Financial Committee Investment Recommendation v1.1
BACKGROUND
Several members have expressed
apprehensions about the current investment policy (intended to preserve the
Abrams endowment for 20 years): poor returns; exposure to excessive interest
rate risk; and, lack of diversification. In actual fact, the total annual
return of the endowment portfolio, which is completely invested in the Vanguard
GNMA fund, averaged 3.57% from 2003 to 2006; note that this four year period is
the worst performance of the GNMA fund in 15 years. Members who felt that
the endowment should help future bridge players warned that unless the GNMA
fund rose to historical total annual returns of 8.5%, the endowment would be
exhausted in less than twenty years.
A Financial Committee was formed
to examine these concerns and, if found valid, develop an investment goal,
policy and specific investment guidance for SCBC (Unit 550). The Financial
Committee participants were:
·
·
Jeff Belden
·
Nancy Wainer
·
·
·
·
Although not unanimous, the Financial Committee did find the concerns
expressed valid and proceeded to develop a set of recommended changes in the
SCBC investment goal, objective and policy. The recommendations below are
endorsed by all but one of the committee participants.
INVESTMENT GOAL
Committee member goals for the
endowment varied; here is a summary of the goals expressed:
·
Provide an inflation-adjusted
portfolio value at the end of 20 years (dollar amount equal to today’s value,
approximately $577,000)
·
Conservatively invest to preserve capital; 100% fixed
instruments (basically, no change to current investment goals or policy)
·
Change the investment policy to
ensure the endowment lasts for 20 years
A question was raised about what
Dolores Abrams would want if she were on the committee. Bob Vatuone had
handled her estate and said that he thought she would be pleased to know the
club is working to extend her endowment to the future bridge players of
The committee recommends SCBC
adopt a financial goal that is likely to provide an inflation-adjusted
portfolio value after 20 years.
INVESTMENT POLICY
In order to achieve the proposed
goal, the committee recommends the following investment policy:
·
Balanced allocation including
equities
·
Minimize the risk to capital
·
Broad diversification
·
Very low investment management
expenses (under 1%)
The committee did not find
general investment advice that suggests it can achieve its goals by solely
investing in the GNMA fund. Further, it could not find forecasts predicting
that the GNMA fund is likely to obtain historic performance results over the
next five years. These findings substantiated the concerns expressed earlier by
club members regarding the investment policy.
INVESTMENT OBJECTIVE
Using the Scenarios
tab in the “SCBC Portfolio Manager . xls” spreadsheet, which is an integral part of
this report and attached for your review and use, the committee studied several
financial scenarios for SCBC over a twenty year time horizon, using the
following assumptions:
·
Any change in the number of tables would not ma
·
It is unlikely there are additional sources of
income available to SCBC which could substantially reduce the total return
required of the portfolio. (The spreadsheet allows modeling additional revenue,
but no one has suggested a pragmatic approach to generating such revenue.
Nonetheless, every effort should be made to investigate alternative sources of
revenue.)
·
A realistic inflation rate for SCBC expenses
(although changeable in the spreadsheet) can be estimated by using the increase
in rent (12% every 5 years) over the twenty year period, which has been
annualized to 2.25% for computational simplicity
·
Other expenses would increase by no more than the
inflation rate (reasonable based on the last four years history)
·
Portfolio mechanics: Dividends
and income are reinvested automatically; 25% of the total portfolio is set
aside for paying expenses and does not generate income in the model (in the
real portfolio, some portion of this sum will generate income); the portfolio
is rebalanced annually.
·
The Club Owners would increase
table fees in 2007 and again in ten years, giving SCBC $3,600 this year and an
additional $3,600 in ten years (these amounts and frequency may be changed in
the spreadsheet)
Note: It
is recommended the Unit negotiate with the landlord well before the next rental
increase for a smaller percentage increase and work with the Club Owners for a
greater share of any future increase in table fees.
Using these assumptions, a 9%
annual return is calculated as necessary to provide an inflation-adjusted
portfolio value of approximately $577,000 after 20 years.
Therefore, the recommended
investment objective is to create a conservative, balanced portfolio that meets
the SCBC policy and generates a 9% return.
INVESTMENT PROGRAM
A majority of the committee
believe that diversification should be achieved by first selecting specific
allocation percentages across asset classes. The first table below shows the
asset class allocations. Rather than invest in a single fund of funds
which has an asset allocation similar to those selected recommended, e.g. Vanguard’s
Life Strategy Moderate Growth, the committee proposes SCBC allocate it’s
portfolio across a number of funds. The recommended portfolio uses Vanguard
index funds, which have extremely low management fees; the suggested Vanguard
portfolio has a weighted-average management annual fee of 0.23%. The
Vanguard index funds selected are closely aligned to the associated asset class
which allows SCBC to better maintain target allocations. The Allocation#2
tab in the spreadsheet shows
the asset class allocations and the specific Vanguard funds which meet our cri
The committee also felt that
SCBC should be 50% invested in the new allocation by the end of June, 2007 and
100% invested in the new allocation by mid-December, 2007.
Operational note: Vanguard is the leader in index funds and
since the SCBC endowment is 100% invested in the Vanguard GNMA fund, the
committee strongly recommends moving the entire portfolio to Vanguard and
closing the Schwab account. Such an arrangement allows the exchange into the
new funds without charge to SCBC. After meeting each fund’s minimum
investment, typically $3000, monthly dollar cost averaging is suggested as the
technique to complete the conversion to the new allocation.
