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Market Meltdowns and Endowment Allocation

Strategies for new market realities
University Business, Dec 2008

THE WORLD’S FINANCIAL markets spent the latter part of 2008 in an unprecedented state of volatility. Pictures of frazzled and depressed traders became one of the worst clichés in the news because they seemed to run every day. Such storied firms as Merrill Lynch and AIG had to be rescued by the federal government, and average people shared stories of how smoothly their accounts were transferred after their banks failed.

It’s unclear if it will blow over, as the 1987 market crash did, or if it is a harbinger of worse things to come, as in 1929. All we know is that assumptions about endowment risk and return have been shaken up. Some types of investments previously thought of as secure, such as money markets, and some strategies, such as securities lending, have proven to be risky. Most people knew that on an intellectual level, but as they had never experienced losses with them, they forgot about it emotionally.

Spending rules based on five-year average performance pay off after a year like this one.

When the Dow is climbing, “you get complacent about risk,” says Robert Furnari, managing director at Northern Trust Global Advisors in Stamford, Conn. “There was a false sense of security, because even risky asset classes that historically had a lot of volatility had settled down.” As much as finance professors talk about rational investors and efficient markets, it’s emotions—hope, fear, and greed—that drive day-to-day market action. And right now, fear is in fashion, so many investors are selling no matter how low prices go. The government has been supporting failing financial institutions, but “the interventions will bring their own problems,” says Dick Anderson, director of the higher education practice at Hammond Associates in St. Louis.

“University endowments are very longterm investors,” so not all of the market’s issues affect them, says John Curry, managing director of the higher education practice of Huron Consulting Group in Boston. Unfortunately, it may be more difficult for a university to keep that longterm focus when part of the endowment is needed today. An individual who won’t be retiring for 20 more years can stay the course; that advice might not work for an endowment expected to contribute $15 million to the institution’s budget—especially if fundraising levels fall off with the economy. (It may be a long, long time before anyone anywhere has any highly appreciated stock to donate.)

“What I’m saying to clients is don’t panic and don’t make any knee-jerk reactions,” says Furnari. The only way to be prepared for any scenario is for endowments to hold a wide range of assets and work with several money managers.

That is easier said than done. The problem now is that the declines in the market have been systematic. Stocks, bonds, cash, real estate, and commodities have all been affected, leaving even many diversified endowments in dire straits. It’s unclear how well hedge funds, originally designed to protect investors from market gyrations, have performed. Most funds report results quarterly, so it won’t be clear until January who did what. Once the good managers stand out, “hedge funds are going to fall like rotten apples,” predicts Anderson.

Curry says that good hedge funds will protect many endowments. “Depending on how they are mixed in the portfolio, that may help them through this,” he says. Unfortunately, some of the funds that will not be doing well will be those that have had long histories of success. The extremes of the 2008 market have tested all sorts of assumptions about risk levels. Strategies that work one day might not work the next as prices whip up and down.

Many investment experts believe that rebalancing the mix of investments in an endowment is important to long-term success. Periodically, investors should buy and sell assets in order to return to the original asset allocation among stocks, bonds, cash, and alternative investments. This year, most endowments will find that their allocation to stocks is lower than it should be, so the challenge will be to sell other assets to buy stocks. Since general price declines have made some assets really inexpensive, the manager of an endowment with extra cash might be able to pick up some bargains.

The problem is that it’s not easy to sell anything these days to raise cash for investment or spending purposes. “Liquidity is such an issue,” Furnari says. “You have to balance that against the cost of selling fixed income to buy equities.” At an extreme, Commonfund had to limit withdrawals from its Fund for Short Term Investments because prices for the underlying assets were falling, even though they would return to full value at their maturity. This is essentially a money market account for colleges, so the limits made it hard for some campuses to pay bills.

The current performance problems will change assumptions for budget targets at most colleges and universities over the next year, such as development goals, library improvements, and tuition rates. The investment committee needs to ensure all constituents know there’s no guaranteed 10 to 12 percent return, says Anderson.

The silver lining, Curry says, is that most universities set their spending rules based on five-year average performance rather than the value of the endowment in any one year. That practice is controversial when the markets are rising, because it holds down spending as a percentage of the endowment. It pays off after a year like this one, as losses will be averaged out to keep the dollar value of spending from falling as fast as the value of the underlying assets. “This smoothing allows you to save a little bit as the endowment goes up,” Curry explains, which will help, especially if the market recovers in 2009.

But even if endowments can maintain their current dollar contribution, there may be pressure on many endowment trustees to find a way to spend more. That pressure may come from families rather than Congress this time. Not only will fundraising slow down in a weak economy, but more students will have trouble paying tuition. Families are watching their 529-plan nest eggs shrink, and with high unemployment fewer parents will be able to pay fees out of current income. Meanwhile banks are reluctant to lend to anyone, even students.

With conservative spending rules and robust assets, most higher ed institutions will survive just fine, as they did when the market fell at the end of the dot-com bubble. But some, especially private IHEs that rely on tuition for much of their budgets, may suffer mightily. Smaller colleges with small endowments will fall further behind, Curry says. “They don’t have enough resilience to just drive through this market.”

There’s a precedent. Ohio’s Antioch College closed in 2007, hurt by low enrollment and a small endowment that left the institution without enough money to operate. Financial markets were reasonably good then. Antioch may be the first in a wave of college closings, mergers, and restructurings brought on by financial problems, as there’s little leeway after a year like this one. “We have a lot more pain to come,” Anderson says.

Ann C. Logue is a Chicago-based freelance writer who specializes in covering financial issues and news.

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