While Catholic theologian, Thomas Merton, long argued that “no man is an island,” many of us retreat into a relatively solitary world when life becomes most difficult. For some, the isolation is a way of dealing with insecurity or shame, for others it reflects a fear that no one else cares or can understand, while still others figure that they can best rely upon themselves to solve their problems. And of course, when facing tremendous obstacles, sometimes we simply cannot see outside of ourselves very well to seek the help we need or to identify the help that might already be waiting.
Organizations are no different. Small businesses and large corporations alike can become strikingly insular under pressure. The times when they most need to look outside for guidance, financing, or other support can easily become the times when barricades go up, trust disappears, and people turn on each other instead of to each other.
Given their community orientation, collective spirit, and life affirming missions, it may seem ironic that nonprofit organizations face similar challenges. Layoffs, budget cuts, uncertain and declining revenues, and higher demand for services make the equation particularly challenging for nonprofit boards and staffs. Whether leading human service organizations, health care facilities, houses of worship, educational institutions, environmental organizations, museums, or other mission-driven organizations, nonprofit officers and executives often feel much like they are stranded on an island when the storms of economic crisis are looming.
Recognizing that many nonprofit organizations face business challenges on a scale and frequency they have never before experienced, and realizing that it can be difficult to access perspectives from peers in different industries or geographic regions, we thought it might be helpful to identify patterns we have witnessed across nonprofit organizations throughout the nation across size and sectors.
1. Executive turnover is higher than in the past.
We have seen more nonprofit executive (CEO, CFO, Executive Director) turnover in the past nine months than in the previous 10 years combined. The causes are as varied as the people and the organizations. Some executives have completed their main objectives at one organization and simply are ready for new challenges. Others have left organizations going through internal structural realignment designed to increase margins, efficiency, profitability, effectiveness, skill sets, etc. We have seen organizations change leaders as a result of clarifying their missions and others change leaders because they are not sure of their mission. Some leaders have moved on simply because the work is terribly demanding and they need a break. And of course, we have witnessed leaders move on because they lacked the aptitude or value system required. Whatever the reason, there’s change amongst executives is occurring on a massive scale throughout the country.
2. Revenues are more uncertain and for different reasons than in the past.
Many organizations that rely primarily on private donations and/or corporate sponsorships are facing the reality that their private and corporate donors live in a highly uncertain world, one buffeted by questions about tax policy (e.g. Estate tax? Charitable deductions?) as well as radically reduced donor liquidity and net worth. Organizations that rely on federal, state or local reimbursements are in a tremendous quandary as they deliver (and pay for) services for which they may not be reimbursed in a timely manner or in the amount committed by the associated municipality. And many faith based organizations—a final safety net in many communities—cannot rely on the revenues contributed previously. When someone who tithed 10% of their income (and yes, there are many who do so), becomes one of many congregants who needs financial support while looking for a job, then the financial model in many faith-based communities falters. There are numerous churches facing bankruptcy; that is not normal.
3. Mission matters more than it did before.
A nonprofit that is not sure about its mission or cannot clearly articulate its mission likely will not endure this period in history. Some organizations are reinventing themselves despite successful work over the past 20, 50, or even more years. They have to. The landscape has changed, the way that society identifies and addresses problems has changed, the way that people communicate has changed. Meanwhile, other organizations are getting back to their roots, honing in on their core competencies and cutting back on non-core initiatives that seemed logical when times were more flush and the competition for dollars less intense. Whether missions are newly revised or thoughtfully reaffirmed, organizations that can express their relevance have a much better chance of achieving sustainability.
4. Financial stewardship is a higher priority and more creative than in the past.
Most nonprofit organizations are accustomed to doing more with less, running lean, and relying on the generosity not just of donors, but also of staff willing to earn less than they might in for profit ventures. Thus, some behavior we have witnessed recently is simply prudent budget management. But we also are seeing more intense integration of financial planning into the broader strategic vision of many nonprofit organizations. Five year planning is receiving more serious consideration than in the past, with more conservative revenue estimates and more realistic cost estimates. Spending models for endowments and supporting foundations are using more conservative spending assumptions, reduced return assumptions, and making allowances for potential emergency draws. Organizations are analyzing their illiquid assets such as buildings and land to evaluate if they can provide liquidity to support operations and special projects. And like the rest of the world, many nonprofits are doing whatever they can to deleverage, that is to pay down their debt and reduce or eliminate their current debt service.
