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THE AGE OF ENDOWMENT A GUIDE TO ENDOWMENT-STYLE INVESTING BY COOPER INVESTORSMARCH 2022
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3When I rst discovered the Cooper Investors (CI) Endowment funds through Peter, I was really excited given my professional experience of endowment model investing. I spent decades working in the family oce sector, predominantly for two large US entrepreneurs’ family oces, where I discovered the power and simplicity of the approach when applied in a disciplined manner.The approach is ideal for asset owners seeking to take a multi-generational approach to their capital, or corpus. Over a period of many decades (including during periods of easy money and periods before easy money) it has proven to be powerful, durable and consistent in its deliverables, despite what shorter term commentators and market participants selling fear and greed may say.During periods of severe market drawdown, such as we saw in 2008/2009 when markets were down -55% at the lowest point, an endowment model* portfolio was -36%. When we experienced the pandemic induced March 2020 drawdown, Q1 2020 MSCI ACWI performance was -21% and the endowment portfolio was -12%.What about upside capture though?Over the last 30 years to Feb 2022, utilising this model1 one would only have given up 700 bps of performance versus the MSCI ACWI. On the downside, your largest drawdown would have been -34% versus the ACWI’s -55%. The essence of this model is about the prevention of the number one danger to the asset owner - permanent loss of capital or wealth. Once it’s gone its gone! Subscribing to the endowment approach can mean the dierence between signicant permanent loss of capital and mark-to-market drawdowns only. Secondly, it’s about maintaining the purchasing power of the portfolio over the long term with the ability to pay regular dividends to stakeholders.Also very important with this valuation driven model is of course, diversication and the ability to rebalance.By way of evidence I can draw attention to one of the family oces I worked for that subscribed to this model. When established for a US technology entrepreneur the AUM totalled $400mm, after 20 years of disciplined investing globally the AUM had grown to $18 Bln. More signicant than the growth was the avoidance of permanent loss of capital a result of severe market drawdowns. Permanent loss of capital would have destroyed the ability to generate such a return after two decades of investment. I commend this White Paper and congratulate Chris, Ryan, Peter and the CI Team for bringing publicity to this eective model and approach in a world full of short-termism, conicts of interest and emotional investing. Dillon B. HaleCEO Peninsula CapitalFOREWORD“Life is like riding a bicycle. To keep your balance, you must keep moving.” – Albert Einstein1 using as proxy global 60/40
THE AGE OF ENDOWMENTIn Douglas Adams’ comedic series ‘A Hitchhiker’s Guide to the Galaxy’ the answer to the ‘Ultimate Question of Life, the Universe and Everything’ is famously revealed to be the number 42. As professional investors both entering 2022 at the age of 42 – and contemplating the myriad of challenges markets and our clients face – we nd ourselves longing for that nirvana of enlightenment promised in Adams’ classic satire. We consider ourselves fortunate at 42 to have been alive and investing in markets long enough to see meaningful bouts of volatility and signicant periods of change, despite us still being in what we would consider the early journey of our investment lives. Capital markets appear poised on the cusp of several momentous inection points. As portfolio managers of the Cooper Investors Endowment and Global Endowment Funds, some cosmic insights on how the future plays out would be highly appreciated. We have worked through three signicant stock market crashes – the 2001/02 Tech Crunch, the 2008/09 Global Financial Crisis and the COVID-19 Crash of 2020. These three periods have provided a lifetime of lessons and inuenced the way we think about risk and volatility, euphoria and disillusionment, patience and dislocation. While we are frequently reminded that we have not yet invested through a period of rising interest rates, we think these three periods still provide a rich set of lessons. INTRODUCTIONCrises are the best learning experiences. The current Russia/Ukraine conict combined with a commodity squeeze and oil spike is a case in point, bringing to mind the 1970’s energy crisis and the classic Mark Twain quote, ‘History doesn’t repeat itself, but it often rhymes.’More signicantly, we are of the generation that has grown up in the internet age and digitisation of the world. We are old enough to remember when there were no smartphones, yet young enough to have adopted these and other new technologies and integrated them into our daily lives, our mental models and the way we think about investing. Our role in managing CI’s Endowment-style portfolios is designed to excel in providing risk managed participation in rising markets while providing strong protection in falling markets. It is perhaps, ideally suited to investors of our vintage who have witnessed both carnage and exuberance several times over. AN IDEAL AGE
5We have selected the elegant, circular precision of kinetic art by Collectif Scale as the theme of this paper and our Endowment Funds. Perpetual in nature and backed by complex engineering, this art form invokes strength in movement, like a tree in a storm that bends but does not break. We chose it because it signies the constant balance between the art and science of investing and represents a lasting tribute to the power of endowment-style investing.
