Investment portfolios of nonprofit organizations including trade associations, professional societies, foundations, and endowments are facing strong headwinds following above-average investment performance between 2009 and 2014. The combination of persistently low bond yields, weak equity market returns, and fairly high spending rates have created a challenging portfolio management environment. The consensus view on Wall Street is that lower returns with higher volatility could be the norm for the next several years. If they are right, how should you prepare your investment committee?  

Unlike past market environments, simply following the traditional diversification formula of 60 percent equity and 40 percent fixed income may not be enough to navigate the new reality. One reason is that the persistent tailwind provided by the multi-decade decline in interest rates is not likely to reoccur in the foreseeable future.  According to Morningstar, over the last 35 years, the Barclays U.S. Aggregate Bond Index produced average annual returns of 8.11 percent while the yield of the index fell from 14.65 percent to 2.28 percent. Since bond prices typically move higher when yields fall, it's hard to envision a future where bonds produce returns resembling those of recent decades.

The consensus view on Wall Street is that lower returns with higher volatility could be the norm for the next several years.

Secondly, a variety of factors suggest that U.S. equity market returns over the next 10 years are likely to be 20-30 percent lower than they have been historically, and yet volatility is likely to be higher. This will be sobering to many investors as they adjust to returns many Wall Street firms expect to be in the mid-single-digit range. These lower returns and higher volatility are likely to add to investor nervousness.

You may be asking, how long will this bull market last? Now in its seventh year, here are some interesting statistics to consider on bull markets:

• The average bull market has lasted 4.7 years.
• Of the 11 bull markets that have occurred since World War II, only three made it through a sixth year.

While we can't predict when the next bear market will occur, we do know that economies and markets move in cycles. Some of the factors that may cause the bull market to stall or lead to lower returns include:

• ongoing reduction of debt on government, corporate, and individual balance sheets
• the strengthening of the U.S. dollar and its corresponding negative impact on U.S. companies' earnings
• uncertainties related to interest-rate hikes and unwinding of the liquidity provided by the Federal Reserve
• extraordinary steps being taken by other central banks in response to persistent deflationary pressures in their economies.

So, what can a nonprofit organization do to help navigate through the challenging market environment that may lie ahead?

1. Revisit Your Budgeting Process and Spending Policy

Achieving spending rates of 4-5 percent is challenging in the current environment. UBS believes high-quality fixed income will provide average returns of only 2-3 percent for the next decade. Thus, organizations have to refocus on meeting these objectives, and that may involve taking on more risk. Revisiting the budgets, spending-policy methodology, return assumptions, risk tolerance, and how risk is defined may be a worthwhile exercise.

2. Understand the "True" Cost of Your Investment Portfolio          

Active management and investment expenses have been highly debated topics within investment committee meetings. According to the S&P Dow Jones Study of Index vs. Active Funds (SPIVA) 2015 Mid-Year Report [PDF], 80 percent of large-cap managers failed to deliver incremental returns over the benchmark over a five- and 10-year investment horizon. Investment committee members are now asking, "Why are we paying for this underperformance?"

As fiduciaries under the Uniform Prudent Management of Institutional Funds Act (UPMIFA), investment committee members should revisit their organization's fee structure and understand whether portfolio management expenses are "customary and reasonable." They may also consider working with their respective investment consultants to determine whether some of the active strategies may be replicated using lower cost or indexed investment vehicles.

3. Thoughtfully Consider Adding to Alternative Investments         

Alternative investments may be a potential solution for your investment committee's consideration to provide improved risk-adjusted returns. Creating a well-structured alternative investment portfolio isn't always a simple task. The largest and oldest endowments have access to a larger universe of both traditional and nontraditional managers. The Yale Endowment Office itself warns that "institutions that are new to alternative assets face difficulties in accessing top managers. While alpha or excess return is not dead, opportunities to access it may not be available to all investors."

Alternative investments may also provide additional diversification benefits, which can result in a more cost-efficient portfolio and enhanced cumulative returns over time. Such investments carry specific risks, liquidity constraints, and costs, which must be evaluated carefully—besides considering one of the most important factors in this decision: access to top talent.

The Bottom Line

The aging bull market, sobering returns of diversified portfolios in 2015, and the volatility thus far in 2016 are reminders that investment portfolios of nonprofit organizations may face a difficult market environment over the next several years. Investment committees should be prepared for this below-average returns environment and adjust portfolio expectations accordingly. The considerations detailed above are the start of a necessary conversation for Investment Committees and fiduciaries to have in today's market environment.