5. Board leadership is essential.
It surprises us how many excellent nonprofit organizations with strong track records of effective service have relatively weak or at least inconsistent Board leadership. In a decent economy, an organization can limp along without good governance; in an economy like the current one, a lack of effective leadership signals the beginning of the end. Look back over this list—every item on it requires courageous, attentive and skillful Board-level guidance. This item can be a hard one to admit, but believe us, many organizations are trying to figure out this challenge without letting the world know that their Boards are not all they can be.
Nothing mentioned herein is radical. Yet for each nonprofit organization, these may well be life or death challenges; at the very least, they compel a level of soul searching that many officers and directors have not previously faced. And as our nonprofit organizations examine themselves, they echo the self-reflection going on throughout America and around much of the world. Yet because many of these organizations serve as a mainstay of our civil society, because they represent a key ingredient in making capitalism more compassionate, democracy more participatory, and society more sustainable, it is vital that on the whole they are successful in addressing these challenges.
We know our audience, and many if not most of our readers are actively engaged in addressing these concerns as professionals and volunteers. But there is a great deal of leadership needed throughout our communities to address these concerns and there are people who are isolated now who have tremendous gifts to offer and service to provide. Even Merton, who practiced the relatively solitary life of a Trappist Monk, created ways to reach out and connect with others in an effort to effect social change. Let’s find those whom are not yet connected to community and invite them to join us. There’s work to be done.
Thursday, July 29, 2010
Thursday, July 22, 2010
Whose Debt Is It Anyway?
In the depths of World War II, when the course of battle was looking most bleak, American forces went on an unusual offensive. War heroes like Medal of Honor Marine Sergeant John Basilone joined actors and singers in grand tours of the United States to host War Bond Rallies. Their goal: to persuade the American public to buy US Government bonds to provide the country with the short-term financial resources necessary to arm the largest and best armed military force the world had yet seen.
And it worked—ordinary citizens stepped up, just as they did when contributing old steel pots and nylons or accepting rations of butter and eggs. Essentially, Americans financed the build out of our military and civilian industry. It is no coincidence that such a massive stimulus helped speed the beginning of the end of the Great Depression.
Fast forward to 2008-2010. In the midst of our modern economic crisis, US leaders from President George Bush to Secretary of State Hilary Clinton, Treasury Secretary Timothy Geithner to President Barack Obama, have repeatedly—and humbly—gone to Chinese leaders requesting that they continue to buy US Treasuries. Such an effort makes some sense given that about 28% of the US Treasuries are owned by foreign governments or sovereign wealth funds. Of that 28%, approximately, 31% is owned by the People’s Republic of China, Hong Kong, and Taiwan. Thus on the whole, China, Hong Kong, and Taiwan hold about 9% of the outstanding US Treasury debt, or roughly $1.14 Trillion as of May 31, 2010 (all data from the US Treasury).
This foreign ownership of US debt—and particularly Chinese ownership—has many Americans deeply troubled. Among other things, they fear becoming deeply indebted to countries that do not share America’s commitment to representative democracy, human rights, and market-driven capitalism. [Yes, we understand that Taiwan is quite different from the People’s Republic of China; however, mainland China exerts tremendous influence in Taiwan and we believe that influence is likely to increase commensurate with the decline of US influence.]
This rise in foreign ownership is concurrent with a decline in private ownership of US debt. US private households directly hold well less than 10% of the US Treasury debt. We can complain all day long about our growing dependence on China, but nothing keeps Americans from using personal savings to help finance our own spending. If the $1.14 Trillion of US debt owned by China, Taiwan and Hong Kong were divided by the roughly 100 million US households, each household would need to pick up about $14,000 to absorb 100% of Chinese-related lending.