THE AGE OF ENDOWMENTWhat does Endowment-style mean to us at Cooper Investors (CI)? First, we are only too aware that we are standing on the shoulders of giants and have borrowed from Nobel Laureate Harry Markowitz, as well as the late David Swensen’s legendary Yale model of Endowment portfolio construction. From Markowitz – who also was 42 years old when he became CEO of the successful hedge fund Arbitrage Management and introduced the world to computerised arbitrage trading – we have borrowed his “60/40” proposition, a diversication strategy of allocating 60% of assets to stocks and 40% to bonds. The appeal of this 60/40 risk framework is its simplicity, but deep consideration is given to the structure of such Endowment funds. We aim for roughly 60% of our portfolio to be invested in equities that can compound away but will likely have moderate to higher correlation with markets. The other 40% is invested in markedly alternative types of listed businesses, where correlations of earnings (and share price) are low-to-negligible with typical market movements. This mindful portfolio construction positions us to meet investment objectives of diversication and long-term performance and allows the portfolio to outperform the majority of market downturns. It is incredibly exciting for us to take these philosophies and infuse them with the CI Way of Investing, a proven money management system for listed equities that has helped shape us into the investors we are today. We aspire to combine this wisdom with the experience of investing in a changing world and thus approach investment opportunities with an optimistic eye on the future while keeping the other battle-scarred eye on the lessons of the past.The CI Way represents both the rm’s values and capital allocation model. It is a culture, a way of doing business and a standardised and integrated investment philosophy. Before we delve into how we apply the CI Way to Endowment-style investing, let us rst discuss the problem, as it is important to understand the ‘why’ before the ‘how.’ The idea of Endowment-style portfolios was born as the solution to a dilemma under the 60/40 framework that we see facing a large and growing subset of clients today. These clients may be charities, educational or healthcare endowments, trusts, foundations or family oces.These clients typically have a xed corpus where the emphasis is on Protect and Grow. The corpus may be a result of historic donations, a liquidation event such as a business sale, or a large one-o bequest. There may be regular drawdowns such as annual scholarships and grants, or it may be as simple as a superannuation fund in decumulation. Generally, the common factor is that there are no regular incoming contributions or accumulation phase. As such, Protect is important as there are unlikely to be new inows of capital that can compensate during large market drawdowns and enable ‘investing at the lows.’ Equally, Grow is important since the corpus should, net of distributions, grow its size faster than the prevailing rate of ination. So, the objectives of Protect (which implies minimal risk taking) and Grow (which requires higher risk for the seeking of return) are fundamentally in conict. Historically many clients, or at least the ones who are large and sophisticated enough to outsource to speciality-focused asset managers, typically opted for the traditional 60/40 framework portfolio, getting their growth exposure from the ‘60’ and their protection (plus hopefully some healthy yield income) from the ‘40’. In today’s investment terms, this creates a problem but one that we believe can be resolved through considered portfolio construction and by using CI’s proven money management system. PROTECT AND GROW
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9Traditionally in a 60/40 asset allocation framework, the Protect component is directed toward xed income assets such as corporate and sovereign bonds, term deposits and cash, while the Grow component is invested in listed and private equity, along with other risk assets including infrastructure and alternative assets such as hedge funds and commodities. First, let’s consider the Protect component. We are at a time where asset markets face signicant challenges. Interest rates are beginning to rise having fallen obstinately for 30 years. Ination is spiking after long periods of easy money that stimulated consumer demand against a backdrop of pandemic-driven supply constraints. It seems improbable that bonds will generate the returns of the last three decades – capital gains require yields (already zero or sub-zero in many jurisdictions) to continue falling, while the income component from coupon payments is so low as to be almost irrelevant for most client needs. And what of its defensive nature? Part of the reason for including a bond component is its negative correlation with equities. Indeed, a whole generation of investors (as well as computer algorithmic trading models) have been conditioned and programmed to believe that when stocks fall, bond prices rise. But what if, as we are seeing more and more today, stocks and bonds both fall at the same time? The 60/40 framework no longer works in a world where bonds and equities may in fact become positively correlated. This is what happens when stock markets sell ROCKY ROAD AHEADo at the same time bond yields are rising. In terms of the Grow component, listed equity markets appear expensive relative to history while private equity has been basking in a period of easy money, enjoying an inow of funds faster than they can be deployed. Due diligence periods are reducing and we have seen recent stories of PE rms no longer competing over the best returning deals but rather who can be quickest to get most deals signed. Quantity has replaced quality.In 2021 market manias seemed to grow monthly – SPACS, meme stocks, cryptocurrencies, NFTs and companies oating with $100bn market caps that were “pre-revenue”. To paraphrase a recent interview with Charlie Munger, ‘selling people things that are good for them’ seems to be almost out of fashion these days. Meanwhile, volatility and drawdowns are happening more frequently and severely. Holding periods are at historic lows as ‘high frequency traders’ battle each other for millisecond advantages, all during a period where the dominance of low-cost passive investing has inevitably increased correlations across industries and asset classes. The overall picture is one of bad behaviour being rewarded, due diligence being tossed aside, capital being sprayed around with little regard for risk while nancial market scrutiny and regulators struggle to keep up with the game.
THE AGE OF ENDOWMENTThis is where clients nd themselves at a juncture in the market, rightfully concerned with how the shape of risk and return in their portfolios will look in this environment. If the trials of markets are not enough, clients are facing other critical challenges and secular trends that are quite unique to them and require specialist insight and understanding. So, Cooper Investors Endowment Funds are specialist equities funds, crafted through the application of the CI Way of investing through two main elements; portfolio construction and stock selection.Portfolio construction places high emphasis on diversication across country, sector, size and ownership structure. We practice a rigorous stock selection process with a list of characteristics we look for in each stock. These businesses require a long track record of successful wealth creation with a long-standing and high-achieving CEO, clean and strong nancial statements and a focus on sustainability and responsible investing. These are businesses that practice “doing well by doing good.” The role of philanthropy has an increasing part to play in the structure and distribution considerations of this client base. Australia’s charitable sector is an essential social and economic engine, employing one in ten with an economic contribution equivalent to 8.5% of