Endowment Management: New and Proven Strategies
Many of the answers to your endowment building questions may be found in tried-and-true investment strategies, but you may need to look farther-all the way to the other side of the globe.
From covering risks to increasing international investments, endowment managers at universities and colleges, as well as investment firms, continue to pay close attention to the economy-in the U.S. and globally-as they look to identify new ways to build endowments.
Short credit is playing a key role in endowment strategy, say managers, because credit spreads are much too narrow and they're likely to widen.
And, as credit spreads widen, they impact equities, fixed income, and most hedge fund strategies.
Credit spread is the spread between Treasury securities and non-Treasury securities that are identical except for quality rating. The term can also refer to an options strategy where a high premium option is sold and a low premium option is bought on the same underlying security.
"Clients for the most part are not rewarded for taking risks in this environment, so we're trying to protect against this," says Dick Anderson, practice leader for higher education at St. Louis-based Hammond Associates Institutional Fund Consultants.
The need for short credit is created by the liquidity in the economy, which raises asset prices. What that means, he says, is that the higher price you pay for an asset, whether it's stocks or bonds, the lower the prospective returns.
"That's the trend," Anderson says. "As people are fooling with that trend and are taking more risks than the prospective rewards, we're trying to counter that by buying protection, and specifically we've been buying credit production, short credit funds."
So while investors are taking more risks, Hammond Associates is working with clients to reduce risks.
"The notion is that everyone is embracing risk," Anderson says. "Our intention is to back away from risk."
A move toward more international investing is another trend that's cited by college and university endowment managers around the country.
"Increasingly we are allocating assets to non-U.S. common stock in both developed and emerging markets," says Jeff Davis, senior vice president for finance at the Kansas University Endowment Association, which has an endowment portfolio for The University of Kansas valued at $950 million.
KU's endowment strategy, Davis says, involves considering allocations that more closely reflect each region's gross domestic product.
"We're increasingly looking more globally rather than just locally in the U.S. for investment opportunities," he says. This includes looking more toward international developed markets and international emerging markets.
"I think the underlying thesis is that if you look at world economies and where growth and opportunities are, it's not just in the United States," Davis adds.
globally rather than
just locally in the
U.S. for investment
-Jeff Davis, Kansas University
Jeff Margolis, director of Institutional Sales and Marketing at TIAA-CREF, a New York-based financial services organization, has noticed that there is definitely a secular trend toward international exposure.
The trend, he says, is likely to continue "as the world, excluding the United States, grows faster than the United States itself," says Margolis, who serves as head of business development for TIAA-CREF Asset Management.
Davis says KU is also looking to increase its allocation to international bonds. "When you look at where the productivity and economic growth is in the world, it's more globally distributed than it was years ago," he says.
Jonathan Hook, chief investment officer for Baylor University (Texas), reveals that the institution moved its international allocation up last year. It's a tactic that has paid off nicely.
"In terms of strategy we are continuing to diversify further," Hook reports. He says the institution is also using diversification as a "first-line measure against a market downturn." Baylor, with a $750 million endowment, has incorporated short credit into its portfolio, he adds, and a goal is to add some return into its domestic equity portfolio.
In addition, its portfolio now has a sub-asset class within the real assets category of investments (those that are physical or identifiable, such as gold, land, or equipment). "We think it will be a lower-risk asset class with good-not necessarily great-returns and be very uncorrelated to the markets," he says.
Further, Baylor is looking into the possibility of recasting its asset allocation to divide its portfolio between different themes or strategies as opposed to the traditional style boxes. The work is in process now and will not be finished for a few more months, at which time it will reach a formal approval stage, Hook says, adding that "it has gotten good response from those who have seen it so far."
Ron Neville, chairman of the Investment Committee of the Drury University (Mo.) Board of Trustees, says he believes his institution is ahead of the curve compared with its peer group. His evidence: Going back more than 15 years ago, Drury made a 20 percent commitment to international equities, which was unusual at the time. "And still today we have a higher commitment than the rest of our peer group," Neville adds. The university has an estimated $75 million in endowment funds.
Diversification is the motivation for Drury's investment strategies, Neville says, but what's been going on in the last month in the markets is flying in the face of that.
The typical situation used to be that if the U.S. markets declined, foreign markets might go up, Neville explains. "But in the last month, U.S. markets have gone down, international markets have gone down, gold's gone down, oil's gone down-everything."
"Another reason for diversification is that a lot of people are predicting that the dollar versus foreign currencies will continue to be weak, so foreign assets will remain stronger. That's helped Drury in the last few years."
Jud Koss, managing director of Commonfund, which manages approximately $36 billion for more than 1,600 educational institutions and other nonprofits, says he sees more and more IHEs turning to outsourcing.
He's not talking about the kind of outsourcing already in place at most institutions-where they hand over aspects of the investment management process to organizations outside the college or university-but rather when an external provider takes over responsibility of the day-to-day management of a majority of an institution's investment funds.
Koss says one of the reasons that "mega" endowments, such as those at Harvard and Yale, just keep getting bigger is that they each have entire internal management companies dedicated exclusively to their endowment's management.
Successful endowment investment becomes more complex, he says, as diversification becomes more important. The number of asset classes has grown from three to 10 or more, yet many colleges and universities just don't have the luxury of full-time staff.
diversify further and
as our first-line
measure against a
-Jonathan Hook, Baylor Unversity
Further, over the last five years, there's been a marked shift toward investments in classes of alternative assets, such as real estate, commodities, venture capital, private equity, oil and gas, timber, distressed debt, and hedge funds.