This situation invites important questions about how we as a nation borrow and invest:
1. Why isn’t there a vocal movement among America’s political and social leaders calling for American citizens to lend money to our government to help finance the departments, benefits, and policies that our Congress has adopted?
2. If you were leading such a movement, how would you persuade ordinary Americans to invest more substantially in US Treasury bonds?
3. If such a movement were to emerge, would American households respond in the positive? That is, would individual Americans be willing to increase lending to the US Treasury?
4. Is there a legitimate concern in having China, OPEC ($235 billion), Russia ($126 Billion) or others with contrasting social or political values serve as major lenders to the United States? Are there compelling reasons to encourage such nations to serve as our major lenders?
5. Assuming that the US continues to increase its reliance on foreign lenders and reduce its dependence on domestic households, how does that impact the US ten years from now? Twenty? Fifty?
6. How would you feel if the Congress mandated that US citizens hold a certain percentage of their net worth (brokerage accounts, 401k, IRA accounts, 529 accounts, trusts, foundations, etc.) in US Treasury bonds? Would that be an appropriate way to help finance US government obligations?
The world has shifted a great deal since the war bond rallies of 1942-45, and perhaps we fancy ourselves too sophisticated to get swept up in a patriotic fervor to loan money to our government. However, one could argue that if we truly believe in the current fiscal stimulus, in universal health care and social security entitlements, in a strong military and financial presence in Afghanistan, Iraq, Western Europe, Korea, the Middle East and Africa, education reform, and in addressing AIDS, hunger, and human rights throughout the world, then we should be willing to finance such activities directly rather than relying upon outside lenders.
And if we are not willing to finance these policies ourselves, then perhaps we need to engage in more difficult discussions about how we allocate America’s financial resources, about what REALLY matters to us?
We look forward to the fantasy concert at Red Rocks Amphitheater here in Colorado co-hosted by Barbara Streisand and her ideological antagonist Kid Rock, where they sing “America the Beautiful” a capella, then ask their screaming fans to help pay for the financial cost of American freedom and ideals. See you there.
And it worked—ordinary citizens stepped up, just as they did when contributing old steel pots and nylons or accepting rations of butter and eggs. Essentially, Americans financed the build out of our military and civilian industry. It is no coincidence that such a massive stimulus helped speed the beginning of the end of the Great Depression.
Fast forward to 2008-2010. In the midst of our modern economic crisis, US leaders from President George Bush to Secretary of State Hilary Clinton, Treasury Secretary Timothy Geithner to President Barack Obama, have repeatedly—and humbly—gone to Chinese leaders requesting that they continue to buy US Treasuries. Such an effort makes some sense given that about 28% of the US Treasuries are owned by foreign governments or sovereign wealth funds. Of that 28%, approximately, 31% is owned by the People’s Republic of China, Hong Kong, and Taiwan. Thus on the whole, China, Hong Kong, and Taiwan hold about 9% of the outstanding US Treasury debt, or roughly $1.14 Trillion as of May 31, 2010 (all data from the US Treasury).
This foreign ownership of US debt—and particularly Chinese ownership—has many Americans deeply troubled. Among other things, they fear becoming deeply indebted to countries that do not share America’s commitment to representative democracy, human rights, and market-driven capitalism. [Yes, we understand that Taiwan is quite different from the People’s Republic of China; however, mainland China exerts tremendous influence in Taiwan and we believe that influence is likely to increase commensurate with the decline of US influence.]
This rise in foreign ownership is concurrent with a decline in private ownership of US debt. US private households directly hold well less than 10% of the US Treasury debt. We can complain all day long about our growing dependence on China, but nothing keeps Americans from using personal savings to help finance our own spending. If the $1.14 Trillion of US debt owned by China, Taiwan and Hong Kong were divided by the roughly 100 million US households, each household would need to pick up about $14,000 to absorb 100% of Chinese-related lending.
This situation invites important questions about how we as a nation borrow and invest:
1. Why isn’t there a vocal movement among America’s political and social leaders calling for American citizens to lend money to our government to help finance the departments, benefits, and policies that our Congress has adopted?