GDP.According to the most recent ocial Australian Charities Report, pre-COVID-19, assets in this sector grew by $30bn in 2019 to $354bn as compared to the previous year, with charity revenue growing approximately 7%, more than three times the rate of growth of the Australian economy. The last few years of bushres and COVID-19 have hit this sector hard – volunteer numbers have dropped by 200,000 while paid employee expenses continue to grow. To ensure this essential sector is able to continue to play a strong role in Australia’s future for the long-term, it is vital for charities to have access to t-for-purpose investment support to protect and grow their precious capital and assets, while beneting all Australians. For family oces, intergenerational wealth transfer and succession planning around key investment decision-making roles increasingly become a part of the conversation. It is estimated that approximately $3.5tn worth of wealth transfer will occur in Australia over the next two to three decades, the biggest wealth transfer in our country’s history. Globally, this gure is expected to exceed $100tn. While the next generations of millennials, Gen Z and beyond, will need to grapple with the duciary challenges of ensuring an appropriate risk and return balance on the capital they’ll be stewarding, there is another key issue. Younger generations often have a dierent view on how things should be done. Priorities around ‘responsible investing’ are rising, with millennials twice as likely as other investors to seek out socially responsible investment products. But as capital pours into ‘ESG’ assets and ‘clean’ investment strategies, will the prices paid and value propositions on oer be capable of generating the returns enjoyed in the past and required for the future? While many of these challenges facing charities, family oces and other non-institutional clients are not new, they are becoming more acute at a time when equity markets have been irting with all-time high valuations while interest rates and ination are rising after a sustained period at benign levels. BETWEEN A ROCK AND A HARD PLACE
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13PROGRESSIVE THINKING FOR THE NEXT CYCLECI manages client assets in our Endowment-style strategies and understands how to eectively position listed equity portfolios to assist in the required shape of our clients’ risk and return appetite (a shape that we describe as ‘the Smoother Journey’). We also understand how Endowment-style equity portfolios aid our clients in solving their unique challenges. At CI, we asked ourselves, ‘what should an entirely listed Endowment-style portfolio look like within the tried and tested investment approach of the CI Way?’ It is a specialty portfolio that combines the ideas of volatility, diversication, correlation and 60/40 framework that won Markowitz a Nobel prize in 1990 and led David Swensen to be called the ‘father of the modern Endowment model’. In a world where bonds yield next to nothing, and top-of-cycle behaviour is everywhere you look in capital markets, we believe that Endowment-style investing is the ideal equity exposure for clients with a long-term horizon that require both capital growth, growing income, and an eye towards responsible investing, while having a lower appetite for downside risk and volatility than an accumulation phase investor. Our Endowment-style investing approach is about running long-only equities portfolios that target a consistent and stable return prole. What sets our Endowment Funds apart from our peers is that we oer greater downside protection and aim for a reduced downside participation of the market between 65% to 75% while aiming for relative volatility of 80% to 85% of the market. We like to keep up with steadily rising markets and grow income over the long term.As we celebrate the 20th anniversary of CI and the Endowment and Global Endowment Funds recording their 8th and 5th year respectively, we want to share with our new and existing clients the features of our Endowment-style strategies: a re-imagining of the 60/40 portfolio framework using publically listed assets in a highly diversied Endowment-style capital allocation that represents a more conservative risk-adjusted equity exposure for suitable clients. This White Paper aims to describe our discussions with clients and make some observations and conclusions around the Portfolio Construction and Stock Selection considerations we apply in managing our Endowment-style funds. We consider the craft to be a mix of Art and Science, so while this is not intended to be an academic research paper the subject matter necessitates that we share some of the quantitative results of our research, as well as qualitative observations.We look forward to discussing the Endowment-style of investing with you in the coming months and years – for those who have perpetual timelines have a long time to continue this conversation.
THE AGE OF ENDOWMENTDO WELL BY DOING GOODEthics should not be separated from investment decisions. A ’whole of life’ approach to decision making is good business practice, so we invest in companies that focus on long term and sustainable value creation for shareholders and clearly stated operational and strategic goals.Cooper Investors is a values-rst rm where our investment philosophy and processes sit within the crucible of the CI cultural values system. Our values include Gratitude, Humility, Intentionality, Curiosity, and Being Present or ‘in the moment.’ We refer to our cultural values and the investment process as the CI Way. “At CI we invest on behalf of over 4 million Australians from all walks of life and all manner of employment and industry. This includes trustees and beneciaries of superannuation funds, churches, charities, and foundations. The sole reason we exist is to invest wisely for them all.” – Peter CooperTHE AGE OF ENDOWMENTThis is reected across our Endowment-style funds through the execution of our proven strategy designed to “do well by doing good.” We proudly allocate a percentage of revenue from the Endowment Funds to support the CI Philanthropy Program each year. As a 100% employee-owned rm, we strongly believe that with success comes responsibility and this concept is embedded within our company DNA.
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THE AGE OF ENDOWMENTENDOWMENT INTERVIEW SERIESGiven the backdrop for markets discussed above, we sought discussion with our clients and industry stakeholders to better understand how they see the current environment and think about their own investment portfolios. In our view, there are no better insights to be gleaned than from people working directly at the coal face.THE AGE OF ENDOWMENT
17We were also looking to road-test our proposition that Endowment-style investing performs to help ease challenges. In particular, whether investors with a genuine long-term investment horizon value a conservative, listed-equities portfolio that aims to provide steady compounding returns with a focus on downside protection and lower volatility.We were curious to explore how asset stewards balance the tension between requirement for capital growth and preservation with the need for income. We also wanted to discuss the rapidly emerging area of Responsible Investing within the context of the organisational mission and therefore the investment portfolio.By the end of November 2021, we had interviewed more than 60 leaders across Australia’s charitable and philanthropic sectors, including a selected number of family oces, asset consultants, retirement experts and nancial advisors specialising in charitable investing. We held one-on-one discussions with decision-makers in these organisations to gather insights and feedback into their perspectives of investing in the current market environment.This group is highly heterogeneous with each organisation having their own unique mission and set of objectives. As we came to learn in the charitable sector, “when you have met one, you have met only one.”But this suited us well as we were seeking a broad range of views in order to help us better understand the needs of the sector, insights from which we discuss below.17
