2016 was a peculiar yet interesting year for institutional investors -- index funds outperformed active equity managers; geopolitical factors such as the U.S. election, Brexit and political turbulences in European countries rattled the macroeconomic environment, making investing ever unpredictable and challenging for institutional investors.

In part two of Trusted Insight’s interview with Ana Marshall, chief investment officer of the William and Flora Hewlett Foundation, Marshall discusses these topics, her outlook on return prospect and interest rates, and her strategy to guard Hewlett Foundation’s portfolio against risks and uncertainties.

 

Trusted Insight: In your 2016 interview with us, you mentioned that benchmarks would have a hard time getting more than their 6 percent annual return in the foreseeable future until the U.S. rates start to normalize. Has your perspective changed at all?

Ana Marshall: No. In 2016, the typical 70/30 portfolio returned a bit above 6 percent and that was only after Trump was elected. Once Trump got elected, it was the concept of stimulus, tax cuts, reflation and normalization of rates that got you back up about 8 percent into year end. It's a difficult macro environment to navigate for an active portfolio manager. Last year was a year where index funds beat active equity managers. Even on the fixed income side, it was a really interesting year.

The truth is, 2016 was not a straight-line year. Now rates will start normalizing as the Fed removes accommodation. Rates typically normalize when there's growth, and growth is good for equities. If rates normalize at a pace that's been pre-told to the market, then fixed income won’t do that poorly. It all kind of works out.


Trusted Insight: Currently, what risks are foundation investors facing within that macro environment?

Ana Marshall: I would say that the biggest risks are global reflation and the European elections.

The Trump Effect has just been so strong and quick. It reflects hope for U.S. growth, tax reform and spending. It's as if the market decided they wanted to price it all in at once. The biggest risk is that none of it materializes, leaving corporate profit estimates a tad too high.


Trusted Insight: How are you positioning your portfolio in order to guard against those macroeconomic risks, particularly for the ones that are unexpected?

Ana Marshall: One of the things we do is sharpen our pencils on the impact on the portfolio of a variety of macro scenarios. What parts of our portfolio will be impacted from unexpected rise in inflation, or rise in unexpected inflation more than what's being priced in? What part of our portfolio is growth, what part of our portfolio benefits from nominal growth rising? What parts of our portfolio are more sensitive if the central banks get ahead of conditions? We try to figure out this period of change and where the sensitivity lies in our portfolio.




Idiosyncratic risk among emerging market countries is higher than it has been in a long time.

Trusted Insight: What is your expectation for the potential interest rate rise in June? Are you fairly optimistic?

Ana Marshall: It’s funny that we now talk in terms of optimism about rising rates. I do believe that rates will be raised. I believe that there's at least two to three times this year. I think they want to see if the first one has any impact at all. The Fed raised in march and likely two more times in the fall.


Trusted Insight: Why has it been an interesting year for fixed income?

Ana Marshall: Overall, fixed income had quite a volatile year -- very similar to equities -- where they had a big disruption in the credit side in Q1 2016. Since then, there has been a compression in risk spreads in the credit side up until the election. After the election, we've had further compression. The credit market did very well last year, but it wasn't because there was a huge change in yields. Instead, the strong returns were due to a reduction in the risk premium as investors believed that there would not be a recession. The election took recession as a left tail risk off the table, so that's what got priced into the market.


Trusted Insight: Is that within private credit?

Ana Marshall: Both, private credit and public credit. Both the high yield and the private credit market. In 2016, credit outperformed equities.


Trusted Insight: In what areas do you expect to see continued growth?

Ana Marshall: It's hard to see returns in 2017 from further risk compression in credit. That said, I don't envision a sell-off in credit. Credit has the advantage of compounding cash flows at a single-digit rate of return. Equity upside is possible underpinned by improving fundamentals.


Trusted Insight: Are there other assets that you think are overvalued?

Ana Marshall: No. I actually don't see huge over valuations anywhere. I don't see huge under valuations anywhere. Things are trading more or less at full value across every asset class. We struggle to find any place in the portfolio where we say, "Wow, this is a really good deal.”


Trusted Insight: Currently, what's your impression of emerging markets, considering there’s been some volatility around that?

Ana Marshall: It's interesting because emerging markets have done well so far this year. They did well at the tail end of last year. The belief was that some global growth will come back and that you have this super leverage trade on improved global growth. It's been very specific though. Idiosyncratic risk among emerging market countries is higher than it has been in a long time. Many individuals or chief investment officers don't have global emerging market mandates, and so they basically choose the countries. Picking the right countries is more important now.

If you were in Brazil or Hong Kong, you might have done fine. If you were in Mexico or Egypt, you might have done less well. I think it's going to be an interesting thing to watch people's emerging market performance relative to the benchmark in a year where active managers had a hard time beating benchmarks anyway. Your country selection in emerging markets probably had more idiosyncratic risk than ever.


Trusted Insight: We recently interviewed the CIO of a major university endowment who was fervently against the idea of benchmarking foundations. Do you agree with that?

 

Ana Marshall: Well, you can be fervently against benchmarking. The only way that a board of a foundation from a fiduciary position knows if assets are being taken care of is if they have a way to measure. Some boards want to measure the investment team skills at asset allocation or the skills in manager selection, and some want to measure both. Many feel they need to measure the return of the foundation against what they could go get at Vanguard with a very low cost index option of 70/30. From a fiduciary perspective, I don't see how a board member doesn't ask for it. I'm on four boards, and I ask for it.

The one area that I do not agree with is using peer benchmarks where the board holds the portfolio return up against other endowments and foundations. The reality is that every portfolio is run with a different risk tolerance that is appropriate only to the institution and that has been agreed upon by the board and the CIO. Just comparing return numbers on the surface fails to capture many other factors.

(Click here to read part one of Ana Marshall's interview.)