2. If you were leading such a movement, how would you persuade ordinary Americans to invest more substantially in US Treasury bonds?
3. If such a movement were to emerge, would American households respond in the positive? That is, would individual Americans be willing to increase lending to the US Treasury?
4. Is there a legitimate concern in having China, OPEC ($235 billion), Russia ($126 Billion) or others with contrasting social or political values serve as major lenders to the United States? Are there compelling reasons to encourage such nations to serve as our major lenders?
5. Assuming that the US continues to increase its reliance on foreign lenders and reduce its dependence on domestic households, how does that impact the US ten years from now? Twenty? Fifty?
6. How would you feel if the Congress mandated that US citizens hold a certain percentage of their net worth (brokerage accounts, 401k, IRA accounts, 529 accounts, trusts, foundations, etc.) in US Treasury bonds? Would that be an appropriate way to help finance US government obligations?
The world has shifted a great deal since the war bond rallies of 1942-45, and perhaps we fancy ourselves too sophisticated to get swept up in a patriotic fervor to loan money to our government. However, one could argue that if we truly believe in the current fiscal stimulus, in universal health care and social security entitlements, in a strong military and financial presence in Afghanistan, Iraq, Western Europe, Korea, the Middle East and Africa, education reform, and in addressing AIDS, hunger, and human rights throughout the world, then we should be willing to finance such activities directly rather than relying upon outside lenders.
And if we are not willing to finance these policies ourselves, then perhaps we need to engage in more difficult discussions about how we allocate America’s financial resources, about what REALLY matters to us?
We look forward to the fantasy concert at Red Rocks Amphitheater here in Colorado co-hosted by Barbara Streisand and her ideological antagonist Kid Rock, where they sing “America the Beautiful” a capella, then ask their screaming fans to help pay for the financial cost of American freedom and ideals. See you there.
Thursday, July 8, 2010
The Death of E.Z. Money
It is sobering to write an obituary, particularly for someone who has touched many of us so deeply, who has become an integral part of our lives, and who in passing leaves a void impossible to fill. One feels a responsibility to honor the departed, yet to do so honestly, to recognize that legacies are complex and subject to varied interpretation by survivors.
The obituary below has not yet been published; indeed, the actual death has not been formally confirmed. However, the subject of our obituary has not been seen in public in recent months, has failed to respond to requests for interviews, and has resisted the probing of the most ardent investigators. We share this draft with you today. Perhaps if our subject reads of his demise, he will dare to inform us that he is alive and well. Should he remain silent, then perhaps we are simply confirming a loss that has already impacted us all.
**********************************************************
E.Z. Money
1942 – 2010(?)
“E.Z. Money was born in 1942 in Washington DC to loving but demanding parents. His mother had struggled through the Dust Bowl, sold apples on the streets of New York City, and suffered great losses from bank failures and stock market crashes. Dad was fighting fascism in Germany, Italy and Japan, and lacked the power of either muscle or will to put up an adequate fight.
“This tumultuous birth has been obscured by history because of E.Z.’s immediate, dramatic influence on his parents. By 1945, E.Z. had brought them great calm, easing their struggles. He remained quiet and unpretentious through the 1950s and 1960s. Of course, during these early years, E.Z. was overshadowed by his cousin, G.D.P., whose growth and vitality made E.Z. seem irrelevant. G.D.P. took credit for many of E.Z.’s accomplishments from the rebuilding of Europe to the growth of the military, from building out the highway system to financing the early years of Johnson’s Great Society.
“But E.Z. was not waiting in vain. By the early 1970’s he had begun to find his calling, playing a powerful role in underwriting the War in Vietnam and fighting the good fight against OPEC and spiraling inflation. Nonetheless, E.Z. still bore the burden of his shameful birth. Most Americans weren’t comfortable with E.Z., feeling that he didn’t really represent the nation’s core values or vision of itself. That disdain, however, was about to change.