THE AGE OF ENDOWMENTDIVIDEND YIELD VERSUS CAPITAL GROWTHSUSTAINABILITYDetermining the right balance between dividend yield and capital growth has been dicult. We found there are varying levels of importance placed on dividend yield as a source of total return, depending at least in part on an organisation’s legal status and whether they can access capital for funding.Perpetual Charitable Trusts can only use dividend income to fund operations or granting and are unable to distribute capital, placing a greater emphasis on dividend yield. In comparison, Private Ancillary Funds (PAFs) are able to distribute capital as well as dividends to meet their cash ow commitments, which led to a much higher focus on total return.It is clear there is a deep need for yield with income being important to the majority of the organisations we spoke to.Yield alone is not a primary aim for our Endowment funds, as high dividends can sometimes be associated with unsustainable capital structures or a nancially engineered yield. We prefer to own stocks where dividends are expected to rise over time driven by the fundamentals of the cash ow being generated by the business – although this may come at the cost of lower initial yield.The search for income is very real in a world enduring low interest rates where term deposits and xed income earn next to nothing, share prices are high (therefore oering lower yields) and rental yields from commercial property are also at, or near, historical lows.Many charities just want secure cash ow to provide reliable income to fund their operations, with capital growth a secondary consideration. An investment portfolio that can provide a resilient and growing stream of untied funding can be highly valuable (“like gold” as one trustee put it) to a charity, particularly as it relates to helping nance and advance their charitable missions.Responsible Investing is a polarising topic presenting us with a wide variety of views, but our observation is that it is becoming increasingly important, in particular for the next generation of philanthropists who tend to place more emphasis on socially responsible investments. In families, it is the sons and daughters of the original wealth generators who tended to care more about this than their parents.Some organisations appreciate having a sustainability overlay but were primarily concerned with performance and returns from their investment portfolio. Others had very strict expectations around what passed muster, quite often tied to causes they were funding and supporting (e.g., an organisation addressing gambling addiction would not countenance investments in casinos, poker machines or wagering).There is also a sharper focus on environmental issues, particularly as it relates to fossil fuels (e.g., coal or oil and gas exploration). However not everyone we interviewed believed fossil fuel investments should be excluded from an investable universe.ESG is important to organisations with a high media prole concerned with managing reputational risk, whereas for trustees it is critical to get policies and actions right so as not to compromise the organisation’s mission or credibility.Our thinking at CI more broadly has been to look beyond simplistic negative screens (e.g., no gambling, tobacco or weapons) and be more purposeful when investing with companies that will be sustainable over the long-term and engage constructively with investors on these important matters.We seek to invest in companies that we think can ‘do well by doing good’ and avoid businesses that have poor or deteriorating responsible investing credentials. In our view, this aligns well with our values and also those more broadly of the sector. Signicantly, this is also an important part of delivering sustainable returns. No-one has the complete answer yet – everyone is on a journey when it comes to Responsible Investing.
19Endowment-style investing using publicly listed equities resonates well with those we interviewed.An investment portfolio that would only experience 65% to 75% of market downside over time but capture 80% to 90% of the upside was broadly considered appealing, particularly if it could also grow income over time at a rate greater than ination (to preserve purchasing/spending power), as well as deliver a less volatile investment portfolio.The ‘60/40’ risk framework (discussed in more detail below), underpinning our Endowment-style portfolio construction, was also considered to be a novel approach to asset allocation and diversication.Most interest was in how the ‘40’ could deliver downside protection, particularly where this can be supported by evidence of a track record of outperformance during signicant market drawdowns.The idea of ‘the Smoother Journey’ appealed to those with a long-term mindset, that is, thinking years and decades ahead, not just about the next month’s or quarter’s returns. A conservative equities portfolio that can steadily compound wealth over time is valuable to organisations looking to protect and grow their precious pool of capital.CAN ENDOWMENT-STYLE INVESTING HELP?We only have to look at the tragic impact of the COVID-19 pandemic which hit the charitable sector hard. The economic downturn means that much-needed funding is hard to nd at the time when charities and social services are being relied upon more than ever.As noted in our inaugural ‘Cooper Investors Philanthropy Impact Report 2021’, the pandemic placed signicant pressure on the not-for-prot sector and our social services, highlighting the importance of having a stable and well-funded charitable sector.No doubt this will continue to be important as society faces the ongoing nancial and mental health burdens arising from the pandemic. But further than this, we believe that charity and philanthropy are part of the solution for many of those challenges.To help power the important work and change that the sector can deliver, these organisations need both reliable and growing funding – to secure the corpus both now and for the future. We believe our Endowment-style investing could be part of the solution, to help organisations deliver on their mission in an increasingly complex and volatile environment.
THE AGE OF ENDOWMENTBe less volatile than the marketProvide a growing distributionPerform better in down marketsGenerally keep up in rising markets
21Current market dynamics present an environment where Endowment-style strategies may be suitable for investors seeking a conservative equities portfolio that can help to protect and grow their precious corpus as well as providing a growing income stream over time.We believe those with a genuine long-term horizon should have an equity component in their investment portfolio to provide growth in both capital and income, in order to preserve purchasing power and oset the ravages of ination (a silent tax on investors).Organisations with a largely xed corpus have limited ability to recover from market drawdowns and invest additional capital at market lows. Therefore, they are likely to have less tolerance for downside participation and volatility in capital and income. With these beliefs in mind, together with our aim of delivering steady compounding returns, we have four other explicit portfolio objectives, which are:• Be less volatile than the market• Perform better in down markets• Generally keep up in rising markets• Provide a growing distribution21CI ENDOWMENT APPROACHBy achieving these objectives, we believe we can deliver market returns with lower volatility and better downside protection over time.While it goes against traditional nance theory, since their inception our Domestic and Global Endowment strategies (now running for eight and ve years, respectively) have both been able to achieve long-term returns better than the market with lower risk.Our Endowment-style investing has worked and our objectives can provide long-term returns that are consistent with our active investment management, which aims to avoid capital wipe-out and ensure a ‘Smoother Journey’ for our investors who are either in a decumulation phase or rely heavily on existing capital to deliver their mission where additional income sources aren’t an option.WE CAN HELP
