Why non-profit investors should think twice before de-risking

Executive summary:

• High expected fixed income returns imply many non-profit investors could de-risk while still expecting to achieve their stated return objective
• For those focusing on minimising volatility it is likely attractive, but for others it is more nuanced
• Investors should consider the context around their return objective and the potential opportunity cost before adjusting their portfolios

Non-profit investors often distill their objectives into a return target. It seems obvious that higher expected returns from fixed income imply that investors should de-risk from equity to fixed income and reduce portfolio risk for a given return target. Although this may be appropriate for some, it is an oversimplification of investment strategy, and it would not result in an appropriate asset allocation for many investors. Non-profit investors should first consider these factors:

1. How was the return objective and strategic asset allocation set?
2. Has the portfolio achieved its return target historically?
3. What is the opportunity cost of underweighting equity?

How was the return objective and asset allocation set?

The stated return objective can mean different things to different non-profit investors. For some it is an aspirational target and for others it is a minimum objective that they would like to surpass, while for others it was the calculation at one point in time of a reasonable return estimate for the portfolio that most aligned with their risk tolerance. In none of these cases is the portfolio built with the expectation that in all market environments the return target will be exactly met.

The strategic asset allocation is designed with uncertainty around the return target and investor preferences in mind. This results in a range of differently constructed, yet appropriate, portfolios for the same stated return target, depending on how the investor prefers to balance risk potential with growth opportunities. Therefore an investor with a lower risk appetite is more likely to consider increasing the allocation to fixed income than an investor focused first and foremost on maximising growth.

For healthcare systems that factor in the cost of borrowing when setting the return objective, there’s also another factor to consider: whether rising borrowing costs will require a higher return objective. Other non-profit investors that care about real returns and real spending should also consider if changing inflation expectations require a higher nominal return objective.

Has the portfolio achieved its return target historically?

Significant losses often create attractive valuations and high forward-looking returns. This is currently the case with fixed income. Although the main losses for fixed income occurred over two years ago, for many non-profit investors those losses—combined with high inflation and strong, but volatile, equity markets—mean that their total-portfolio returns may have fallen short of meeting their objectives in the past three to five years.

Due to the wide variety of returns over this time period, the answer will vary from investor to investor. Ultimately, though, before considering de-risking, all investors should review their historical performance while determining their return objective for the next five to 10 years.

The opportunity cost of underweighting equity

Even if an investor expresses confidence that fixed income returns will be elevated down the line, this should not necessarily equate to a tactical preference for fixed income over equity. In addition, it’s important for a typical non-profit investor with a capital constrained portfolio to understand that any increase in allocation to fixed income will come with a corresponding reduction in the allocation to equities. In other words, both the tactical and long-term expectations of equity returns relative to fixed income returns still matter—and may not have changed just because fixed income yields are up.

Crucially, since equity returns often come in waves to compensate for the years in which they are low and/or negative, it is important to not miss out on those strongly positive years. For instance, an investor that saw relatively high fixed income yields in October 2022 or October 2023 and correspondingly de-risked out of equity and into fixed income would likely regret that decision—unless it was based on an organisational need to reduce total portfolio risk.

This is not to say we expect the same returns out of equity in 2025 that we experienced in 2023 or 2024. But we are mindful that it is a possibility, and without strong conviction otherwise, are hesitant to underweight equities. If there is not an organisational need to reduce risk, non-profit investors should consider asking: If I reduced my allocation to equities because of high fixed income yields, but then equities outperformed core fixed income 25% to 6%, how would I feel?

The bottom line

A seemingly simple proposal—taking advantage of higher expected fixed income returns by increasing  allocations to the asset class, in order to achieve return objectives with less risk—is not so simple. That’s not to say that doing so shouldn’t be considered, as there are many valid reasons why adding to fixed income could be appropriate, including an organisational desire to minimise volatility and drawdowns.

Ultimately, the main takeaway is that non-profit investors shouldn’t de-risk just because yields have increased—as tempting as that may be.