Thursday, June 21, 2012

Meeting Client Objectives

Last night I met with the investment committee of an endowment fund here in Boston. The fund has been a client of my bank's for several years.

I like meeting with this group.  Their focus is far removed from the financial world; instead, much of their daily lives are focused on helping others, especially those that are going through difficult times.

Their endowment fund provides a good portion of the resources necessary to do their important work in the community.

The focus of the endowment, therefore, should not be a benchmark like the S&P 500 or the Barclays Government/Credit bond index; instead, they simply need the endowment to provide the income and growth necessary to fund their outreach activities.

At the time I started working with them, they had allocated about 55% of their portfolio to stocks, with the remainder in fixed income. 

This is a fairly typical endowment approach, since historically an allocation of roughly 50/50 between stocks and bonds has proven to be a good balance of risk and return.

Problem is, with interest rates at multi-decade lows, allocating a large chunk of a portfolio to bonds may satisfy the desire for risk reduction, but offers little opportunity for growth.

Moreover, as older higher coupon bonds mature, reinvestment rates in investment grade bonds are unappealing.

For groups like the one I met with last night, lower income levels could mean that some of the work they are doing in the community might have to be curtailed, which is obviously undesirable at a time when so many are in need.

So last summer I recommended - and they approved - changing their allocation to stocks from 55% to 70%, with a particular focus on dividend-paying stocks.  This increase in stock allocations would doubtlessly mean more volatility, but would accomplish several important objectives.

First, buying high quality stocks that offer attractive dividends would gradually increase the income being generated by the portfolio.  In many cases today, stocks are paying higher dividend yields than bonds issued by the same corporations.

Second, investing in stocks of companies that were gradually increasing their dividends would mean more income in the years to come. 

Finally, increasing the opportunity for growth in the portfolio is an important consideration for the future.

Inflation may be muted but it is not dead.  If inflation runs at its current 2% rate for the next ten years, the fund will need to be worth roughly +22% more than today's value in order to maintain its real (i.e., inflation-adjusted) spending power.

The result?

Well, here's how I started the meeting:

I have some presentation material that will show how your portfolio has done versus the various benchmarks.  However, I can tell you that your investment strategy has been a success.

The income from your portfolio is up roughly +5% from what it was in 2011.  Since so many of the companies in your portfolio are increasing their dividends, I anticipate that income in 2013 will be even higher than in 2012.

The value of your portfolio has also increased, even after significant withdrawals to fund your activities in the community. 

In short, your decision to increase your allocation to dividend-paying stocks may have seemed slightly more risky at the time, but it accomplished the important objectives of more income and increased principal growth.

But after the material was distributed, I also observed:

You might notice that your stock portfolio has lagged the S&P 500 so far this year. While as your stock manager this obviously does not make me happy, I would also argue that it is somewhat irrelevant in light of the fact that your portfolios is meeting your objectives.

No one on the committee disagreed.