THE AGE OF ENDOWMENTEquities are an essential part of Endowment-style investing. History shows that equities can compound a xed corpus meaningfully over time, as well as preserving and growing spending power through growing dividends. The long-run advantages of equities become readily apparent when you look at the cumulative returns over the long-term. The chart below shows over a century of asset class returns, and since 1900 equities have compounded at nearly 7% a year, triple the rate of bonds albeit with higher volatility. Equities give us a claim on a real stream of income which provides some protection against ination. More importantly, equities represent ownership of real businesses which are linked to human endeavour. Genuine wealth creation and ourishing human prosperity is driven by innovation and entrepreneurship, not government stipends and interest receipts.A portfolio that invests primarily in xed income assets at today’s low interest rates is unlikely to keep up with ination. To make matters worse, any increase in interest rates will negatively impact the capital value of bonds. If bond coupons don’t keep up with ination, trustees may have to eat into their corpus to fund operating expenses or grant commitments. This can result in the exact outcome organisations want to avoid – low or falling income as well as capital impairment – and ultimately not being able to deliver on their important missions.This reinforces why we think the goal for a conservative equities portfolio should be to grow income, at least at the rate of ination, and steadily grow the principal capital pool.Now, it is important to be clear – these are long-only listed equity portfolios, not market neutral or absolute return funds. If markets fall it would be misleading to suggest the Endowment-style portfolios won’t also see negative returns for a time but what we’re trying to avoid is massive drawdowns that lead to permanent impairment of capital (i.e., ‘the blow up’). Ultimately, our Endowment-style investing approach is about running simple, long-only equities portfolios that target a consistent and stable return prole.Source: Elroy Dimson, Paul Marsh & Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002 & Credit Suisse (Chart Illustrative)Figure 1 Cumulative Returns on US Assets, 1900-2020 (real terms)10,0001,00010010101900 6020 8040 200010 7030 9050 10 20EQUITIES ARE ESSENTIAL FOR ENDOWMENT-STYLE INVESTINGTHE AGE OF ENDOWMENTEquities 6.6% per yearBonds 2.1% per year
23We think downside protection is one of the most powerful arguments for Endowment-style investing. The relationship of downside versus upside becomes very important when compounding returns over long periods of time. In simple terms, the less you fall the less you will have to recover to get back to square one.The chart below shows that market drawdowns occur regularly. The red bars represent the largest declines from a peak (high) to a trough (low) that occurred each year. The blue bars represent the calendar year total returns for the S&P 500. Over the last 30 years of the US stock market, most years provide positive returns with only a few really bad years. That is until you realise that in most of these years you had to endure a signicant drawdown, in many cases at least 10%.Take 2020 as an example. Over the 12 months to 31 December, the S&P 500 returned 16%, but along the way investors had to endure a 34% drawdown. COVID-19 induced the fastest bear market in history but an unprecedented government and central bank stimulus meant this was followed by the fastest share market recovery on record. To earn the full return in 2020, investors needed the resilience to stay fully invested during these periods of gut-wrenching market turbulence.Accepting that market drawdowns occur regularly, as the magnitude of the drawdown increases the required recovery increases exponentially. Losses are asymmetric – a stock that halves needs to double to recover its losses (see chart).Figure 2 S&P 500 Largest Intra-year Drawdown vs Year-End Total Returns (1 January 1980 to 31 December 2021)Figure 3 The Maths of Drawdowns11%26%-17%1980-10%-18%198115%-17%198217%-7%19831%-13%198426%-8%198515%-9%19862%-34%198712%-8%198827%-8%1989-3%-19%199030%-6%19918%-6%199210%-5%19931%-8%199438%-3%199523%-7%199633%-11%199729%-19%199821%-12%1999-9%-17%2000-12%-29%2001-22%-33%200229%-14%200311%-7%20045%-7%200516%-7%20065%-10%2007-37%-48%200826%-27%200915%-16%20102%-19%201116%-10%201232%-6%201314%-7%20141%-12%201512%-10%201622%-3%2017-4%-19%201831%-7%201916%-34%202027%-5%202125%43%150%67%233%100%400%900%LossLargest DrawdownGain needed to recoup lossAnnual Total Returns-10%-20%-30%-60%-40%-70%-50%-80%-90%Source: Morningstar, FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Data are as of 20 November 2020. Drawdown refers to the largest market drops from a peak to trough during year.WHY DOWNSIDE PROTECTION MATTERS
THE AGE OF ENDOWMENTOne of our Fund’s core objectives is to exhibit lower volatility than the market. Put simply, this means that our portfolios should be less volatile than the benchmark as measured by the standard deviation of returns. We would also expect that typically when the market falls, the portfolio falls less than the market.Volatility is a normal part of investing and it is important for long-term investors to persevere through the inevitable bouts. However, in recent years periods of heightened volatility have become increasingly normal in an environment marked by rapid market swings.Figure 4 shows that there have been 56 volatility shocks since the 2008 global nancial crisis, dened as when the VIX Indexi increased more than ve points in a day. In the seven previous years (largely due to the bursting of the Tech Bubble) that only happened ve times.Whether this is because equities are becoming more sensitive to changes in interest rates and economic growth, or are at the mercy of computer trading programs that can dump huge volumes in short order is unclear. The fact is investors are navigating volatility more frequently and for extended periods.Severe volatility can be highly disconcerting for investors. After all, when equities markets fall, as they often do, the timing of this fall can have a major impact on both nancial and psychological wellbeing. Well established research by Kahneman and Tversky (1979, 1992) shows that people prefer avoiding losses more than twice as much as realising equivalent gains.Therefore many charities and foundations are likely to have a relatively lower tolerance for volatility, which is challenging where equities represent a signicant portion of assets. While we want equities for both growth and income, stock markets are inherently volatile, at least in the short-term and drawdowns occur regularly.Hence, we think a portfolio that is less volatile than the market is a highly desirable attribute for retirees as well as charities and foundations, that is, investors seeking equities exposure but also wanting a smoother investment journey with less nancial and emotional stress.Figure 4 Daily Point Increase1 in the VIXFigure 5 Volatility (standard deviation) during down and up markets1.231990-20001.342000-20101.57Volatility (standard deviation) during Down and Up Markets2010-2020Volatility in Down Markets14% 22% 17%Volatility in Up Markets11% 16% 11%Down/Up Volatility Ratio1.23 1.34 1.571 Volatility increases are represented by an increase in the VIX daily, as at 15-Apr-20.2 Volatility shocks are any increase in the VIX daily greater than 5 points.Source: Northern Trust Asset Management, Bloomberg, FactSet, Russell 1000 Indexi The VIX refers to the CBOE Volatility Index, which is a real-time index representing the market’s expectations for volatility of the coming 30 days.200030252015105020012002200320042005200620072008200920102011201220132014201520162017201820192020VOLATILITY IS NORMAL