“The 1980s invited E.Z. to step more boldly into the limelight. E.Z. reconciled with his cousin, G.D.P. They made a pact: they would support each other’s growth, collaborating to usher in an age of economic prosperity never before experienced by any society in any age. It worked. Interest rates and inflation were subdued, jobs created, technologies invented, and all without meaningful complaint from the country that made E.Z. welcome. Of course, a new generation was ascending the corporate and political power structure, a generation that had known E.Z. from their earliest years. While the previous generation recalled life without E.Z., their children did not. And who could complain, so long as E.Z. and G.D.P. blazed a new path of material wealth.
“By the 1990’s, E.Z. had fully come into his own, spawning a whole network of associates and sycophants. New friends such as hedge funds and private equity funds clamored for E.Z.’s attention, using him to forge a new industry of financial innovation. They secured great wealth for themselves and increased influence for E.Z. The modest days of the 50s and 60s had come to seem quaint. There was no going back.
“E.Z. also proved to be an able politician, thriving regardless of which party dominated Congress or sat in the White House. While a few skeptics complained about the access E.Z. had to policy makers and corporate executives, most were content to let it go without complaint. E.Z. and G.D.P. had forged a pact that had become ingrained in the minds of economists, policy makers, and even consumers—E.Z. would make G.D.P.’s growth possible, while G.D.P.’s growth would take care of E.Z. It was the perfect arrangement. Whether operating at the level of municipalities, corporations, or families, their partnership was broadly embraced.
“As E.Z. aged however, cracks began to appear. E.Z. was as confident as ever and certainly in as much demand, but he struggled to maintain the façade of dominance. In 1998, E.Z. was accused of being behind the Russian Debt Crisis and associated failure of Long-Term Capital, an American hedge fund. He was pegged with exacerbating the NASDAQ bubble in the late 1990’s, initiating the telecom debt crisis of 2002, and creating a climate that facilitated accounting frauds at Enron and WorldCom.
“But it was the housing crisis that started in 2007 and continues today that really called into question E.Z.’s legacy. No longer does conventional wisdom stand by E.Z. or support his pact with G.D.P. Somewhere along the line, that pact broke down and most consumers and voters know it or at least sense it. Some accuse E.Z.’s handlers of masking the breakup of his partnership with G.D.P. even as their separation intensified. Some policy makers laud E.Z. and sing his praises, though they may do so because they don’t know who else to promote. For so long, G.D.P. and E.Z. were a team; it is hard for many to imagine one without the other.
“Today, we say goodbye to this influential American, appreciative for what he helped create and wary about imagining life without him.
“Mr. Money is survived by his parents and his aging cousin, all of whom now spend their time traveling the globe. Contributions in Mr. Money’s name can be made to the Department of the Treasury, attn: debt relief.”
**********************************************************
The public is not certain if E.Z. Money truly has died. Many key decision makers are still expecting E.Z. to rejoin G.D.P. and prove that their pact retains its former power and influence. There are many constituencies that still think the heady days of the 80s and 90s are “normal” and eagerly await their return.
Personally, we wonder if E.Z. Money really ever existed. After all, his is a life story that seems more a work of fiction: Born of violent parents, overshadowed by a domineering cousin, dismissed and disrespected, embraced as a savior, then cast again into disdain, now seeking redemption.
Perhaps E.Z. Money has really been nothing more than a phantom of our imaginations, someone we have created because we needed him to be real. He gave us confidence and hope, made us believe that literally anything was possible, and made it all seem so easy. Whether real or imagined, alive or dead, a gift or a curse, E.Z. Money will be missed.
The obituary below has not yet been published; indeed, the actual death has not been formally confirmed. However, the subject of our obituary has not been seen in public in recent months, has failed to respond to requests for interviews, and has resisted the probing of the most ardent investigators. We share this draft with you today. Perhaps if our subject reads of his demise, he will dare to inform us that he is alive and well. Should he remain silent, then perhaps we are simply confirming a loss that has already impacted us all.
**********************************************************
E.Z. Money
1942 – 2010(?)
