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| Path: Main Street : Resources & Library : Research Articles : Feature Article |
Balanced investment approach can increase foundation returnsby Winsor Pepall
October 2, 1996; Canadian FundRaiserBonds, GIC's and money market instruments are favourite investment vehicles of many not-for profit groups because of the high level of current cash flow. However, if the cash flow is spent, the growth potential of the underlying asset is reduced.
The total return numbers for a bond portfolio can be increased substantially by taking a balanced investment approach. Data from Frank Russell Company, a well known consultant in fields that include the capital markets, reinforces this view and is shown in the graph below. This data and the analysis use a ten-year time period because of the long-term mandate for most not-for-profit funds.
The average annual return from a bond portfolio, for each of the ten-year spans in the period 1924 to 1994 was 5.9%, while the measure of volatility was 3.7%. In the same time-frame the average return from stocks, at 10.2%, was substantially higher, but so was the degree of risk. A 50/50 blend of bonds and stocks produced a much higher rate of return (8.5%) than bonds and almost 85% of the return from stocks, but with substantially less risk.
Over extended periods, inflation severely affects all portfolios. A balanced portfolio, however, can accommodate both capital preservation and the need for cash flow by embracing the concept of Total Rate of Return and adopting a disciplined disbursement policy. Total Rate of Return includes both the income generated, be it interest or dividends, and capital growth.
We have come through an unusual period in which the returns from fixed income investments have challenged and periodically exceeded those from equity vehicles. We will return, however, to a more normal pattern of returns that reflect the relative risks of lending versus ownership, as this is the very foundation of our society.
The table, Foundation Disbursement Model highlights the results of a "Buy & Hold" approach where a $10 million bond is bought and held until maturity and all of the income generated is spent. This is contrasted with four basic managed portfolios, each with different disbursement levels.
FOUNDATION DISBURSEMENT MODEL 1976 TO 1995 ($Millions) Bond Approach Total Rate of Return Capital Start Amount End Inflation Adjusted Starting Capital Annual Disbursement Rate Total Period Disbursement 1. Buy and Hold 9.5% 10.0 10.0 29.1 9.5% 19.0 2. Managed 11.5.*% 10.0 37.9. 29.1 4.5% 15.9 3. Managed 11.5*% 10.0 29.1 29.1 5.89% 18.1 4. Managed 12.8%** 10.0 48.5 29.1 4.5% 18.3 5. Managed 12.8%** 10.0 29.1 29.1 7.2% 22.5 Balanced Approach 6. Managed 12.0%* 10.0 42.3 29.1 4.5% 15.9 7. Managed 12.0%* 10.0 29.1 29.1 6.49% 18.1 8. Managed 14.0%** 10.0 61.7 29.1 4.5% 18.3 9. Managed 14.0%** 10.0 29.1 29.1 8.57% 22.5
* Median Return: Represents the performance of the fund at the mid-point of more than 2,500 funds in the database maintained by SEI, an independent provider of Canadian investment performance data.** The First Quartile Return: The performance of the fund that is ahead of 75% of those in the SEI database. Source: Integra Capital Management Corporation
In Example 1 the Buy and Hold to maturity approach produces a very acceptable cash flow for Total Period Disbursement, but the level for the Ending Capital, unchanged from $10 million in 1976, is not appealing. This would have the purchasing power of less than $4 million in 1995.In building the model, the Annual Disbursement for all but Example 1, was tied to the four-year moving average of the capital available at the beginning of each year. This approach produces an annual disbursement rate that is largely independent of the recent behaviour of the stock or bond market
Each alternative to the first example produces dramatically better Ending Capital. The results from a Managed Balanced Fund (Examples 6 & 7), with only Median returns, are consistently better than those from Managed Bonds (Examples 2 & 3), effectively giving the foundation added flexibility.
The bold figures of the Annual Disbursement Rate in Examples 3, 5, 7 & 9 represent the rate when it is pushed to the stall point, or the level at which the Ending Capital begins to lose its purchasing power. To derive the Inflation Adjusted Starting Capital, the Starting Capital has been adjusted for inflation and represents the capital level that must be maintained to protect purchasing power. Broadly speaking the stall point is reached when the Disbursement Rate approximates 55% of the Total Rate of Return.
In the detailed tables that support the summary shown here it is worth noting that when the Managed Balanced approach was used, there was never a year when the Annual Disbursement amount declined. This was true whether the performance was Median or First Quartile and even at the "stall point" for disbursements. It was not the case, however, for Managed Bonds.
In the final analysis balanced funds can provide extra returns and can do it with less volatility than a bonds-only approach.
For more information, detailed tables showing the effects of investment performance, inflation and disbursement levels, call Winsor Pepall , (416) 869-5153.
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