25There are three main tools that we apply to Endowment-style portfolios: Portfolio Construction, Risk Framework and Stock Selection.Portfolio ConstructionOur portfolio is constructed with the intention to be as diversied as possible. Diversication can be an over-used term, so what we’re really aiming for is uncorrelated sources of risk and return.In the book ‘Principles’, Ray Dalio describes diversifying with 15 to 20 good, uncorrelated return streams as the ‘Holy Grail of Investing’.Dalio’s scope includes other asset classes – bonds, gold, real estate, art, collectibles, etc. With public equities, achieving genuine diversication is more dicult than it sounds. With a high degree of indexing prevalent across equity markets today, combined with globalised nancialisaton and the interconnectedness of economies, correlations of equities are higher than in the past. However, a good degree of diversication can be achieved with equities by thinking beyond the traditional narrow denitions of diversication (e.g., country and sector) to include further categories. For example:• Size – indexation, passive and high-frequency trading have all led to increased correlations between larger stocks. Owning some smaller-and-medium-sized businesses can oset this.• Ownership Structure – stocks with high degrees of index ownership tend to be more volatile and correlated. Stocks with tight registers, large insider ownership, family and founder owned, or with lower turnover mutual fund ownership (described by Larry Cunningham as ‘Quality Shareholders’) tend to be less volatile and move dierently.• Investment Proposition – At CI, we utilise a classication system of stocks called ‘Subsets of Value.’ A detailed explanation of methodology is beyond the scope of this paper, but suce to say we tend to see Stalwarts, Growth and Cyclicals (to name three of the subsets) moving dierently during dierent points in the cycle. Equally, Low Risk Turnarounds, while adding volatility, can add signicant uncorrelated diversication.• Asset Class – While the Fund only invests in listed equities, we can still get access to a variety of what are essentially alternative underlying asset classes with uncorrelated sources of return via listed structures. REITs and listed infrastructure are obvious examples that have become more widely investable of late, although investors must be wary of management incentives and debt levels. Perhaps a more interesting example is royalty companies which provide a stream of future earnings linked to stakes in real world annuity assets such as gold, pharmaceuticals or music rights. Our analysis shows that these assets have signicantly lower correlation to equities, below 0.2 for example in the case of Franco-Nevada, a Canadian-listed gold royalty company. Another example would be listed investment companies – particularly those linked to families with long track records of savvy capital allocation. Ideally these vehicles (quite prevalent in Europe) can be invested in at a discount to NAV, giving the investor gains from both the NAV growth and the latent option of possible discount compression over time.Example – Latour ABIdeally, some positions tick multiple diversication boxes at once. Latour AB is a listed holding company headquartered in Sweden and represents the investment and ownership interests of the billionaire Douglas family. It was owned by the Global Endowment Fund and hit all four of the above attributes.Subset of Value: Asset playLatour ABSize: <US$10bn McapAsset Class: Listed investment companyOwnership: 75% family ownedHOW DO WE ACHIEVE THE OBJECTIVES?
THE AGE OF ENDOWMENTTo conclude, all positions invested in the Endowment-style portfolios go through a rigorous correlation analysis. We ask the question, ‘How correlated are they to each other, their peers, their main index, and existing positions held in the portfolio?’ as well as ‘Will the new investment increase or decrease the overall diversication in the portfolio?.’ This discipline helps minimise areas of correlation growing unnoticed in the portfolios that can represent hidden fault lines in future that can be cracked open during periods of volatility when overall levels of market correlation tend to rise.Risk FrameworkWith diversication taking care of the objective of reducing volatility, the major aims of Protect (i.e., reduced downside capture) and Grow (generally keeping up in rising markets) can be addressed. There are some stocks we observe that typically tend to outperform in down markets, and some that outperform in rising markets (there are the rare gems that do both, but that can take longer periods to observe). However, these relationships do not always hold. The membership of each group can change over time and of course can depend on the major narratives driving the market move – for example a ‘bond-like equity’ such as a utility or infrastructure asset can outperform if the market is falling due to fears of a slowing economy. But if the market is falling in tandem with rising bond yields (and thus a rising discount rate reducing equity multiples), bond-like equities can fall in sympathy as a ‘long-duration’ asset. Sometimes bifurcation of performance can occur within a category. During the COVID-19 pandemic, infrastructure stocks linked to mobility (toll-roads, airports) dropped precipitously, while those infrastructure stocks linked to daily life (water, logistics, internet access) outperformed. With all of this considered, we allocate into two broad capital pools in the Endowment-style portfolios, and as mentioned in the introduction, we give a nod to Markowitz by borrowing his nomenclature of “60” and “40”.We expect stocks in the “60” portion of the portfolios to drive the portfolio forward in a rising market. There will be more growth equities in here with the expectation that upside capture and downside capture will be skewed higher. The “60” portion invests more in the Stalwarts, Cyclicals and Growth Subsets of Value with typically higher co-ownership with other CI equity funds.Conversely, stocks in the “40” portion of the portfolio do the heavy lifting in terms of downside protection, reduced volatility, and uncorrelated sources of return. The “40” targets idiosyncratic risk and the majority of its investments are not owned in any other CI portfolios. It is in the “40” where the royalty companies, listed infrastructure, family-linked investment companies and niche Japanese businesses can be found.As noted in the introduction, the appeal of the 60/40 risk framework is its simplicity. It has also proven to be an eective categorisation tool. To better illustrate how this works in practice, Figure 6 below shows summary data for key portfolio construction and performance metrics we look at from a 60/40 perspective.Domestic GlobalRatios1“60” “40” Portfolio “60” “40” PortfolioDownside capture 89% 58% 67% 86% 52% 63%Upside capture 108% 81% 89% 106% 91% 90%Volatility (annualised)214.1% 11.1% 10.8% 14.8% 11.6% 11.6%Beta31.00 0.72 0.76 1.00 0.68 0.77Correlation40.95 0.87 0.95 0.93 0.81 0.91Figure 6 Endowment Strategy 60/40 portfolio metrics1 Upside and downside capture measure the ratio between the portfolio’s return and the benchmark return in months where the benchmark return is positive (upside) or negative (downside).2 Volatility (aka Standard Deviation) is a measure of the variability of the portfolio’s return over time, often used to describe its level of risk.3 Beta is a measure of the portfolio’s systemic risk relative to the benchmark (e.g. a beta of 1.1 would indicate that the portfolio is exposed to 110% of the benchmark’s systemic risk).4 Correlation describes the strength of the relationship between the portfolio and its benchmark on a scale from -1.0 (always move in opposite directions) to 1.0 (always move in the same direction).