“E.Z. Money was born in 1942 in Washington DC to loving but demanding parents. His mother had struggled through the Dust Bowl, sold apples on the streets of New York City, and suffered great losses from bank failures and stock market crashes. Dad was fighting fascism in Germany, Italy and Japan, and lacked the power of either muscle or will to put up an adequate fight.
“This tumultuous birth has been obscured by history because of E.Z.’s immediate, dramatic influence on his parents. By 1945, E.Z. had brought them great calm, easing their struggles. He remained quiet and unpretentious through the 1950s and 1960s. Of course, during these early years, E.Z. was overshadowed by his cousin, G.D.P., whose growth and vitality made E.Z. seem irrelevant. G.D.P. took credit for many of E.Z.’s accomplishments from the rebuilding of Europe to the growth of the military, from building out the highway system to financing the early years of Johnson’s Great Society.
“But E.Z. was not waiting in vain. By the early 1970’s he had begun to find his calling, playing a powerful role in underwriting the War in Vietnam and fighting the good fight against OPEC and spiraling inflation. Nonetheless, E.Z. still bore the burden of his shameful birth. Most Americans weren’t comfortable with E.Z., feeling that he didn’t really represent the nation’s core values or vision of itself. That disdain, however, was about to change.
“The 1980s invited E.Z. to step more boldly into the limelight. E.Z. reconciled with his cousin, G.D.P. They made a pact: they would support each other’s growth, collaborating to usher in an age of economic prosperity never before experienced by any society in any age. It worked. Interest rates and inflation were subdued, jobs created, technologies invented, and all without meaningful complaint from the country that made E.Z. welcome. Of course, a new generation was ascending the corporate and political power structure, a generation that had known E.Z. from their earliest years. While the previous generation recalled life without E.Z., their children did not. And who could complain, so long as E.Z. and G.D.P. blazed a new path of material wealth.
“By the 1990’s, E.Z. had fully come into his own, spawning a whole network of associates and sycophants. New friends such as hedge funds and private equity funds clamored for E.Z.’s attention, using him to forge a new industry of financial innovation. They secured great wealth for themselves and increased influence for E.Z. The modest days of the 50s and 60s had come to seem quaint. There was no going back.
“E.Z. also proved to be an able politician, thriving regardless of which party dominated Congress or sat in the White House. While a few skeptics complained about the access E.Z. had to policy makers and corporate executives, most were content to let it go without complaint. E.Z. and G.D.P. had forged a pact that had become ingrained in the minds of economists, policy makers, and even consumers—E.Z. would make G.D.P.’s growth possible, while G.D.P.’s growth would take care of E.Z. It was the perfect arrangement. Whether operating at the level of municipalities, corporations, or families, their partnership was broadly embraced.
“As E.Z. aged however, cracks began to appear. E.Z. was as confident as ever and certainly in as much demand, but he struggled to maintain the façade of dominance. In 1998, E.Z. was accused of being behind the Russian Debt Crisis and associated failure of Long-Term Capital, an American hedge fund. He was pegged with exacerbating the NASDAQ bubble in the late 1990’s, initiating the telecom debt crisis of 2002, and creating a climate that facilitated accounting frauds at Enron and WorldCom.
“But it was the housing crisis that started in 2007 and continues today that really called into question E.Z.’s legacy. No longer does conventional wisdom stand by E.Z. or support his pact with G.D.P. Somewhere along the line, that pact broke down and most consumers and voters know it or at least sense it. Some accuse E.Z.’s handlers of masking the breakup of his partnership with G.D.P. even as their separation intensified. Some policy makers laud E.Z. and sing his praises, though they may do so because they don’t know who else to promote. For so long, G.D.P. and E.Z. were a team; it is hard for many to imagine one without the other.
“Today, we say goodbye to this influential American, appreciative for what he helped create and wary about imagining life without him.
“Mr. Money is survived by his parents and his aging cousin, all of whom now spend their time traveling the globe. Contributions in Mr. Money’s name can be made to the Department of the Treasury, attn: debt relief.”
