Lessons from the COVID-19 Crisis: An Endowment Perspective

March 23, 2021 marked the one-year anniversary of the S&P 500’s low in the early days of the COVID-19 crisis. From that 2020 low, the S&P 500 rallied to its largest one-year increase since 1936, richly rewarding those who added risk while causing regret for those who chose to wait. While unprecedented in many ways, the market’s behavior during and after the onset of COVID-19 reinforced several lessons for endowments as to how to manage through —and hopefully benefit from— periods of market crisis.

1. Endowments should be willing to increase risk exposure during large market drawdowns. Endowments have the benefit of long-term capital which can afford them a different perspective during periods of market turmoil. Seen from a “1,000 foot” view, a crisis can be scary: fear and uncertainty are at the root of the market’s decline. This was certainly true during the onset of COVID-19 in 2020, as it was during the near-collapse of the global banking system in 2008. Given a long-term horizon, however, an endowment should shift to a “30,000 foot” perspective by putting the drawdown into historical context. A -20% peak-to-trough decline in the S&P 500 is historically rare, occurring only 9 times in the last 70 years[1]. A -30% decline has occurred only 6 times over that same period, and only in one case did the decline exceed -50%. History has rewarded investors willing to add risk to their portfolios during such occasions. In each of those 9 cases, the S&P 500 was up more than +20% one year after the trough. The analysis is not limited to equities; similar results have also been generated in credit markets. Since 1990, investors who added high yield bond exposure when spreads exceeded 1,000 basis points, for example, would have seen returns of greater than +15% one year later in all four instances[2].
2. Endowments should be positioned to identify and take advantage of the unique market opportunities a crisis may present. Critical factors include having the right investment manager and governance program in place and ensuring the investment policy statement provides enough flexibility to be opportunistic. Each crisis is different in cause, length, and the opportunities it presents. In 2008-2009, the banking crisis meant that stressed and distressed credit offered particularly attractive risk-adjusted return potential. Compare that to 2020, when the crisis created opportunities for venture capital funds, biotech specialists, and growth-oriented equity managers. Commodity exposure, a laggard for much of the last decade, also rebounded sharply as investors began to price in an economic rebound and higher prospects for inflation. While this is not an exhaustive list, these are examples of opportunities born of the COVID-19 crisis that could have boosted portfolio returns, provided the right investment and governance structure was in place.
3. Endowments should have an “action plan” in place before a market crisis occurs. Whether established through a formal document or just a discussion among an investment committee, such a plan should address topics such as expectations for portfolio changes, sources of liquidity, frequency of communication among staff and committee members, potential spending needs, and even donor relations. Without foresight, a market crisis can quickly expose flaws: investment committees can be too slow (or too polarized) to act, liquidity may not be readily available, and concerns about future spending, underwater endowments, and fundraising can be added distractions. The nature of the plan may also depend on whether the investment manager is discretionary or non-discretionary. An Outsourced CIO, for example, should already have the tools and discretion to act quickly, while a non-discretionary consultant may require more frequent communication to help facilitate investment decisions. Endowments can also use an action plan to help address bigger-picture issues. For example, one of our clients added an “Adverse Market Adjustment” section to its Investment Policy Statement. This provision mandated a shift in asset allocation targets to a higher equity weighting when a specific market “trigger” occurred (in this case, a -20% decline in the equity market). In addition to making sure the portfolio gained equity exposure during a period of market stress, this provision also served as a creative solution to a common issue: the committee believed a more aggressive asset allocation would help meet future spending needs but had concerns about the timing for implementation. The Adverse Market Adjustment triggered on April 1, 2020, resulting in greater equity exposure during the subsequent recovery.

If history is any guide, the next big crisis may well be caused by something not on the collective radar of investors today. Regardless of the cause, endowments should think through how they will manage through such a crisis before it occurs.