Dutch foundations (known as "stichtingen”) face a large financial risk. In 2022, bonds (more specifically, government and high quality corporate bonds), which are typically perceived as secure investments, failed to shield Dutch foundations from significant financial losses. As this trend could continue, we should be concerned about the long-term financial health of foundations and, given their social mission, the ripple effect on society.
Recent reports from the Dutch financial newspaper Het Financieele Dagblad highlight the financial challenge faced by foundations. Over the past year, the average financial losses among 70 Dutch philanthropic organizations stood at 14%. This figure is notable, considering that foundations, based on their social mission, typically adopt a more cautious investment approach compared to other investors. They adhere to an investment strategy focused on bonds and equities, in which bonds are viewed as lower-risk assets. The expectation is that bonds shield against declines in equity prices due to the negative correlation between these asset classes—when equities decline, bonds remain stable or go up, and vice versa.
However, contrary to expectations, both bonds and equities experienced a downturn in 2022. The graph below illustrates the rarity of such an occurrence, with last year's severity being unprecedented:
Even though 2022 was an extraordinary year, it is not new that bonds and equities are moving in the same direction. The last time this occurred was over 20 years ago and the common factor between these two periods is higher inflation. Indeed, when inflation rises above 2%, the correlation between bonds and equities becomes positive, in other words they may decline simultaneously (see graph below). This means that an investment strategy based on bonds and equities may no longer provide the level of diversification that investors intend.
The key question for Dutch foundations is whether the higher inflation of 2022 was an isolated incident, or the beginning of a new normal. Indeed, the latter is likely. In the past 20 years, inflation remained low because of a stable world order. However, the world has changed, as political developments have led to a new situation both between and within countries:
Together, these political developments have created an environment where inflation is likely to persist at elevated levels for the longer term. As we have shown, this poses a significant risk to the financial stability of foundations still adhering to an investment strategy based on bonds and equities.
It is time for Dutch foundations to reassess their investment approach and explore alternative investment strategies. Specifically, foundations should examine the prospect of investing in assets that provide a hedge against the sensitivity to interest rates of bonds and equities. This is crucial to mitigate the risk posed by the possibility of prolonged higher inflation, which could keep the correlation between bonds and equities positive. Non-interest rate correlated assets, such as physical assets like commodities (typically playing a minor role in an investment portfolio) and certain types of hedge funds (which may have a more significant role), are examples worth considering.