The Income Share Agreement (ISA) as an investment hedge – why is it safer?
By Karthik Krishnan
The ideal investment for a financial investor is one that moves with the market in a good economy and against it (or not change much with it) in a bad one. Finding such an investment is hard. The best that investors can typically do is to invest a portion of their assets that are not very correlated (i.e., move less in tandem with) the market. So that when your other assets are tanking in value, there is something in your portfolio propping up the returns. This is the underlying theoretical logic behind diversifying your investment portfolio.
As of this writing, there are already murmurs of a recession and people are looking for safe havens for their investment. So perhaps it is worthwhile to think about where to put away extra dollars so that you will find them when you return from the protection of the recessionary storm shelter!
It turns out that income share agreements (ISAs), which is a relatively new asset class, may be a potential answer to investor’s prayers as they are awaiting the looming dark clouds.
In simple terms, an educational income share agreement is an obligation, but not a loan, where a student gets funded for education and pays back the obligation over a certain number of months, and the payment is calculated as a fraction of monthly income. Payments pause or are forgiven if income falls below a minimum threshold. If the payment term is completed (with or without payment) or if a maximum cap amount is paid, the obligation is over. Learn more about the MentorWorks Education Capital ISA Program here.
To understand why ISAs can be a recessionary hedge that can also take advantage of a bull market, it is important to understand the notion of dynamic correlation. Correlation is how the prices of two assets move together. Dynamic correlation is a measure that allows this price co-movement of assets to change over time. A great investment in one whose value increases with the market (i.e., has a positive correlation) during a strong economy, but does not decrease with the market during a weak economy (i.e., has zero or even negative correlation with the market). Given that ISAs pay off a percentage of personal income, we need to understand how personal income moves with the market.
It turns out that personal income has the characteristics of a hedge. Using data from the Bureau of Labor Statistics and the Census Bureau on total U.S. wages and compensation and average wages by education levels, we measured the dynamic correlation of wages with the S&P 500 stock market index over the last 65 years. It turns out that during the most severe major recessionary periods in the past 65 years, where stock prices declined substantially, the correlation between wages and stock market prices drop, whereas in regular economic growth periods, this correlation is high. In recessions where the correlation did not drop substantially, the price declines in the stock markets were not as steep. See Figure 1 for details. This is precisely what you would want in an ideal investment.
What if you invest in educational ISAs for individuals that subsequently receive college or advanced degrees? Figure 2, which shows average income for each type of education level (High school, college graduate, and advanced degrees) based on Census Bureau data, indicates that such the dynamic correlation is broadly similar across education categories, but tends to move against the market more for individuals with college or higher degrees. For instance, during the 2008 financial crisis, income of high school educated individuals had a positive correlation with the market, while incomes for individuals with college or advanced degrees had negative correlations.
We also look at how annual stock market growth compares to growth in aggregate wages and income. See Figure 3 for details. It turns out that total wages grew almost constantly across the last 65 years, with the only major decline happening during 2009 in the aftermath of the financial crisis. In contrast, the stock market annual price growth is highly variable, jumping between negative and positive growth across years. When we split this analysis by education levels, the patterns are similar in Figure 4. Thus, in terms of dynamic correlation and price stability, investing in income may be superior from a safety perspective.
What about unemployment? Common wisdom suggests that unemployment increases in recessions – which would put a spanner in our recession-proofness argument. It turns out that, not surprisingly, unemployment rates even in recessions are much lower for individuals with at least a Bachelor’s degree. Figure 5 shows unemployment trends from the Census Bureau for individuals 25 years or older across different education types. At the peak of the 2008 recession, the unemployment rate for college educated individuals is 4.9% compared to 10.6% for individuals with lower levels of education. In general, investing in college educated individuals is a safer bet in terms of job safety.
What are the mechanisms behind the trends we report above? We can speculate, and having talked to many industry experts on risk, we believe these are certain plausible reasons. It turns out that companies may be reluctant to fire key talent in a recession, particularly those with skills derived from higher education. This belies the usual na recession where people consistently lose their jobs. Companies might prefer to reduce hiring rather than resort to firings as a first resort in recessionary environments. With unemployment rates already at significantly low levels, it is a big risk for companies to lay off a significant portion of their workforce when they know that they will having to end up re-hiring when the economy improves. However, a recessionary economy of the magnitude of the 2008 financial crisis can still hurt employment and wage growth substantially, but as Figures 3 and 5 show, these trends can reverse rapidly when economic growth restarts.
So, are ISAs a good investment? We believe that a well-designed program with proper screening and underwriting can always unlock value for investors in any market setting . The candidate + program based screening approach we follow at MentorWorks allows us to protect our investors from recessionary environments and eat their economic cake in a strong economy. Of course, a part of any portfolio will underperform in a bad economy. ISA funded students that have yet to get a job will need some time to find employment in a recessionary economy. On the other hand, students funded and employed prior to a recessionary economy as well as those that we fund for higher education during a recession can have better outcomes.
Personally, I would prefer to fund more students during a recession as more individuals seek higher education during such times. This will a great time for deal flow for ISA investors. Just as recessions have provided the best opportunities for the great investors of our time like Warren Buffet to buy cheaply, they may be perfect times to realize the powerful benefits of ISAs in your investment portfolio.
I acknowledge thoughtful comments by Emilian Belev (Suffolk Univ. and Northfield Information Services), Lauren Cohen (HBS), Mine Ertugrul (Umass, Boston) and Debarshi Nandy (Brandeis). Any errors or omissions in this article are solely my responsibility.