the US economy showing mixed characteristics from early to late parts of the cycle. Overall, we believe we are in mid-cycle of the expansion and approaching the late part of the cycle over the next year or two. Some of the mid-cycle characteristics we see are profit margins peaking, stronger credit growth, and housing recovery. Though the US economic expansion period seems mature time wise, we believe there’s still room for expansion. There is a lot of slack in the economy, economic activity is still muted and shows early-cycle characteristics, and inflation is nowhere near pre-recession levels.
• #11: Over the next five years, we predict heightened levels of volatility than what the market experienced over the last 3 years. The exorbitant amount of quantitative easing has artificially pushed down volatility to one year lows. We expect a reversion to the mean within the next five years once quantitative easing ends. This record low volatility leaves the market vulnerable to outside shocks, such as risks from credit tightening, China recession, and Ukraine. There is a strong possibility that we will enter into an economic contraction in about 3 years, coupled with heightened levels of volatility and market corrections throughout.
• #12: Credit Cycle: Though we do not believe the US economy is at risk of a recession in the next five years, we do see the US approaching the late stage of the credit cycle. A couple warning signs we see are as follows:   Figure 2: Spreads High Yield Credit Spreads: High yield spreads are approaching 2007 lows since 2000 due to strong demand, but not enough supply. We believe investor demand of high yield credit and leveraged loans is euphoric, evidenced by very tight spreads (See Figure 2). This demand is largely driven by the investor’s search for yield in this low interest rate environment. With money market funds yielding 0% and 10 year treasuries yielding about 2.5%, investors are flocking into high yielding, junk quality bonds. We are concerned that investors are too focused on yield and not on the credit risk that they are taking. High yield and leveraged loans are a lot less liquid than investment grade debt and thus, any shock to the credit cycle can cause a liquidity crisis, which will lead to higher volatility. Low Default Rate Levels: Default rates have also moved lower than pre-Great Recession periods. This is another sign the credit cycle may be peaking.
• #14: View and Outlook: With the fed funds rate near 0%, bond valuations are near 30 year highs. Thus, we feel bonds are in the late stage of the cycle and hold a below average view. We expect a bear market in bonds that will start happening sometime within the next 5 years. We expect the Fed to raise rates to 3.25% over the 5 years, starting in mid-late 2015. Bonds have a negative correlation to interest rates so upwards movement in the Fed Funds rate will be a major driver of downside pressure in bonds. The higher the bond duration, the larger the impact of rates on bond prices. Another driver of return is supply and demand. Demand for bonds tends to rise during times of fear as investors see bonds as safe havens. We expect to see heightened market volatility and even a market correction starting in mid-late 2015 and into 2016. Calculations: Per Figure 1 below, we forecasted the expected return of bonds using the Barclays Aggregate Bond Index and its current duration of 5.2 years and SEC yield of 2%. Next, we forecasted the fed funds rate movement over the next 5 years, which we expect to increase 3% over that time period. We then broke out each of the return contribution components into 3 sections: Income: Return earned from yield. Rough calculation for simplicity. Current SEC yield of 2% + projected fed funds rate increase Return from Duration: Impact of duration risk on return 5.2 years x projected fed funds rate increase Return from Supply and Demand: Projected impact of market demand on bond prices No formula – looked at historical periods of bond returns in varying environments and forecasted when market volatility to project price return. We expect demand for bonds to increase in 2015 and 2016, but drop sharply in 2017 and 2018. After projecting returns each year, we averaged the returns over a the 5 year period and calculated the standard deviation.
