Bonds are no longer the safe haven they have long been. Above all, the current inflation is hitting the market hard. Large US foundations show how to set up their portfolios to be crisis-proof: More than half of their assets are now in private equity and real assets.
The bond market is currently under pressure from several directions. The bottom line is that rising interest rates are causing the prices of the bonds in the portfolio to fall. While the asset class was at a peak in 2021, it is currently losing ground – as it was during the global financial crisis of 2008. This volatility is not expected to go away. The risks increase, especially for those who hold securities with longer maturities.
In view of the high inflation, the US Federal Reserve could step on the brakes even harder and further force a decline in the bond markets. Parts of the US economy, such as housing construction, are already beginning to see the effects of tighter financing conditions. Equities are also already feeling the effects of higher bond yields, particularly growth stocks. With the Fed’s additional plan to reduce its balance sheet, the ample liquidity markets have become accustomed to will dwindle.
With tough lockdowns as part of China’s zero-Covid strategy, the fallout from the war in Ukraine and rising inflation, it seems like there is little safe haven left for investors. But pessimism is not justified. Because the portfolio of debt securities with negative interest rates is falling rapidly, making an investment in government bonds more attractive again. In addition, equities could quickly return to where they started the year if the global economy avoids a recession and inflation and interest rate expectations ease. Investors will have to be patient.
Real assets such as real estate (including logistics centers and selected commercial properties) and infrastructure should offer portfolios some inflation protection in the meantime, especially when invested through private equity. Since private assets have only a low correlation with listed securities, they improve a portfolio’s income profile and protect it against losses in value.
Private Equity and Real Assets
How well this works is shown by the large US endowment funds, which are financed for the benefit of educational and other institutions and through gifts and donations. The largest belong to American universities, led by Harvard University (with $51.5 billion in assets under management at the end of June 2021), followed by the University of Texas (with $42.9 billion) and Yale University (at $42.3 billion). The primary investment goal of these university endowment funds is to generate sufficient income to maintain the purchasing power of your assets over the long term and to ensure the operation of the university. In general, foundations target a real return of 5 percent per year (adjusted for inflation) over an extended period of five to 10 years.
In recent years, these funds have progressively reduced their exposure to traditional asset classes such as equities and bonds, in favor of investing in alternative assets including private equity, real assets and absolute return strategies. They inherently offer greater diversification and higher returns as they are better able to take advantage of inefficient market prices through active management. For example, the equity portion of the major US endowment funds has fallen from 45 percent of total assets in 2002 to 29 percent in 2021, while the portion of alternative investments rose from 32 percent to 59 percent over the same period.
Smaller foundations with less than $25 million in assets under management are less consistent with this strategy. They continue to have a strong investment focus on domestic US equities and investment grade bonds. This is because investing in alternative assets requires extensive research and other resources that large players can more easily leverage. The allocation of smaller foundations is therefore about 60 percent equities, 32 percent fixed income investments and 8 percent alternative investments.
Endowment fund performance was very strong in fiscal 2021, the highest since data began being collected in 1989. According to the National Association of College and University Business Offers (Nacubo), which annually reviews the investment strategies of elite US universities, the average return was for all institutions in the 2021 financial year at 30.6 percent – with a range from 23.9 percent for the smallest funds to 37.7 percent for the large endowment funds. For comparison, Global 60/40 funds (which invest 60% of their portfolios in stocks in the MSCI AC World Index and 40% in the Bloomberg Barclays Global Aggregate Bonds Index) returned 22.5% over the same period. US 60/40 funds (which invest 60 percent of their portfolio in the S&P 500 and 40 percent in a 10-year US Treasury) returned 22.1 percent.
With their strategy of investing more in private assets, endowment funds have been able to achieve long-term outperformance. The fact that small-cap stocks outperformed large-cap stocks in fiscal 2021 and that inflation or 10-year Treasury yields rose by more than 50 basis points has played into their hands.
Against rising inflation
Thanks to their strong performance in the financial year, the foundations’ average annual return over ten years rose from 7.5 to 8.5 percent. In doing so, they benefited from the strong appreciation of a number of asset classes, in particular equities, private equity and real estate. This number takes into account university spending needs, long-term inflation expectations, and fees and costs. For the current year, due to rising inflation expectations, the target nominal return has been increased to 7.94 percent: 4.6 percent for general expenses, 2.3 percent for inflation and 1.04 percent for fees
and costs.
The managers of endowment funds will therefore be more challenged to achieve the long-term goals in the coming years. Foundations are therefore likely to shift their assets even more towards real assets to hedge against rising long-term inflation expectations. For owners of large fortunes in Germany and Europe, it should be worthwhile to restructure their portfolios in line with those of the large US foundations. In this distribution, they can then wait until their formerly safe havens are safe again.