The committee’s investment
recommendation is based on the objectives and goals agreed on by the committee
in combination with specific advice from several sources:
· The guidance from FundAdvisors.com for
selecting the “Ultimate Buy-And-Hold Portfolio” and the suggested Vanguard
balanced model portfolio, modified to meet SCBC’s
objective and policy. (See the entire article at http://www.fundadvice.com/articles/buy-hold/the-ultimate-buy-and-hold-strategy.html)
· The specific asset and fund allocation used within the Vanguard STAR fund
and more loosely on the Vanguard Life Strategy funds
·
In-depth personal study of
long-term financial investing by several of the committee’s members
·
A recent review of a similar
portfolio by a professional financial planner
·
Personal experience and implementation
of using index funds for retirement investing
CONCERNS AND ISSUES
The portfolio suffers
negative return(s): This
situation will definitively occur several times over the 20 year time
horizon. While the chosen allocation is “conservative” it exposes the
endowment to somewhat more total risk than the current, 100% GNMA bond fund
allocation. The committee examined a similar fund (STAR) and its annual
performance over the last 15 years of available data (see the Compare Funds tab in the spreadsheet). While STAR had two
years of negative returns, its 15 year performance is vastly superior to using
GNMA: starting with a value of $370,000 and using an inflation rate of 2.25%,
if the SCBC endowment had been invested in the STAR fund, it would have been $873,740
after 15 years, while had the endowment been invested exclusively in the GNMA
fund, its value would be only $233,297. Both of these projections include
paying expenses over the period. Of course, results typical of the STAR
fund can not be guaranteed and the recommended portfolio is not likely to
perform quite as well as the STAR fund over a long period of time.
Additionally, forecast results (9% annual return) require that SCBC remain
steady in its investment policy over a sufficiently long period.
If the new portfolio does
have a negative return in a year, how will SCBC pay its bills? In the current operation, the monthly
interest generated by the GNMA fund covers a large portion of the SCBC
expenses. The interest is not reinvested, rather it is
placed into a checking account at a local bank and used to pay the
expenses. When the interest amount is less than the expenses, shares of
the GNMA fund are sold to make up the difference. With the new balanced
portfolio, cash for expenses will also be drawn out of a Vanguard fund,
specifically the Prime Money Market Fund and placed in the local bank account.
At the end of the year, the value of this specific fund will be substantially
reduced and “out of balance”. The Treasurer, as part of the annual
rebalancing of the entire portfolio, “replenishes” the Prime Money Market
Fund. Note: even a bond fund like GNMA fund can have a negative total
return and did in 1994.
How can future SCBC
Treasurers figure out the target allocations? The committee has developed a fairly
simple allocation model, but with 13 funds, calculating the number of shares to
achieve rebalancing can be laborious. The committee has provided within the
supplied spreadsheet the functionality to automatically generate the number of
shares to buy and sell for each fund at literally the push of a button.
In the provided spreadsheet, the rebalancing function is active so that you can
try it out for yourself.
After a year of poor
performance, a new Board might reallocate the portfolio to more conservative
funds or abandon the asset allocation model: The Board must recognize that the recommended investment approach
is a long-term strategy that frees the Board from short-term management of the
investment portfolio. It is based on a significant history of the market, which
has ups and downs when viewed on a short-term basis. The committee strongly
recommends that the Board adopt a motion to maintain the asset allocation in
the portfolio, with changes only for rebalancing, correcting operational issues
and or refining fund selection, for a minimum of five years.
How did the committee arrive
at 9% as the long-term annual return for the recommended portfolio? The model portfolio was entered into a
financial planning tool that Vanguard provides. This tools
uses more than 40 years of market data to do simulations, which are primarily
based on asset class rather than specific funds. The tool projects a 9%
annualized return for this type of portfolio. Vanguard funds similar to the
recommended portfolio were also examined to determine if the 9% was a
reasonable expectation. Here are their “since inception” returns (with the year
of inception):
·
Life Strategy Moderate Growth:
9.81% (1994)
·
Life Strategy Conservative
Growth: 8.80% (1994)
·
STAR: 11.12% (1985)
·
Isn’t investing in equities
risky? Every
investment and every investment policy involves risks, both short-term and
long-term. In addition there are various types of risks. The recommended policy
means the SCBC portfolio can and will lose money in certain years.
However, consider this: due to inflation, currently the Unit’s endowment is
losing money now even though it is invested solely in bonds because the return
is so low. The bond fund is subject to several kinds of risks, including
interest rate risk and redemption risk. In other words, our current investment
policy contains risk, perhaps more than most people realize. The
recommended strategy is said to be one of the best approaches to long-term
investment success. By utilizing broad
diversification across major asset classes, SCBC will be exposed to much less
risk when compared to investing in individual stocks and bonds. The recommended
strategy does not involve investing in individual stocks or bonds; the
recommended portfolio only invests in broad market indexes (with the exception
of the Prime Money Market Fund, the GNMA bond fund and the PRIMECAP Core fund,
which is a highly diversified fund in itself).
Are Directors liable if the
investment strategy do not perform to expectations? It
is highly unlikely, given the portfolio amount, that
any legal action would be brought, unless fraud or gross negligence is found.
The Directors have fiduciary responsibility for managing the club’s finances
and endowment. In other words, not taking any action could also subject the
Directors subject to a suit as could making a considered,
carefully researched, investment decision.
In any case, the D&O insurance fully covers our decision(s) in this
matter.
v1.1
1. Corrected portfolio values after 15 years if invested in STAR versus GNMA. This calculation originally did not set aside 25% of principal for contingency and expenses. STAR still was $640,000 larger than GNMA after 15 years.
2. Removes
PRIMECAP Core fund; adds Small Cap Value Index fund. These changes allow a
purer allocation to the asset classes chosen by the committee and increase the
percentage allocated to Value and small caps, which were under-represented. As
a result, the management fee weighted-average was lowered to .23%.