Endowment fairy tales – part II



“Invest in a broad array of stocks and bonds and hold them for the long term.” 

Those who held General Motors stock and/or bonds in 2006 might disagree.  Same goes for WorldComm, Enron, Kodak, AT&T, Adelphia Cable, RIM/Blackberry, JCPenney and a host of other disasters.  Corporate bonds are not exempt either, with their tendency for weaker returns over time and being subject to a complete wipe-out in a bankruptcy reorganization, let alone a wholesale liquidation.  The longer term variety can make you money as interest rates decline (principal values increase) but are also be subject to principal erosion when rates head back upwards.  Companies can be affected by changes in technology (Kodak), or outright greed (Enron) and wind up with stock prices in the pennies per share. It a’int pretty out there.

An important question is why you are investing.  For an endowment, the answer is to provide a steady source of income while growing the overall value by an amount that exceeds inflation.  We don’t invest because we believe in the stock or bond markets and want capitalism to spread the wide world over.  We don’t believe in certain companies or industries as the exemplification of goodness.  Our goal is to make money – legitimately, mind you – but still make money.

In my travels, I find it fascinating how few endowments ever exceed the performance of the S&P 500 index.  The reason, I posit, is that this index captures the influence of the overall economy while allowing participation in some of the super star stocks of any given time period.  That is, out of these 500 stocks, a few are bound to break out and deliver returns that far exceed economic growth.  You know the stories of companies that experience a doubling or quadrupling in one year.  Chances are your value-based investment manager will not pick them.  The S&P 500 does, however.  Mind you, the influence of one stock on your overall return is quite small but it is an influence, nonetheless.

Consider that the average annual rate of return for the S&P 500 was 9.63% over the 38 year period from the beginning of 1975 through the end of 2012.  Since losses have a greater impact on returns than gains (see explanation below), the compound annual growth rate was 8.32% for the same period. By contrast, compound annual growth for CPI was 3.99%. Not to beat a dead horse but you could have had an annual spending rate of 3.3% over that period of time and covered inflation while adding 1% of real growth to endowed assets.  Instead, institutions were busy spending 6% and had to curtail spending when endowments inevitably went underwater during the loss years.

Let’s consider more specifically the influence of losses versus gains and why compound rates are preferred over average rates.  Presume you had a personal portfolio of $3,000 at the end of 2007 but then lost a third of its value during 2008.  At the end of the year, your value wound up being $2,000.  You got beat up.

To get back to $3,000, an increase of one-half is needed ($1,000 / $2,000).  I call this the law of diminishing denominators where a loss of 1/a (1/3rd) requires a subsequent gain of 1/(a-1) (1/2) to get back to the original value.  This is why compound rates are more accurate than using average returns.  In our example, the average rate of return for the two years (2008 and 2009) is +8.33% (-33.3% + 50%) / 2.  Since the investment wound up unchanged between the two years, the average rate sends the wrong message.

So, what do I suggest?  Well, along with moderating your spending rate, it makes sense over time to use an S&P 500 fund for your equity component.  It avoids the cost of an investment adviser (up to 1% from your return) and beats a majority of money managers.  This is particularly appropriate for smaller endowments of under $15 million.  As the invested value exceeds $15 million, other strategies are possible.  I’ll talk about those in the next installment.

What about bonds?  I recommend the ownership of a diverse representation of specific bonds, versus a bond fund.  The reason for this is how math and the markets intersect.  In a bond fund, the overall portfolio is priced every day and that overall value is what you will receive if you sell your shares.  If I buy a specific bond instead, it is priced at purchase based on a market determined rate of return.  This is the rate I will receive if I hold the bond until maturity.  If rates go up, the value of the bond will decline – but it doesn’t matter. I’m not selling.   My rate of return remains fixed at the value established when I purchased it and, if I hold the bond to maturity, that is the rate I’ll receive. Conversely, if rates decline materially, the bond will increase in value.  This offers the opportunity to sell the specific bond and glean capital appreciation.  If you plan to have bonds as a part of your portfolio, I recommend a market basket of quality corporate bonds versus a bond fund.  The risk of value depreciation is reduced measurably, versus participating in a fund.

Next installment – alternatives to stocks and bonds


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