June 13, 2013
Keep Your Eye on the Horizon
We often hear this phrase spoken in a variety of disciplines. Hikers often mutter it before embarking from the trailhead. The phrase is most ubiquitous on the open seas with sailors' attempts to steady their ship for a long journey. This phrase also is often spoken from trusted investment advisors to their clients. Within the investment community, it generally encompasses taking a long-term view of your investment horizon to ensure proper alignment of goals, objectives, time frames, and results.
Today more than ever, investors are challenged in maintaining this long-term focus. Volatility and complexity within global investment markets are at all-time highs. Sentiment, momentum, and noise compete for attention, often enabling investors to lose their compass. Complicating matters is an extremely rich fixed-income environment and global equity markets that have more than doubled since 2009 lows. This current capital environment presents a serious impediment to investors and will continue to remain challenging.
The chart below was produced recently by AQR Capital Management in New York and was featured in John Authers' piece "The Long View: Timing Is All During the Fed's 'Tapering' Terror"in this past weekend's Financial Times. It shows what the expected 10-year real return for a diversified "60/40" would have been for rolling time periods since the beginning of the century. Based on AQR's work (Cyclically adjusted PE ratios), the outlook for investors has never been so dire.
Given the outlook for diversified investment portfolios, investors will be tasked with a monumental challenge to meet their goals and objectives. Global market participants will need to use every tool in their arsenal to ensure they navigate the uncertain path that lies ahead. Some of these tools include the ability to act nimbly in swiftly changing investment markets, the flexibility to take on more esoteric return patterns, and the willingness to assume greater illiquidity risk.
Well-thought-out investment programs are accompanied by an investment policy and plan, serving as a guidepost to achieving portfolio objectives. Investment objectives should be clearly defined and memorialized, with the intent of defeasing specific investor liabilities. For a married couple, that may mean providing inflation-adjusted income necessary to maintain a specific quality of life into retirement. For a college endowment, it may entail earning a total portfolio return to satisfy an annual draw while also maintaining purchasing power to not disadvantage future generations of students.
Too often, however, short-term behavioral biases are juxtaposed with well-established long-term investment objectives. Many times, quarterly comparisons to nebulous benchmarks or cocktail party fodder around "Keeping up with the Joneses" usurp measurement or discussion of what matters most. The scene in "Meet the Parents" plays out in arenas all across the globe. "How is your portfolio? I would say strong, to quite strong."
It is paramount for investors to ascertain adherence to investment objectives and to measure long-term results accordingly. In his seminal work "Pioneering Portfolio Management," David Swensen tackles this very issue with a clear and articulate graph that measures whether or not the Yale University endowment portfolio is preserving real purchasing power for future generations of students. An example of this measurement process is depicted below for a hypothetical portfolio:
In this particular example, a college's initial endowment and subsequent contributions are grown by the rate of inflation over time. The dark blue line represents the actual portfolio market value after a quarterly spending draw. This simple example can help stakeholders of the institution determine if the endowment portfolio is preserving its purchasing power over time. Similar examples can be used to measure the progress of preserving intergenerational family wealth.
Analyzing whether your portfolio is achieving a stated policy objective is an important gateway to ascertaining whether or not your investment program is designed properly to produce the desired outcome. In addition, current capital markets dictate forward-looking return expectations that may make achieving a long-run objective an arduous task. What is important is ensuring the measurement of progress toward clearly defined investment objectives in the face of unprecedented market complexity and volatility.
With a well-thought-out investment roadmap and clearly defined measurement criteria, investors will be better equipped to face today's uncertain times. In a market environment often dominated by myopic time horizons, achieving portfolio objectives demands discipline, skill, and patience. Determining where you are going and how you are getting there necessitates investor attention. Once investment goals and objectives are established with a thoughtful plan for achieving them, it is vital to keep your eye on the horizon along the way.
Nick J. Fazzie, CFA
Nick is an Investment Officer with Hirtle Callaghan and is responsible for servicing and implementing the firm’s Investment Strategy decisions within client accounts. Prior to joining Hirtle, Callaghan & Co., Nick worked with Aberdeen Asset Management. Nick received his B.S. in Accounting and M.B.A with a concentration in finance from University of Delaware. Nick is a CFA charterholder and a member of The CFA Society of Philadelphia. In addition, Nick holds his Series 65 license.