27Since inception, for both the domestic and global Endowment strategies, the “40” portion of the portfolio has behaved as desired, providing highly eective downside protection and alpha generation in weak markets. While the overall portfolios have exhibited pleasing downside protection over the journey, importantly, the “40” portions have exhibited much lower downside capture and volatility, reecting the less-correlated and lower-beta characteristics of these exposures.Conversely, the “60” portion, with a higher correlation to markets, has delivered a strong ‘beta’ component. That is, it has allowed the portfolio to capture a good amount of the upside of a steadily rising market with upside capture of over 100%. However, the quid pro quo is that the beta component of the “60” portion typically remains high in a falling market, meaning downside capture is also much higher.Putting all of this together the 60/40 risk framework for equities, or at least our take on it, has so far helped to provide a good balance between portfolio protection in down markets as well as participation in rising markets. Figure 7 Domestic Endowment Strategy – 60/40 Exposure BreakdownFigure 8 Global Endowment Strategy – 60/40 Exposure Breakdown“60” Exposure (%FUM)“60” Exposure (%FUM)“40” Exposure (%FUM)“40” Exposure (%FUM)CashCash100%100%90%90%80%80%70%70%60%60%50%50%40%40%30%30%20%20%10%10%Mar 2014Dec 2016Mar 2015Dec 2017Mar 2016 Mar 2017 Mar 2018Dec 2018Mar 2019Dec 2019Mar 2020Dec 2020Mar 2021Dec 20210%0%
THE AGE OF ENDOWMENTStock selection is the bread and butter of all Cooper Investor’s portfolios. Utilising the overall ‘Money Management System’ of the CI way, promising investment ideas will be placed on the watchlist of the relevant portfolio and be analysed by the investment team using the internal VoF methodology.CI’s VoF system is both a qualitative and quantitative methodology derived from the three parts of the system, being: Value Latency, Operating, Industry & Strategic Trends and Focussed Management Behaviour. This system is central to the success of all our portfolios and funds. Given the specic objectives of the Endowment-style strategies, certain aspects are over-emphasised in terms of importance. These are attributes which, through our analysis of previous nancial crises, business failures, and internal pattern recognition of what the track record of success looks like, we have observed to be of particular importance. These are: · Quality (which includes both management track record and nancial quality) · Balance Sheet Strength · Growing IncomeTaking EBOS Group (EBOS) as an example. EBOS is held in CI Endowment Fund (domestic) and continues to check all the boxes from a stock selection perspective. EBOS is a business dealing with the wholesale and distribution of healthcare and animal care products. The company is well diversied and enjoys leading positions in its key markets.EBOS boasts an exemplary track record evidenced by its management’s consistent execution of strategy and disciplined capital allocation. This is well supported by the company’s nancial performance – EBOS has high and improving returns on capital along with dividends that have compounded at double digit rates, illustrated in the charts below.In addition, EBOS has a strong and prudently managed balance sheet. It has the exibility to pounce on any acquisition opportunities and condence that it will be a bulwark in tough markets. The company has a tight and credible register of shareholders, underpinned by the 16% stake of the Zuellig family, which adds stability. The attractive combination of quality, defensiveness and growth makes EBOS an anchor position in that portfolio. Figure 9 EBOS Return on Capital Employed (ROCE) Figure 10 EBOS Dividends Per Share (NZ$ cents per share)Source: Company data. CAGR = compound annual growth rate.12.9%4147596369727889FY14 FY1416.7%FY16 FY1616.3%FY18 FY1817.1%FY20 FY2014.9%15% ROCE Target11.6% CAGRROCEFY15 FY1517.1%FY17 FY1715.9%FY19 FY1918.0%FY2118.2%1H22 FY21
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THE AGE OF ENDOWMENTQuality is in the Eye of the BeholderArticulating a clear denition of ‘quality’ is dicult given the inherent subjectivity and judgement involved. While there is little consensus on what constitutes quality, we see it as analogous to Supreme Court Justice Potter Stewart’s obscenity doctrine of “you know it when you see it” (Jacobellis vs Ohio, 1964).There are numerous quantitative measures to assess the quality of a company, such as returns on capital, prot margins or conversion of prots into free cash ow. However, many important aspects are qualitative and not easily captured in the numbers. For example, factors such as management quality, capital allocation and the company’s track record, particularly as it evidences behaviour around crises or key strategic pivotsWe believe a nuanced approach is required, one backed by considered and experienced judgement when making an evaluation. Investors tend to under-appreciate how sustainable and persistent the returns of higher-quality companies can be. If investors can own that persistence the compounding eects over time can be signicant.However, there are some risks associated with high quality companies with good track records, such as extreme overvaluation as investors can overpay for quality and reliability. We aim to balance the trade-o between quality and price.There is also an argument that high-factor exposure to quality can lead to underperformance if value and cyclical stocks outperform. Investors should be mindful of these risks when constructing a portfolio.Our proposition is that high-quality companies should perform better than low-quality companies over the long term and particularly during large drawdowns or highly volatile markets. We would expect high quality companies to go down less and recover faster. Quality companies are also likely to have recurring and predictable earnings and dividends, which underpin a secure and growing income stream.These characteristics are highly suitable for our clients with complex needs such as charities or foundations looking for a more conservative equities exposure. As such our endowment-style portfolios endeavour to have a strong bias towards quality companies.Balance sheetBalance sheet strength is another feature commonly linked to quality and the ‘safeness’ of a company. This is an important factor for any investor that wants to sleep well at night.Past experience, sometimes painfully acquired, has taught us that too much gearing amplies downside risk if something goes wrong. It also increases the likelihood that a bad scenario occurs such as a deeply discounted rights issue or even the complete loss of equity value. However, that is not to say all debt is bad, because when used appropriately it can boost a company’s return on equity (ROE) given that the cost of debt is usually cheaper than the cost of equity. So, some debt is ne when it is prudently managed and is appropriate for the company and the industry in which it operates.Empirical ndings on the relationship between corporate leverage and stock returns are somewhat mixed. However, Fama and French (1992) found that book leverage is negatively related to stock returns. Further, companies with high leverage also tended to have high volatility and high betas.At CI we believe a strong balance sheet is important. Highly leveraged businesses don’t enjoy a great deal of exibility when something unexpected happens, indeed it can put a lot of stress on the company to do uneconomic things to satisfy creditors to the detriment of shareholders. Having a good balance sheet increases condence that the company can ride out market cycles, but it is also an important source of downside protection. Ultimately, a strong balance sheet puts a company in a better nancial position to control its own destiny and to take advantage of opportunities when they present themselves.Dividends Are GoodGenerating income has long been a priority for many investors and has only become more challenging in recent years as already low rates since the Global Financial Crisis have been pushed even lower by the economic fallout from the COVID-19 pandemic. The chart below demonstrates that around 40% of the S&P 500’s total returns over the last 90 years were generated from dividends. We do not know how much of a typical investor’s time is spent pondering and analysing this aspect of a business, but we suspect far less than 40%.
