Protecting Endowments in a Bear Market
The market volatility and protracted declines that are common in a bear market environment can be unsettling for any investor, and perhaps more so for those stewards of a nonprofit endowment, which oftentimes is a critical resource supporting the organizational mission.
Many decades of history illustrate that these times are a natural part of the market cycle, and we should anticipate that they will occur periodically. The good news is that all bear markets eventually end. How we prepare for and act during these periods are important determinants of how well an endowment performs and recovers from such events.
Ways to prepare for a bear market
A well-designed and implemented Investment Policy Statement (IPS) and Spending Policy are, in our view, the first lines of defense to protect your organization’s endowment and ability to spend from it during inevitable bear markets.
We believe these are two of the most important governance policies a nonprofit can have and should be designed to be integrated and work together. During challenging times, such policies can provide guardrails and discipline to keep our natural emotional responses in check.
Because it is the nature of nonprofit boards and committees to have an evolving cast of members, these documents also provide important institutional memory for policy decisions.
Investment Policy Statement
The IPS sets forth an investment strategy designed to achieve targeted return goals within an acceptable range of potential risk outcomes that over time will meet the needs of the organization. The document generally details the allowable asset categories to be included and the targeted allocations for each.
There should be a balance of asset types to provide for diversification and help smooth out returns through market cycles:
- Stocks are often the drivers of growth, yet also add to the volatility that can be uncomfortable.
- Bonds can provide steady income streams and may serve as a cushion when stock prices are falling.
- Alternative and private investments are generally less correlated with stocks and bonds and often dampen the ups and downs of the public markets.
Understanding how various allocations have performed through cycles in the past can help guide an organization to the most appropriate mix to meet return goals and prepare for downturns.
Recognizing that the organization will be using the endowment to support mission-related programs, the IPS should outline targeted levels of liquidity and the means to supply it. This way, programs may have the funding they need and can avoid selling investments at distressed prices, which would inhibit the ability to participate in the eventual market recovery.
There should also be guidelines around a disciplined approach to rebalancing the investment allocation to seek to take advantage of market peaks and valleys—providing opportunities to “buy low and sell high.”
Endowments and foundations have the benefit of a perpetual time horizon, allowing them to take on higher near-term volatility to try and earn higher returns over time.
Spending Policy
The Spending Policy determines how much of the endowment will be used each year and how that will be calculated. This document aims to unite the endowment with the organizational mission and long-term strategic plan by outlining what funds will be made available and for what purposes.
Good spending policies balance the need to support current operations and preserve the endowment for future generations, while reducing cash flow volatility for budgeting purposes. In our experience, this is often best achieved by applying a modest percentage payout rate to a smoothed portfolio valuation using a multi-period moving average—for example, paying out 4% of the average value from the trailing 20 quarters.
This helps smooth out the ups and downs of endowment value and allows the portfolio the opportunity to grow in excess of the cost of living. Over time, the cash distributed may exceed that of a higher-percentage spending policy because of portfolio growth.
However a spending policy is calculated, it is imperative that the spend rate is supported by the investment strategy and expected long-term returns. This supports intergenerational equity—a top priority for the board and investment committee of an endowed nonprofit organization.
Final thoughts
There is no silver bullet to keep endowment portfolios from losing value in a bear market. The best protection comes from having sound policies that guide a prudently managed investment portfolio and how the nonprofit may spend from it.
Bear markets don’t last forever. How an endowment weathers the temporary storm depends greatly on how it acts during it. Having a solid Investment Policy Statement and Spending Policy to guide your actions can help keep your organization on track and well-positioned for the eventual market recovery.
ABOUT THE AUTHOR
James Sonneborn, CFP, CFA, MBA
Jim is a Partner, Wealth Advisor in our Morristown, NJ, office. He has over 35 years of experience managing investment portfolios and providing financial advice to individuals, families and charitable organizations in the New York metropolitan region.
As a Wealth Advisor and Co-Chair of legacy firm RegentAtlantic’s Neighborhood Nonprofits Group, Jim works with a wide range of clients and has a particular specialty in philanthropic strategies. For donors, Jim works to construct strategies that align with the client’s philanthropic goals. In the nonprofit sector, Jim focuses on helping organizations strengthen their financial position through endowment management and planned giving consulting. Jim currently serves on the boards of The Rippel Foundation and the Environmental Endowment of NJ.
Jim holds a BA in Business from Western Colorado University and an MBA in Finance from Drexel University, as well as the CERTIFIED FINANCIAL PLANNER™ certification and Chartered Financial Analyst and Certified Divorce Financial Analyst certifications.
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