It is early June and the stock market closed slightly above its resistance point of 18,000. This is somewhat surprising given the market’s double digit plunge in the first six weeks of 2016 which was quickly erased with an impressive climb during the last half of the first quarter. The magnitude of those movements both up and down gives the first ninety days of 2016 the dubious distinction of being one of the most volatile quarter since 1951. To appreciate the gravity of this statistic, one must remember that the Tech Bubble of 2001-02 and the Credit Crisis of 2008-09 are included in this range, as are a multitude of other market disruptions.
It is hard to craft a storyline that would lead us to see a significant stock market run over the coming months. Investors are dealing with a slowing Chinese economy, a potential Brexit, negative global interest rates, declining corporate profits and disappointing domestic employment numbers, all as we are about to embark on the campaign trail of an unprecedented presidential general election. Lack of portfolio appreciation would prove problematic for institutions that are dependent on their endowments to support financial operations, scholarships, programs, projects, as well their fundamental missions.
Most endowments provide annual mission critical support to the institutions they serve. Endowment spending commonly follows a predetermined policy that defines the level of support that can be safely withdrawn while preserving the principal of the fund in perpetuity. Having a spending formula removes annual subjectivity and short term thinking with regards to balancing the short and long term needs of the institution. An endowment’s objective is twofold: providing a current income stream while also maintaining or growing the purchasing power of the endowment for the future. There are many spending strategies utilized by foundations; however, approximately 75% of endowment spending follows a “Moving Average Spending Method”. Most of the funds have a rate of 4%-5.5% of their portfolio value averaged over a rolling 3-year period or 12 quarter period.
There is little doubt that the economy has improved since the end of the Great Recession but the degree of advancement is debatable. What is not in question is that since the bottom in March of 2009, market performance has been exceptional. That being said, we have seemingly been stuck in a trading range since 2014 with very little growth. The rolling 3-year returns for a 60% equity and 40% fixed income portfolio have started their descent.
The averages peaked in 2014 at 12.1% annualized, declined to 8.4% in 2015 and if the market were to end the year at its current level this measure will plummet to 4.1%. To go a step further, if equities reverse course due to the economic headwinds outlined above and the 4% gain so far this year is erased, the rolling 3-year return will fall to slightly over 2.5%. This will require spending to dip into the endowment principal. One must be aware of end point sensitivity given that these funds are perpetual and fiduciaries should avoid making short-term decisions that stifle the ability of the organization to fulfill its mission over the next year.
There are alternatives to the traditional spending policy formula outlined above that board members can avail themselves of. They can explore fixed rate, income only, inflation based or hybrid solution spending methodologies; however, none of them are a panacea. Before implementing a different strategy, great care and due diligence should be taken to appreciate how changes affect the organization today as well as in the future. It is critical we remind ourselves that the market can be a fickle beast. It can move on headlines and emotions and there will be ebbs and flows in our return experience. What is important is that whatever formula being implemented, always remain disciplined.