The COVID-19 pandemic and accompanying volatility is forcing endowments to rethink how they invest, govern and grant. Kanika Sood reports on the latest in the sector.

Sue Dahn is one of Australia's best known financial advisers. She also wears many hats in the philanthropic world.

To count a few, she advises private endowment clients at Pitcher Partners, acts as the responsible person for multiple private ancillary funds and is a director for a public ancillary fund. She also sits on their investment committees.

Dahn says her endowment clients had returned about -8% in FY20 to March end. By April end, the number sat at -5%. She expected them to finish FY20 with about -2% in returns.

The mayhem of last few months does not need much exposition. But to recap -- equities markets were down over 20% before rebounding strongly, credit markets faced a liquidity squeeze in March, oil futures traded in the negative territory for the first time in history in April, property and infrastructure asset values were revised down and ASX-listed companies reigned in dividends.

On a panel in early July organised by Philanthropy Australia Dahn was one of the four panelists offering some pointers for endowments in future crises.

Among the issues that came up were: Best policy for rebalancing investment portfolios during extreme volatility, the most effective way of making grants (out of income, as is traditionally done, or via total return), considerations for using balance sheet for granting, the future role of franking credits and whether governments' COVID-19 specific incentives for distributions out of public ancillary funds are good enough.

To rebalance or not to rebalance

Dahn said the big question is - how disciplined the endowments need to be about rebalancing back to their strategic asset allocation after drifting away from it during the March volatility.

"Because on some of those days, you could have been churning through a lot of transactions costs, if you rebalanced one day back up from a big market fall, when the market might have done that for you all on its own," she said.

"So the governance model was tested. Investment policies were tested to see whether the ranges around rebalancing were, in fact too tight."

Dahn saids some endowments decided to suspend rebalancing completely in March to avoid the higher transaction costs.

Perpetual Private partner Daniel Tome's clients fell in both camps - who rebalanced intensively and those who didn't.

"The more aggressive foundations or particularly those with founders still alive and still contributing looked to rebalance a little bit more aggressively. And those that perhaps have been around for a long time with co-trustees looked at being prudent," he says.

For Jenny Wheatley, the chief executive of Vincent Fairfax Family Foundation and Cambooya, the conversation with trustees had to go from short-term performance to long-term returns. Meanwhile the investment team rebalanced cautiously.

What's the best way to grant: income or total return

Endowments have traditionally made grants out of the income they generate. But, Dahn thinks that approach is "somewhat outdated" and the sector needs to shift to taking a total return approach, especially as income sources dry up in a world of reduced dividends and low interest rates.

"And that's been a really useful philosophical and intentionality conversation with endowments. If the policy is we can grant 4%, we have 1% to run the show...we have 1% to maybe grow the capital base," She said.

"If we think about the last five years, we've actually been making an average of 6%...and it's very likely that the next five years will be much the same. And we can continue with those granting levels to run each of our operations and still grow the capital base. "

Perpetual's Tome and Fairfax's Wheatley agreed with Dahn's comments. Tome added that legacy trusts may have restrictions that only allow them to distribute income.

"There's a case to be made [for] skewing portfolios towards Australian equities, most definitely, but certainly [in] a more diversified approach. And a total return approach is going to provide a better risk adjusted return over time. And so having those discussions with co trustees and founder about how they're investing these funds for total return approach is critical," he said.

New ways endowments donated in COVID-19

Tome says Perpetual's philanthropic clients became more flexible in their giving during the pandemic.

This included untying grants, paying them sooner, using their own capital or even lending them money - all of which must be linked to investment and governance response, he says.

"From an investment perspective, it has forced a reevaluation of risk tolerances in investment as well as the giving side -- clients have been willing to push the envelope a bit more on the investment side and on their spending policies in the face of this unprecedented need," he said

"Ultimately my counsel is that the purpose of the funds should drive the investment decision making. If that shifts to the circumstances, then the investment policy should be reviewed and shifted as well."

Balance sheet philanthropy

A May 2019 survey from Philanthropy Australia asked endowment decision makers if they would consider using their balance sheets to offer non-grant financial support to an organisation? Less than 10% said yes, about 25% said they were considering it and the majority at just under 70% said no.

Wheatley revived the question to the panel.

Dahn was in favor, citing Ford Foundation which used its balance sheet to raise capital via a bond issue.

"They've used their balance sheet to leverage their balance sheet to raise to raise bond capital, at obviously historically low levels...They can effectively, with a reasonable to higher degree of conviction,  make more money on the equity side of their balance sheet that will more than cover the repayment of the debt," she said.

JBWere director of philanthropic services Luke Branagan said while he supports similar endeavors in Australia, they might be hard to come by.

"We hear discussions of people [in Australia] wanting to do it or explore it, but they're not really sure how to achieve it...but I just don't think there's a provider to come in and assist foundations -- the foundation of your sophistication [Fairfax] I think can enter into this world -- but many don't have that capability," he said.

Franking credits: where do they add?

Wheatley also asked the panelists what value franking credits added to their portfolios. Dahn suggested between 70 and 90bps, depending on the asset allocation, but she noted that was subject to tax changes. Branagan and Tome said they have tilted towards international equities in recent times, seeking growth.

"It really is a material amount of the of the total return, which is, of course received in cash after a lag [when tax returns are processed]... think trustees need to be [aware], this isn't the end of the change or the end of what we need to adapt to," Dahn said, referring to potential changes in the tax system arising from stimulus debt.

"Definitely skewed towards alternative asset classes, as well as towards international equities, which inherently have a bit of a buffer as well, with the currency differential and our currency is it's a pleasant buffer when markets go into volatility mode because of how our currency reacts to the sort of risk off risk off events," Tome said.

Lastly, on the subject of whether government's increased distribution permission guidelines for private ancillary funds in FY20 are good or bad, the panel was split.

Dahn said the credit could have been more or better aligned.

"It's not a restriction on freedom, but it is a bit of a dictation as to, you should be giving now versus you should be giving later," Tome said.

"And that might be a little bit dangerous in terms of providing incentives for people to actually create these foundations in the first place...I think that's absolutely useful, but certainly shouldn't be mandated in my opinion."