• #15: View and Outlook: Stocks are a leading indicator. Returns are driven primarily by corporate profit growth, consumer sentiment, and forward looking economic expectations. S&P 500 has recently reached its all-time high, largely driven by the influx of liquidity from the Fed rather than fundamentals. The earnings growth we’ve seen was mostly due to companies increasing margins by cost-cutting rather than top-line growth. For that reason, profit margins seem to be approaching their peak in the United States. Unless we see an increase in sales, we believe the equity risk premium going forward will be lower than the last 20 years, at about 5.75%. At the same time, due to upcoming elections, rich valuations, ending of QE, slowdown of emerging markets, and other geopolitical risks, there are a lot of catalysts that can lead to higher volatility. For that reason, we predict stock volatility to be higher over the next 5 years than the 20 year average. Calculations: Benchmark: S&P 500 Expected Return Formula = Projected Equity Risk Premium + Expected Return Bonds + Expected Return of Cash = 5.75% + 0+ 1.5% = 7.25% Standard Deviation = S&P 500 20yr Ann. Volatility (ending 1Q 2014) + Add’l Risk Factor = 16.9% + 1.1& = 18%
• #16: View and Outlook: We believe the demand for hedge funds will continue to remain strong, while the supply of hedge funds has decreased significantly since 2007. We are overweight this asset class since we still expect positive expected returns in equities over 5 years, but with more market volatility. We believe hedge funds will give us equity-like returns with about 50% of the risk and can outperform stocks in volatile environments. Our Alpha assumption is 3.1 since in periods of market volatility and uncertainty, hedge fund managers have more investment tools to be able to generate strong alpha vs. the market, using leverage, long/short capabilities, and derivatives. Hedge fund returns are economically driven and tend to outperform in periods of volatility.
• #17: Cycle Stage: Mid to Late cycle, Attractiveness: Average Expected Return: 10.25%, Standard Deviation: 23% View and Outlook: Private equity tends to have high correlations to stocks. Though the private equity market is in high demand, with increasing LBO deals and rising debt levels, we believe there is still room to run in healthcare and energy sectors. However, due to the high expected volatility going forward and illiquidity, we remain even weight the asset class. Our endowment will likely not be given opportunities to invest with all the marquee private equity managers due to our smaller size so our expected return is the pooled average.
• #18: Real Estate Cycle Stage: Mid cycle, Attractiveness: Average Expected Return: 10.5%, Standard Deviation: 20% View and Outlook: Coming from the lows of 2009, we believe the real estate market is still in mid-cycle, but we will not experience the high growth rates as we did the prior 3 years. Real estate is driven by supply and demand. The demand for real estate is driven by ease of bank lending, mortgage rates, consumer sentiment, and interest rates. Publically traded REITs in particular, especially those focused on income, tend to be more interest rate sensitive. Going forward, we have a neutral view on this asset class due to expected increase in supply, reduced demand from future higher mortgage prices, and uncertain impact of Fannie and Freddie resolution on housing market. Calculations: Expected Return = FTSE NREIT US REIT Index Ann. Return Last 5 yrs (Q2 2009 – Q1 2014) – Adjustments for slower growth = 17.1% - 6.6% = 10.5% Standard Deviation = FTSE NREIT US REIT Index 20yr Ann. Volatility = 20%
• #19: Commodities Cycle Stage: Mid cycle, Attractiveness: Average Expected Return: 2%, Standard Deviation: 18% View and Outlook: Commodities is a very broad asset class, made up of precious metals, agriculture, and oil to name a few. Return for commodities is driven by supply and demand. The demand is driven by consumption and the economic environment. Much of the world’s commodities are used by the emerging markets, which are showing signs of economic slowdown. Though the valuations for certain commodities seem attractive, we believe there will be higher volatility than historically seen in this asset class going forward our expected returns will be similar to inflation. Calculations: Expected Return = Expected Cash Return + Commodity Risk Premium = 1.5% + 0.5% = 2% Standard Deviation = DJ Spot Return Index 20yr Ann. Volatility (ending 1Q 2014) + Adjustments = 16.7% + 3.3% =18%
• #21: Hedge Funds 28.0% Stocks 20.0% Cash 15.0% Bonds 10.0% Private Equity 10.0% Real Estate (UL) 10.0% Commodities 7.0%
• #23: Strategy for Deciding the best Portfolio: High Sharpe Ratio Low Standard Deviation Low Fees Weather Uncertain Market Conditions
• #24: Decision making process/rationale
• #25: Strategy for Deciding the best Portfolio: High Sharpe Ratio Low Standard Deviation Low Fees Weather Uncertain Market Conditions
• #26: Decision making process/rationale
• #27: Strategy for Deciding the best Portfolio: High Sharpe Ratio Low Standard Deviation Low Fees Weather Uncertain Market Conditions
• #28: Strategy for Deciding the best Portfolio: High Sharpe Ratio Low Standard Deviation Low Fees Weather Uncertain Market Conditions