Emerging From the Crisis: Endowment Forum Highlights
After a dismal year for endowments, the NACUBO 2010 Endowment Management forum was light on talk of investment opportunities. Rather, presenters warned of ballooning government debt and the downside of excessive monetary expansion; several mentioned gold as a good hedge against paper currencies and inflation.
By Mimi Lord
Following the worst year in endowment performance since NACUBO's annual surveys began in 1971, speakers and participants at the 2010 NACUBO Endowment Management Forum focused substantially on lessons learned from the financial crisis. They placed particular emphasis on liquidity and risk management. More than 400 representatives from colleges, universities, and the investment industry attended the January 28–29 event in New York City. Few investment-oriented speakers mentioned attractive opportunities; instead, more expressed lingering concerns about the economy, burgeoning government debt, and potential problems from excessive monetary expansion.
NACUBO's President and CEO John Walda and Senior Vice President Matt Hamill opened the forum with headlines of the 2009 NACUBO-Commonfund Study: the average endowment declined 18.7 percent in the fiscal year ended June 30, 2009. This far exceeded the previous record decline of 11.4 percent in 1974, with the total loss of all educational endowments in the study approaching $100 billion over the recent one-year period. In comparison, the S&P 500 index lost 26.2 percent and the Barclays Capital Aggregate Bond Index gained 6.1 percent over the one-year period.
John Griswold, executive director of Commonfund Institute, provided additional details of the 2009 study, the first in which NACUBO and Commonfund combined their previously separate studies into one. In an unusual twist, he noted, the category of largest endowments (those with assets exceeding $1 billion) experienced the worst returns—averaging –20.5 percent. In contrast, the category of smallest endowments (those with less than $25 million) performed the best, with an average of –6.8 percent returns. As a result of the losses, the number of institutions with assets greater than $1 billion dropped from 75 in FY08 to 52 in FY09.
The main reasons for smaller endowments' relative outperformance, explained Griswold, were their greater exposures to fixed income and cash, and their lower exposures to real estate and commodities. While the endowment model initiated by large institutions—with broad diversification and sizable allocations to alternative investments—proved challenging in FY09, Griswold said the model is not broken and that he continues to believe that it provides long-term superior returns. He applauded schools for maintaining their endowment spending levels during the crisis, providing continued support to institutional programs and overall budgeting.
Dual Difficulties: Illiquidity and Debt
Roger Goodman, vice president and team manager, Moody's Investor Service, presented an overview of two long-evolving campus trends that converged during the crisis: the growing illiquidity of endowment portfolios and the increasing debt levels of colleges and universities (along with greater needs for liquidity to support the debt). Goodman said variable-rate debt levels at many institutions increased because of a heavy focus on reducing costs, but at the expense of higher risk. In addition, there were incentives to increase debt in order to preserve funds for investment in the endowment.
Goodman challenged participants to question whether the crisis “was truly the 100-year flood or rather the 100-year flood that occurs every 10 years,” adding that answers to that question will determine the extent of changes campus leaders will make.
Other questions he posed included the following:
- Were board members fully versed in the risks of debt and investment choices?
- Did the endowment results exceed colleges' risk tolerance?
- Where does responsibility lie for risk and liquidity management?
- Is there a need for a higher-level campus officer who oversees both the finance and endowment operations?
As a result of the problems exposed during the 2008–09 downturn and the lack of transparency for liquidity in the sector, Moody's has developed new measures for assessing sources of liquidity and liquidity sufficiency in worst-case scenarios, noted Goodman.
Maintaining liquidity for uncalled capital commitments and for campus distributions became a primary concern of endowment fiduciaries, as highlighted in several forum discussions, including the session “What Has the Recent Past Taught Us?” moderated by Commonfund's chief investment officer (CIO) Lyn Hutton. Participating in the presentation, Emory University's CIO and vice president of investments, Mary Cahill, said her team began in-depth liquidity modeling in 2006 and worked closely with the Atlanta-based university's finance office to ensure that liquidity was available for the needs of both the endowment and the university overall. Copanelist Jonathan Hook, vice president and CIO of the Ohio State University Foundation, Columbus, described how his staff kept a close eye on available cash on a 1-day, 10-day, 30-day, and 90-day basis. He challenged endowment fiduciaries to stop the “performance derby” atmosphere that prevails at many institutions to the detriment of other goals.
Panelist John Michaelson, partner and portfolio manager, Imperium Partners Group and chair from FY04 through FY09 of the investment committee at New York City's Cooper Union for the Advancement of Science and Art, noted that Cooper Union had learned hard lessons during the dot-com crash. Since that time, the institution has focused heavily on asset correlations and downside risk protection. Cooper's endowment declined only 8 percent during FY09, while returning 16 percent annually for the five years ending June 30, 2009. Since Cooper's endowment spending provides 75 percent of the school's operating budget, the committee stays in close communication with the financial office. “What works for Cooper and for Yale, however, is very different,” he said.
Jane Mendillo, who joined Harvard Management Co. as president and CEO in July 2008, said that big lessons from the 2008–09 crash included: (a) asset correlations can approach 1.0; (b) pricing of illiquid assets can be far more volatile than expected; (c) leverage associated with alternative investments needs to be considered carefully; and (d) liquidity must be tied to university funding. Although access to cash became an issue during the crisis, said Mendillo, “We are certainly not backing away from illiquid investments; however, we are more focused on the necessary risk premium.” She noted that Harvard's 8.9 percent annualized return over the past 10 years (compared to a 1.4 percent annualized return from a traditional 60 percent equity–40 percent fixed-income portfolio) was due to the evolution of its policy portfolio over the past 25 years toward broad diversification among both public and private investments.