31Source: Morningstar and Hartford Funds, 2/21. *Total return for the S&P 500 Index was negative for the 2000s. Dividends provided a 1.8% annualized return over the decade.Figure 11 Dividends’ contribution to total return varies by decade1940s67%1950s30%1960s44%1970s73%1980s28%1990s16%2000sNA*2010s17%40%1930-2020Average for all decadesS&P 500 Index Dividend Contribution to Total ReturnS&P 500 Index Price Only (no dividends)Average annual total return31This is important because history shows that dividends make up a substantial portion of a shareholder’s returns over the long-term, although the contribution can vary greatly from decade to decade, as shown in the chart.This leaves income-focused investors in somewhat of a quandary. They can either accept the low yields on oer, take on more risk in the portfolio in order to achieve higher income or eat into principal as a source of income.There have been many discussions about the role of yield in an equity portfolio, and in particular the role of yield for charities and foundations relying on distributions to support their spending commitments and ongoing operating expenses.One common suggestion or point of view is that for these investors, an equity portfolio or product should be specically targeting a high-dividend yield. In our view, targeting high yield will likely, in the long-term, deliver a sub-optimal return. Whereas a portfolio targeting a more moderate but growing yield will likely provide a better long-term return with less volatility, as well as go some way to addressing the risk of rising interest rates. High yields can be associated with aggressive capital structures or nancially engineered dividends. Unsustainable dividend policies are more prone to dividend cuts or suspensions, which was the unfortunate fate for many during the COVID-19 pandemic, impacting income available to charities and foundations when it was needed the most.For our Endowment-style equities portfolios high yield or yield alone is therefore not the primary aim. We are interested in all the uses of cash a management team chooses – depending on the business and its maturity, organic investment or M&A may for a time be a better long-term return generating decision than paying out every last cent as a dividend. Compounding capital will ultimately drive a larger dividend in the long term. We prefer businesses where dividends are expected to rise over time.A good example is British technology and engineering rm Halma plc, that has the enviable track record of increasing its dividend by at least 5% a year for the last 42 consecutive years.In our experience, companies with a track record of sustainable and growing dividends are on average likely to be stronger and steadier performers. These types of companies also tend to be higher quality than average, where years or decades of dividend growth suggest a comforting level of capital discipline and nancial strength.We like moderate dividends, particularly those that we think can be expected to grow consistently over the long term, but don’t like very high dividend yields as they can often be associated with higher risk. A high yield portfolio’s total return can exhibit large annual deviations from market returns. These attributes would be inconsistent with the objectives of a portfolio constructed to perform better in down markets and be less volatile than the market.
THE AGE OF ENDOWMENT“I’d rather have the best long-term record than the best one-year record. This is a long term game.” – the late David Swensen, Yale Investments Oce We hope you have enjoyed reading this paper and perhaps gleaned further insights into how our Endowment-style of equity investing can be applied.Finally, if you also share the view that 42 is an ideal age, or if aspects of what we have shared spark your interest and could support the needs of your organisation and mission, please contact our team at Cooper Investors. We look forward to continuing the discussion in person.Good investing, Chris Dixon and Ryan Riedler
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THE AGE OF ENDOWMENT
35Ryan RiedlerDeputy Portfolio Manager – Endowment Fund B.Comm, Grad Dip. App Finance and Investment, A.FinChris DixonPortfolio Manager – Global Equities Funds BA (Hons), CAChris joined CI as joint portfolio manager in November 2011. As a member of the Global Equities team, he focuses on European and Japanese companies.Having commenced his career in 2002 Chris has operated in a variety of roles in nancial markets and has travelled extensively, living in four countries and investing across multiple asset classes.Chris joined Chandler Corp in 2007 and focused on equities in a role that covered a broad mandate of responsibilities including portfolio management, investment strategy, fundamental research, risk management and dealing. Prior to that he spent a number of years managing equity derivatives at Lehman Brothers. Chris qualied as a certied Chartered Accountant with Ernst & Young in London.Ryan joined CI in July 2010 as a research analyst in the Australian equities team and was appointed Deputy Portfolio Manager of the Endowment Fund in 2014. Prior to joining CI, Ryan worked at Ernst & Young in the corporate nance division. Ryan has had exposure to a broad range of sectors including nancials, healthcare, infrastructure, property trusts and retirement and aged care.Chris and Ryan are both members of the Cooper Investors Philanthropy Fund sta committee.COOPER INVESTORS ENDOWMENT TEAM
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