The 2006 Commonfund Benchmarks Study shows that most endowments and foundations are using alternative investments to a greater extent, as well as active asset allocation, diversification, and risk management, to maximize both returns and intergenerational equity.
John S. Griswold, executive director of the Commonfund Institute, Commonfund's research and education arm, says the leaders achieved significantly higher returns by increasing allocations to alternative strategies and reducing allocations to domestic equity in 2005.
"This indicates institutions' greater need for special expertise in due diligence, risk management, and proper diversification of an alternatives portfolio," he says, responding to the study.
The trend has meant sub-categories, each carrying a different risk of loss, impact, return expectation, and higher levels of derivative risk. "These schools don't have the manpower to observe all the investments needed to obtain the diversification," Koss notes.
Another Commonfund study, the 2005 Educational Endowment Report, showed that the 707 institutions participating have an average of 1.2 full-time equivalent staff members. But staff size varies widely, usually in proportion to the size of the endowment, according to additional Commonfund research.
Michael West, treasurer and vice president for finance and administration at Skidmore College (N.Y.), believes it is likely that smaller to mid-size schools like his will follow successful strategies used by the larger schools. The college grew its endowment from $35 million in 1993 to more than $220 million in 2006.
Those strategies, he says, will include moving out of traditional U.S. stocks to low correlative investments such as hedge funds, and using different strategies within that asset class with specialized managers, such as investing in distressed securities.
"This trend will result in many more managers, even for relatively small portfolios," West says. "Also, there is likely to be continued movement to international investing, as returns are attractive, diversification is improved, volatility in returns are minimized, and as the world economy grows at a faster pace than the United States."
Those kinds of changes, West says, will be difficult for smaller to mid-size schools because generally they do not have access to the best managers in these asset classes due to investment minimums, frequent personnel changes, and closed funds. Also, smaller colleges are more limited in the risk profile that they can take on, he says.
"Generally smaller and mid-size colleges do not have the resources-staffing and related time-to manage these complicated, changing, volatile investments," West maintains.
"These schools generally cannot compete with the salaries on the street, nor recruit or retain the highest-quality professionals, and they don't have the economies of scale larger schools can achieve by spreading the costs of investment management over a larger pool of assets."
The Commonfund Benchmarks Study released in January, which covers 729 private college and university endowments, public educational endowments, independent school endowments, and private foundations in support of education, showed 32 percent of the institutions are expecting to increase their alternative strategies allocations. Twenty-four percent said they expect to decrease domestic equity allocations, and 16 percent expect to decrease cash and short-term allocations. Few expect to make any change to fixed income allocations. International equities expectations are split, the study shows, with 14 percent anticipating a decrease, and 10 percent an increase.
West says that although firms are forming or have recently incorporated to contract or outsource investment management, and pooled investment vehicles do exist, generally results are uneven, or untested over different market cycles.
TIAA-CREF's Margolis acknowledges that college and university endowments are outsourcing "a bit more," but he says it is still not pervasive.
According to Commonfund, the outsourcing trend is being fueled by the lack of time university and college trustees, specifically investment committees, can give to endowment strategy.
Calling it a "conundrum faced by the twin trends of growing complexity and static resources," Commonfund CEO Verne Sedlacek, in a commentary published last winter in CFQ, the firm's quarterly booklet, questioned whether the investment committee model is the optimal way to manage a portfolio.
The article poses this question: How can trustees exercise their responsibilities in a manner consistent with that of a fiduciary and how a group of individuals can focus their limited resources in a way that can fully address all of the issues spanning everything from high-level policy to manager selection?
That's what Commonfund's managing director Koss wonders too, saying that some trustees get caught up in what he calls the "downstream stuff"-such as rebalancing portfolios-when they should pay more attention to the upstream, big-brain picture.
"Those are things that these folks shouldn't get mired in," he says of what lies downstream.
However, West gives Skidmore trustees a lot of the credit for the college's significant endowment growth.
commitment [to international
the rest of our peer
group. ... A lot of
people are predicting
that the dollar versus
foreign currencies will
continue to be weak."
-Ron Neville, chairman of the
Investment Committee of the Drury
University Board of Trustees
"As our trustees become more engaged appropriately in investment policy and strategies, and more invested in the college, and choose to spend more time with us, we gain their valuable expertise, and access to their contacts. Frequently they see the difference their contributions and the contributions of others make and they donate more money to the college," West says.
Further, the trustees are able to reflect on deals or managers and consider what's good for Skidmore.
"This engagement, reflection, and judgment is far superior than a paid consultant's advice giving the college historical data on performance of a fund, or the r?sum? of a fund manager," West says. "This is a critical difference, I believe."
He cites Arthur Zankel, former chair of the investment committee and longtime member of the board. According to West, it was Zankel who more than a decade ago led the college to looking at investment classes, including alternative investments, hedge funds, and real estate.
"Skidmore's portfolio structure looked more like a university than a small college," West says. It was Zankel's connections and those of other trustees, along with Zankel's national reputation, that allowed Skidmore to get into funds generally closed to schools of Skidmore's size.
"His and others' direct knowledge of a fund's management team, their investment philosophy, mistakes, lessons learned, and experience trumps a third party or report on these important and critical issues," West points out.
Zankel, whose two sons attended Skidmore, helped recruit other strong investment professionals to the board. Today, Skidmore's investment committee remains strong, and Zankel recently left Skidmore $42 million in his will-"clearly a transformative gift for the college he loved," West says. "Leadership and appropriate engagement makes a difference."
Toni Cardarella, a freelance writer based in Kansas City, Mo., specializes in business and finance topics.
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