GF570 Unit 10 Foundation Annual Portfolio Review Example

Beat the Objective, Trailed the Benchmark: A Unit 10 Portfolio Review Report to a Foundation's Trustees

[Student Name]

Purdue University Global

GF570: Portfolio Management

Unit 10 Portfolio Review Report

[Instructor Name]

[Date]

The foundation and every figure are composite and illustrative, carried from earlier units; the publications and article cited are real.

Scorecard

Each policy test, with the year's result:

1. Return objective, 7.95 percent over rolling ten years: 11.07 percent for the year. Met for the year; too early to judge the ten-year test.

2. Policy benchmark, after fees: 11.07 against 11.60. Missed by 0.53 points.

3. Expected volatility, ceiling 13 percent: 12.26 percent at year-end weights before rebalancing. Met.

4. Fifth-percentile one-year loss, limit 15 percent: about 12.6 percent. Met.

5. Liquidity, at least 60 percent within thirty days: 78 percent. Met.

6. Illiquid holdings, cap 20 percent including half of unfunded commitments: 19.0 percent projected. Met, narrowly.

7. Asset class ranges: U.S. equity at 38.4 percent against a range ending at 37. Not met; rebalanced in January.

8. Grants and expenses, at least 5 percent distribution: $9.6 million of grants against a required $9.2 million. Met.

The Year's Return

Strong U.S. equity markets carried the year. The foundation returned 11.07 percent, about $20 million in gains, well above the 7.95 percent needed to sustain grants in real terms. That margin is welcome but should not be read as evidence that the objective is now within easy reach: one strong year says little about ten.

Against the Benchmark

The 0.53-point shortfall came from three sources, as the attribution analysis showed. The private equity program, in its first year, trailed its public-market benchmark by 4 points, costing 0.48 points of total return; young private equity programs typically lag in their early years because of fees and valuation timing (Kaplan & Schoar, 2005). The emerging markets manager trailed its index, costing about 0.30 points. A positive allocation effect of 0.39 points came almost entirely from the restricted acquirer shares, which the foundation could not sell, and should not be counted as skill.

The One Exception

U.S. equity drifted above its range as the market rose and the acquirer shares grew. The committee rebalanced halfway in January, as the policy requires, at an estimated cost of about $26,000 including excise tax on realized gains. The acquirer sale plan begins this quarter and will remove the largest source of drift.

The year was good by the measure that matters most, the return needed to keep grants growing with inflation, but the allocation the trustees adopted is still expected to compound about a point short of that measure over a decade, and a strong year does not change that expectation.

The Structural Gap

The asset allocation model estimated that the adopted mix compounds at about 6.7 percent a year over ten years against a 7.95 percent objective, with roughly a 37 percent chance of meeting it. One good year raises the realized average but not the expected return for the years ahead. The trustees have three options, unchanged from last year: accept a likely slow erosion of the foundation's real value, raise the volatility ceiling toward 14 percent to permit more equity and private assets, or trim costs and grants closer to what the law requires. The committee recommends deciding this at the spring meeting rather than letting a strong year defer it.

Managers

The small-cap value manager and the core-plus manager met expectations. The emerging markets manager is placed on watch for one more year, with a review of whether its underperformance came from a consistent process or from a few large positions. The screened index account tracked its benchmark closely after accounting for its exclusions. Research on manager changes cautions that replacing managers after a short period of underperformance often fails to improve results (Goyal & Wahal, 2008).

Excise Tax

Realized gains and investment income for the year produced about $95,000 of federal excise tax at 1.39 percent. The committee will continue to choose tax lots carefully, especially as the low-basis acquirer shares are sold, since that sale alone could double next year's tax.

Costs

Fees for the year were about 36 basis points, about $660,000, in line with the implementation plan. Half went to private equity, which will remain the largest fee item as commitments are called.

Governance

The committee met six times. All manager guidelines were confirmed in writing. The investment policy was reviewed and is recommended for readoption without change, apart from clarifying that the acquirer sale plan may be accelerated if the shares exceed 15 percent of assets (CFA Institute, 2010).

Looking Ahead

Three items will shape next year. First, the acquirer sale plan will sell about 12 percent of assets over four quarters, cutting both the fund's largest source of active risk and its main cause of drift; it will also realize the largest capital gains in the portfolio and the excise tax that comes with them, roughly $200,000 if the shares hold their current value. Second, private equity capital calls will move the program from about 4 percent invested toward its 12 percent target, raising illiquid holdings close to the policy cap; the committee will slow new commitments if the cap comes within one point. Third, grant needs are expected to rise to about $10 million as the foundation's training partnerships expand.

Risks to Watch

The fund's largest single risk remains a sharp fall in equity markets, which would reduce the three-year average that sets grants and could prompt trustees to question the strategy. The fifth-percentile loss estimate of about 12.6 percent is within the trustees' stated tolerance, but the committee will remind trustees before any such fall what the policy expects of them. A second risk is that private equity distributions arrive more slowly than calls, tightening liquidity in a down market.

Benchmark Note

Because the private equity benchmark trails public markets by a quarter, it will make the program look weak in rising markets and strong in falling ones because of the lag. Trustees should judge private equity over a full cycle rather than year by year.

A Comment on Communication

Trustees told the committee they found last year's quarterly reports hard to follow. Starting this year, each report will open with the scorecard above, a one-paragraph summary and a chart of the fund's value against the amount needed to keep grants growing with inflation, with detailed tables moved to an appendix.

Decisions for the Trustees

1. Readopt the investment policy with the clarification above.

2. Decide at the spring meeting among the three options for closing the structural gap.

3. Confirm the emerging markets manager's watch status.

References

CFA Institute. (2010). Elements of an investment policy statement for institutional investors. CFA Institute.

Goyal, A., & Wahal, S. (2008). The selection and termination of investment management firms by plan sponsors. The Journal of Finance, 63(4), 1805-1847. https://doi.org/10.1111/j.1540-6261.2008.01375.x

Kaplan, S. N., & Schoar, A. (2005). Private equity performance: Returns, persistence, and capital flows. The Journal of Finance, 60(4), 1791-1823. https://doi.org/10.1111/j.1540-6261.2005.00780.x