By Floyd Keene, The Triple EEE Foundation
In today’s world of economic uncertainty, many foundations are concerned about world events and how bad developments could affect their portfolios.
Europe, Washington politics, a large slowdown in China, Middle East uprisings, a new liquidity crisis. All these events could clearly affect the market and have very bad effects on a foundation’s portfolio.
Are you having trouble sleeping at night? Are you timid in your investment policy for fear of a world calamity? If you are, you are not alone. Many investors share your fear.
But there is one easy way to control your fear, so it does not adversely effect solid investing decisions: Do a stress test on your foundation’s portfolio. Moreover, given the incredible volatility of the market in recent months, do it now. Do it before world events surprise us all with a massive market correction, which could happen at any time.
In the words of the Boy Scouts: Be prepared.
Of course, you’re probably asking, what the heck is a stress test? I’ve never heard of that. Banks do stress tests. What does it mean to stress test a foundation’s portfolio?
You’re right. Stress testing a portfolio is a relatively new concept. If you call your broker or investment advisor and say you want to stress test your foundation’s portfolio, he or she will likely think you are talking crazy talk. They have never heard about the concept either.
But stress testing your portfolio is a very basic idea and can be accomplished either simply or in a more sophisticated manner. The simple test is probably useful and adequate for most foundations.
How to Stress Test Your Portfolio
Like a stress test for banks, it begins by assuming the worst possible outcome for your portfolio (i.e., a black swan event). You don’t have to identify the event. You only have to assume its effect on your portfolio. For example, you may want to assume that your portfolio decreases by 25%, as many did in 2008. You then ask the question: What does this 25% drop do to my foundation’s financial situation? To my foundation’s operations?
Will a 25% drop cause me to fire staff? Revisit my payout ratio and spending policy? Give fewer grants or cut grant amounts?
The important question is this: Will the black swan event only hamper my operations or outright devastate them?
If you conclude that a 25% drop is merely a “paper pain,” affecting the foundation’s net worth but not the major aspects of how it operates, then you have passed the stress test. If this worst case scenario will instead cause dramatic undesirable changes in how your foundation operates, then it may be time to reassess the risk in your portfolio. It may be time to decrease your equity exposure. To move some funds from stocks to bonds or cash. To rebalance your portfolio.
To show how stress tests work, let’s take two simple examples:
Foundation 1: This foundation has a conservative $10 million portfolio (30% equities, 60% investment grade bonds, 10% cash).
Assume a black swan event results in equities being down 25%. Bonds are also down about 5%, because corporate and other non-Treasury bonds also suffer from a world calamity. Cash, which is earning next to nothing in interest, stays the same. Thus, the overall portfolio is down about 11%. If this 11% drop is only a “paper pain,” the stress test is passed. If disastrous effects on the foundation’s operations would occur, it is probably time to reevaluate the portfolio’s risk.
Foundation 2: This foundation has a very high risk/high reward $10 million portfolio (60% equities, 35% alternative investments such as hedge funds and real estate, 5% cash).
Assume a black swan event causes the equity market to drop 25% and alternative investments to drop 35%. The net value of the portfolio decreases about 28%. What would this do to the foundation’s operations? If it can absorb a 28% decline without disastrous effects, that’s fine. But, if not, it should consider reworking of the portfolio’s risk (e.g., having some bonds or more cash, at least).
Clearly, in the case of a black swan event, Foundation 1 (down 11%) is much better off than Foundation 2 (down 28%). But, in the case of a rising market, Foundation 2 is likely to be better off. As is always the question when balancing risk and reward, how much can you afford to lose in order to do better if the market drives upward?
As indicated above, you can make your stress test as simple or sophisticated as you want. For example, in the above two cases, you may want to assign a higher loss possibility to financial stocks (e.g., 50% rather than 25%), because the volatility of financial stocks could well be exacerbated during a black swan event. Likewise, conservative high dividend stocks may warrant a lower loss percentage (e.g., 15% rather than 25%).
There are a number of approaches and assumptions that can be used. The important thing is this: Stress test your portfolio—and do it now! In the event of a market catastrophe, a prior stress test may save your grant program, your grantees, your staff, and your foundation itself.
Then you can sleep at night.
Floyd Keene is president and founder of The Triple EEE Foundation in Deerfield, IL, and vice chair of ASF’s board of directors. He received his bachelor’s and law degrees from the University of Wisconsin and, before leaving the business world, was a senior executive at Ameritech, a Fortune 500 company. He is a strong advocate of mission investing, and his foundation’s assets are currently 100% mission invested.
