How Endowments and Foundations Can Manage Sequence of Return Risk
Canada's charitable sector provides vital support to the communities we live in – support that would not be possible without the funding which assets held by charities, foundations and endowments generate. Good stewardship of these assets requires an understanding of the unique risks faced by the charitable sector.
One key risk which can impair charitable organizations' funding levels, striking at the heart of their very raison d'être, is sequence of return risk. This is the risk to an investment portfolio arising from the inopportune timing of negative returns. If a portfolio suffers losses early on and the charity is required to make a disbursement, its capital base may be permanently impaired.
A new in-depth paper by TD Asset Management Inc. notes that to manage this risk, it is important to understand how it interacts with the Disbursement Quota - the minimum amount an endowment or foundation is required to spend annually on its programs or on gifts to qualified donees, such as other charities.
The paper argues there are two ways endowments and foundations can reduce sequence of return risk: through resilient asset mixes and cash flow management.
Resilient Asset Mixes
Building a resilient asset mix begins with studying a plan's liquidity needs, time horizon, spending requirements, and contribution and growth expectations, all of which will have a bearing on the optimal investment policy. The objective is to construct an asset mix that meets each of these objectives, while minimizing sequence of return risk by muting volatility and maximum drawdowns.
Optimization techniques – such as Monte Carlo simulations, which account for the cross-correlations between asset classes – are an effective way to build a resilient asset mix. As part of the analysis, it's important to recognize that correlations are unstable over time. For instance, the correlation between bonds and equities has been negative in most historic environments (providing good diversification), but it can turn strongly positive, particularly in a rising yield environment (providing poor diversification), as we saw in 2022.
Cash Flow Management and the Value of Tactical Asset Allocation
A critical, but often overlooked, way to minimize sequence risk is good communication between clients and investment managers about cash flow needs. Regular touch points and a proactive dialogue can help ensure that investment managers are aware of the size and timing of upcoming withdrawals. Securities can be sold over a period of time, taking advantage of market movements to raise cash in advance of the withdrawal and minimize the risk of facing a major market drawdown immediately before the withdrawal must be made.
This can be further enhanced by active tactical management which recognizes that thoughtfully considering what assets to sell in order to fund a withdrawal can have an enormous impact, especially after steep market declines. For example, if equities fell sharply in the period leading up to a withdrawal, it may be wise to avoid locking in losses and fund the withdrawal primarily through cash or bonds rather than through selling equities.
For more information, read the full paper.
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