July 22, 2021

How MCF's Investment Mindset May Differ From Yours (and Why That's a Good Thing)

By Carmen Jeschke

carmen headshot no background

When fundholders establish an endowment at Madison Community Foundation (MCF), they do so because they want to create a permanent legacy; they are investing for future generations. To make this happen for the nearly 1,200 funds we steward, MCF operates under significantly different investment conditions than individual investors.

Time Horizon and Risk Tolerance

Individual investors typically have short- or medium-term investment time horizons – saving for a down payment on a house or building a college savings plan, for example. These goals may be measured in years or decades, and the timing affects an investor’s risk tolerance.

Risk often is seen as a trade-off between earning a higher return and having a lower chance of losing money in a portfolio. When you’re investing for a goal that is more distant (retirement, or college when your children are young), you have more time to make up any losses, which may make you willing to take risks for the potential of higher returns. As you draw closer to needing that money, your willingness to risk losing any of it will naturally diminish.

But MCF’s investment horizon spans hundreds of years. This perpetual time horizon means MCF’s investment manager faces different risk considerations than an individual investor encounters. An endowment’s sensitivity to loss is much lower than that of most individual investors (meaning it has a higher risk tolerance) because the endowment has ample time to make up for any short-term losses which the long-term higher returns taking risks typically provide.

The long horizon of MCF’s endowment also increases the power of compounding in the portfolio. Because interest compounds exponentially, a longer investment horizon can generate more profits than a short-term investment.

Liquidity Needs

As an individual investor, your need for liquidity is generally higher than an endowment’s. Major purchases, income fluctuations, expenses and the desire for emergency reserves are liquidity considerations you may face as an individual investor.

Endowments, on the other hand, typically face fewer liquidity needs. While MCF’s endowment needs to generate enough liquidity to support annual distributions and operations, it can keep a much higher percentage of its assets in investments that are more illiquid, and that typically offer higher returns in exchange.

An endowment’s investment goals – to generate continuous income to support annual distributions, while combating inflation and preserving the real value of the fund’s principal – differ from those of most individual investors, who are more likely to be weighing objectives such as capital appreciation versus preservation and income versus expenses.

In 2020, early in the COVID pandemic, MCF ran a stress test to assess whether the portfolio had sufficient liquidity to meet the projected spending needs. We reviewed outflows, such as distributions, and inflows, including contributions. The test showed that the diversified portfolio had sufficient liquidity to preserve current distribution levels for five years.

Liquidity allows for greater portfolio diversification and protection against performance of the markets in times of economic downturn. Investing in a way that allows you to cover your liquidity needs while staying invested for the longer term is ideal, because, historically, the markets have always rebounded from short-term volatility and rewarded investors who stayed the course.

Asset Allocation

Most individual investors have the bulk of their portfolio invested in stocks and bonds. The closer you draw to your end goal – buying the house, sending the kids to college, retiring – the more you typically shift from stocks (with their higher risk, higher return profile) to bonds (which have a much lower risk profile).

MCF established its first endowment in December 1942 with a $30,000 contribution. At that time, endowments invested primarily in safer assets, such as bonds. Endowments began investing in the stock market in the 1940s, which allowed them the potential for higher growth. Although investment records no longer exist from those early years, MCF’s portfolio most likely followed the same strategy as its peers.

In the 1980s, MCF’s portfolio began to incorporate alternative assets – such as private equity and real estate – and is now able to take advantage of a much broader scope of investments than is applicable for most individual investors.

Currently, MCF allocates approximately 25% of its $220 million diversified portfolio to alternatives, including private capital, venture capital, private real estate and natural resource programs, and diversifying strategies such as hedge fund investments. Our investment management firm, Commonfund, and our Investment Committee have long recognized that emerging assets classes offer better return prospects and that the longer time horizon allows them to take on the greater risk of alternatives. In fact, MCF’s private investments have realized a 7.9% net internal rate of return, which is a 4.8% premium above public markets.

Tax Implications of Investment Decisions

Finally, investors need to consider the tax implications of any investment. Managing income, realizing capital gains, determining whether to buy or sell are factors that require significant tax management for individual investors. But as a tax-exempt organization, MCF doesn’t face the same tax implications on its investments.

Investing to Serve the Community

MCF’s disciplined, steadfast investment mindset allows us to realize the legacy our fundholders intended. It helps us know we are playing a key role in helping the Madison community thrive – today and long into the future.

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