**********************************************************
The public is not certain if E.Z. Money truly has died. Many key decision makers are still expecting E.Z. to rejoin G.D.P. and prove that their pact retains its former power and influence. There are many constituencies that still think the heady days of the 80s and 90s are “normal” and eagerly await their return.
Personally, we wonder if E.Z. Money really ever existed. After all, his is a life story that seems more a work of fiction: Born of violent parents, overshadowed by a domineering cousin, dismissed and disrespected, embraced as a savior, then cast again into disdain, now seeking redemption.
Perhaps E.Z. Money has really been nothing more than a phantom of our imaginations, someone we have created because we needed him to be real. He gave us confidence and hope, made us believe that literally anything was possible, and made it all seem so easy. Whether real or imagined, alive or dead, a gift or a curse, E.Z. Money will be missed.
Thursday, July 1, 2010
The Past Does Not Predict the Future
Four-year-olds are prone to asking, “Why?” Why does the sun set? Why does the car need gas? Why does the canoe float? Why did God create the animals? Why do I need to go to bed?
As we age, these questions persist but change in tone, losing their innocence. Why do terrorists attack? Why is the climate behaving this way? Why has the economy faltered? Why do World Cup referees miss the obvious?
The investment industry expends a great deal of energy trying to understand why certain conditions have occurred in the investment markets and how those conditions can help predict future activity in those markets. For the last 30+ years, finance academics and analysts have evaluated “correlation” to explain how action in one part of the investment markets causes action in another part. Correlation is a calculation intended to indicate that if “X” happens to the US bond market, then one can expect “Y” to happen with US equities, if “X” happens with US equities, then “Y” should happen with Non US equities, and so on. A correlation of +1.00 indicates that two asset classes move together, 0.00 indicates they move independently, and -1.00 that they move inversely.
This would be an aside of little interest to most people except for one critical piece of information: Almost all financial planning tools and almost all asset allocation modeling software assumes that one can predict the correlation between asset classes with a reasonably high degree of accuracy and that correlation is reasonably consistent over time. Advisors to pension plans, insurance companies, endowments, foundations, and private investors often use analytic tools that rely on predicting the correlation between asset classes to determine how best to strive to meet their objectives.
Yet, predicting correlation between asset classes in a complex and ever-evolving economy is not easy. Most applications use historic correlations between asset classes to estimate future correlations. But here at Syntrinsic, we have a problem with that. Our analysis finds that historic correlation between asset classes is not consistent, predictive, or otherwise reliable as a measure of future correlation. In short, the past does not predict the future.
Consider the example of US bonds and US equities (stocks). If one calculates the rolling 12-month correlation between these two asset classes over the past 25 years (1986 to 2010), one would expect to see some consistency of that correlation. However, the correlation ranges from +0.89 to -0.78. Given that the highest correlation possible is +1.00 and the lowest is -1.00, it would be hard to argue that there is a meaningful data point that can be used to describe the historic correlation between these assets. And yet, many analysts actually use historic correlation to estimate future correlation.
Some would argue that 12 month correlation is insufficient, and that the measure of correlation really requires longer sweeps of time. So we ran our analysis for 2, 3, 4, 5, and 10 years as well. While the result is smoother than the 1 year analysis, it is hardly reassuring for those who think of correlation as a reasonably fixed and predictive data point. The 10-year analysis—which is the smoothest—still ends up with a range from +0.53 to -0.23.
Most importantly, whether short-term or long-term data sets are being used, try to find a period when the backward looking calculation of correlation would have predicted the next 5-7-10 years. You won’t likely find one. For example, if one took a snapshot in December 1997, when 10-year correlation was at +0.53, and used that to predict correlation for 1998-2007, then one would have been terribly disappointed, as that next ten years had a correlation of -0.22.
For some, these observations may seem technical, obscure, and even irrelevant; however, deconstructing the use of correlation in financial planning ties into many major fiscal policies. Just consider the intense debates raging about the funding of municipal and corporate pension plans—much of that debate is linked to models that assume forward looking behavior based in significant part on historic correlations. If those correlations are not adequately predictive, then what?
