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The traditional 60% S&P 500 - 40% Aggregate Bond index investment portfolio has been the benchmark for portfolio construction for decades due to the inverse return relationship between equities and fixed income and higher historical bond yields. This simplistic mix had provided returns for pensions that allowed them to meet their actuary assumed returns. The S&P 500 index posted an approximate annualized average return of 11.3% for the past 10 years (ending 2019), while the current yield on the Aggregate Bond Index less than 1.5% (coupon rate of hovering around 3%). The correlation between the two indexes has been slightly negative for the past ten years, and bonds have not provided a consistent offset for drawdowns within the S&P 500 index. Over the next five years, earning a 5% annualized return will be tough. Based on recent comments from the Federal Reserve (the Fed), the expectation for higher interest rates in the intermediate term is minimal. While investors cannot control what the Fed is doing, we can recalibrate current positioning and take a serious look at the risk within the portfolio and its governance.
The first question that most investors have started to ask themselves is how to replace the missing yield from the fixed income market. When seeking a replacement, many forget to fully vet the additional risks associated with finding an alternative. While there might be other public and private options, each one brings a different type of risk profile to the portfolio, which must be considered. Hence, swapping one investment for another is a naïve approach that could have detrimental effects if the understanding of current and potential strategies is vague. This is an important area to focus on, and what an investment advisor is paid to do. You might have a relationship with an advisory firm in which they present you with options or a fiduciary that does the decision-making and portfolio construction for you. In either case, this is the time for an investment committee to focus on oversight elements that are usually glazed over. From an investment perspective, members should take this time to:
- Re-evaluate their Strategic Allocation
- Update their Investment Policy
- Refresh their Objectives
- Evaluate their tactics around allocation of assets and assessment of those decisions
- Revisiting their Spending Policy
- Gauging the overall risk of their exposure
- Homing in on their underlying market exposures to events that could be detrimental to returns
- Measuring the volatility of returns for each fund and portfolio as a whole
- Considering drawdown of the portfolio
Understanding and addressing the potential holes within the governance of a board is equally important to understanding current market conditions. Unfortunately, this rarely gets the same attention as the latest news from the stock market does.
As investment professionals, we spend far too much time talking about the markets, but clients’ governance structure usually has glaring holes and creates just as much risk for plans. The adoption of good governance starts with:
- Addressing educational needs within the board
- Introduction of term limits
- Staggering board terms
- Independent, third-party reviews of board investment process
- Proactively minimizing conflicts of interest
- Re-evaluate current investment advisor beyond investment performance
- Utilizing board assessments
It is crucial for boards to maintain discipline in their governance and review processes; while it may not seem as exciting as stock and fixed income movements, it is equally as important of an exercise for more efficient portfolio management.
About the Authors
Floyd Simpson III, CFA, CFP, is Senior Managing Consultant with PFM Asset Management LLC. As part of PFM’s OCIO business, Simpson works with clients across the country to develop and implement multi-asset class strategies for their portfolios. He also serves on the Multi-Asset Strategies Group and the Multi-Asset Class Investment Committee.
Mallory Sampson, CFP, is Senior Managing Consultant with PFM Asset Management LLC. Sampson manages PFM’s institutional multi-asset class relationships in Texas, with a focus on higher education, endowments, foundations and OPEB trusts.