This is a great time for asking “Why?” at every level of business, finance and investment. Why were certain investment models created in the first place? Why did those models persist through the boom years of 1981-1999? Why have those models failed to meet expectations in 2000-2010? And obviously, what are we planning to do about it?
Today’s four-year-olds are depending on our ability to address these questions with candor and rigor. It would be embarrassing if 30 years from now they were asking us why we kept using models that don’t work .
Even FIFA is considering adding some sort of instant replay to the World Cup. That just goes to show that anything is possible if one asks the right questions.
As we age, these questions persist but change in tone, losing their innocence. Why do terrorists attack? Why is the climate behaving this way? Why has the economy faltered? Why do World Cup referees miss the obvious?
The investment industry expends a great deal of energy trying to understand why certain conditions have occurred in the investment markets and how those conditions can help predict future activity in those markets. For the last 30+ years, finance academics and analysts have evaluated “correlation” to explain how action in one part of the investment markets causes action in another part. Correlation is a calculation intended to indicate that if “X” happens to the US bond market, then one can expect “Y” to happen with US equities, if “X” happens with US equities, then “Y” should happen with Non US equities, and so on. A correlation of +1.00 indicates that two asset classes move together, 0.00 indicates they move independently, and -1.00 that they move inversely.
This would be an aside of little interest to most people except for one critical piece of information: Almost all financial planning tools and almost all asset allocation modeling software assumes that one can predict the correlation between asset classes with a reasonably high degree of accuracy and that correlation is reasonably consistent over time. Advisors to pension plans, insurance companies, endowments, foundations, and private investors often use analytic tools that rely on predicting the correlation between asset classes to determine how best to strive to meet their objectives.
Yet, predicting correlation between asset classes in a complex and ever-evolving economy is not easy. Most applications use historic correlations between asset classes to estimate future correlations. But here at Syntrinsic, we have a problem with that. Our analysis finds that historic correlation between asset classes is not consistent, predictive, or otherwise reliable as a measure of future correlation. In short, the past does not predict the future.
Consider the example of US bonds and US equities (stocks). If one calculates the rolling 12-month correlation between these two asset classes over the past 25 years (1986 to 2010), one would expect to see some consistency of that correlation. However, the correlation ranges from +0.89 to -0.78. Given that the highest correlation possible is +1.00 and the lowest is -1.00, it would be hard to argue that there is a meaningful data point that can be used to describe the historic correlation between these assets. And yet, many analysts actually use historic correlation to estimate future correlation.
Some would argue that 12 month correlation is insufficient, and that the measure of correlation really requires longer sweeps of time. So we ran our analysis for 2, 3, 4, 5, and 10 years as well. While the result is smoother than the 1 year analysis, it is hardly reassuring for those who think of correlation as a reasonably fixed and predictive data point. The 10-year analysis—which is the smoothest—still ends up with a range from +0.53 to -0.23.
Most importantly, whether short-term or long-term data sets are being used, try to find a period when the backward looking calculation of correlation would have predicted the next 5-7-10 years. You won’t likely find one. For example, if one took a snapshot in December 1997, when 10-year correlation was at +0.53, and used that to predict correlation for 1998-2007, then one would have been terribly disappointed, as that next ten years had a correlation of -0.22.
For some, these observations may seem technical, obscure, and even irrelevant; however, deconstructing the use of correlation in financial planning ties into many major fiscal policies. Just consider the intense debates raging about the funding of municipal and corporate pension plans—much of that debate is linked to models that assume forward looking behavior based in significant part on historic correlations. If those correlations are not adequately predictive, then what?
This is a great time for asking “Why?” at every level of business, finance and investment. Why were certain investment models created in the first place? Why did those models persist through the boom years of 1981-1999? Why have those models failed to meet expectations in 2000-2010? And obviously, what are we planning to do about it?
Today’s four-year-olds are depending on our ability to address these questions with candor and rigor. It would be embarrassing if 30 years from now they were asking us why we kept using models that don’t work .
Even FIFA is considering adding some sort of instant replay to the World Cup. That just goes to show that anything is possible if one asks the right questions.
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