A mix of industry and higher education financial professionals spoke about the economy and financial market conditions. Presenters included John Paulson, president, portfolio manager, and director, Paulson & Co.; Karl E. Case, economics professor, Wellesley College, Wellesley, Massachusetts; Michael Goldstein, managing partner, Empirical Research Partners; Robert Millard, partner, Realm Partners; David Darst, managing director and chief investment strategist, Morgan Stanley Smith Barney; and Larry Kudlow, founder and CEO, Kudlow & Co.
Paulson described the process his firm followed in assessing the fragility of the mortgage market in 2006–07, which prompted the firm's purchasing of protection on tranches of subprime debt and resulted in enormous gains. As corporate bonds plunged during the crisis, his firm focused on identifying and buying distressed bonds that he and his copartners believed would not default. Paulson emphasized that while “making money” is important, protecting capital in down markets is the key to long-term superior returns.
Paulson expressed his concerns about the extent of the Federal Reserve's monetary expansion and the potential for inflation. Because of extensive global monetary easing, Paulson said he has less confidence in paper currencies and believes gold is the best alternative. Possible developments that could negatively affect the markets would be a double-dip recession—although he doesn't expect it—and sovereign debt defaults. He referred to Greece's $400 billion in unsecured sovereign debt as a significant concern.
In addition to gold, Paulson noted that he sees opportunities in the following areas:
- The banking sector, as provisions for credit losses subside.
- Public real estate, especially in the hotel sector.
- Companies that are reorganizing or have emerged from reorganization.
- Merger arbitrage.
Paulson's forecast for U.S. GDP growth in 2010 is 2.5–3.0 percent.
Karl Case, who, along with economist Robert Shiller of Yale University, New Haven, Connecticut, developed the widely recognized Case-Shiller Home Price Indices, said he is optimistic that a bottom is forming in housing prices following the 30 percent average decline since prices peaked in 2005. Inventory of for-sale properties has dropped from an average clearing period of 11 months in November 2008 to a 7.2-month period in December 2009. This is in large part a result of the dramatic falloff in new housing starts, said Case. Currently, housing starts are running at an annual rate of 550,000 units compared to an annual rate of 2.3 million units at the construction peak in early 2006. Concerns linger, however, because of continuing high rates of bankruptcies, foreclosures, and unemployment.
Other views about the market were mixed. Kudlow expressed the most optimistic near-term economic outlook, with a 2010 GDP growth projection of 4–5 percent, but expressed fears of significant inflation in coming years. As for currency, Darst predicted that gold would continue to appreciate in coming years as the U.S. dollar loses stature as the primary reserve currency. Millard shared his valuation metric that compares current values of all wealth to GDP, indicating that prices currently are too high and will revert to more normalized levels. Finally, Goldstein referred to the tremendous cash flows of large corporations resulting from severe cuts in capital spending and corporate overhead and providing strong potential for equities.
Endowment Management Practices
Other sessions centered on trends and improved practices at both small and large endowments. John Palmucci, vice president for finance and treasurer, Loyola University Maryland, Baltimore; and Michael Eadie, associate vice president for finance and controller, Canisius College, Buffalo, New York, spoke of developments at their institutions to build greater expertise on the investment committee, including the addition of professionals from the investment industry who are not board members. At Loyola, all six members of the committee are now investment professionals, said Palmucci, with three selected from the board and three from outside.
Judy Van Gorden, senior vice president and CFO, Arizona State University Foundation, Tempe; and Sally Staley, CIO of Case Western Reserve University, Cleveland, led a discussion on issues and trends at larger endowments. The session included comments from various participants about the increased focus on all types of risk and the imperative to understand the unique risks of one's own institution. Staley noted that institutions may vary considerably in how they view: (1) risks related to illiquidity, (2) underperformance relative to benchmarks or peers, (3) losses of any size, and (4) volatility. She cautioned against peer comparisons of performance since institutions' needs and constraints vary so much.
Jack Rich, senior vice president and CIO, Abilene Christian University, Abilene, Texas, on the other hand, noted that performance analysis relative to peers as well as to other benchmarks had boosted initiatives at his institution to improve committee expertise and operating practices.
Ohio State University's Hook explained how his endowment team had evolved from analyzing the portfolio in distinct asset classes and subclasses to viewing the investments in larger buckets, which he categorized as follows: (a) market-exposure equities that consist of both long-only and long-short strategies; (b) return enhancers that include higher volatility investments such as private equity, venture capital, and distressed debt; (c) inflation hedges such as timber, agricultural investments, and commodities; and (d) risk reducers such as fixed-income and absolute-return hedge funds. He said his team has adopted customized benchmarks for each of those buckets and uses other specific benchmarks for each manager.
Investment officers from several large endowments described how they have developed subteams that focus either on marketable or private investments, along with a dedicated risk-management specialist. Yoke San Reynolds, vice president and CIO, University of Virginia, Charlottesville, said that her institution's endowment's bylaws require expertise in different investment areas, and that subcommittees are established for each asset class. Harvard's Mendillo described a new initiative that better integrates the endowment's internal investment team—which manages about one third of total endowment assets—with its external management teams. That integration is proving beneficial in revealing additional investment opportunities, she said.
A concluding discussion moderated by Timothy Peterson, partner, Ashland Partners & Co., focused on “Endowment Practices for an Improved Future.” Panelists reemphasized the importance of close communications with other university offices and the continual need for improving processes and expertise. University of Virginia's Reynolds and Mark Schmid, vice president and chief investment officer at the University of Chicago, stressed the need for liquidity modeling that not only prevents problems, but also provides reassurance to university fiduciaries.
Copanelist Chris Bittman, partner, Perella Weinberg Partners and former CIO of the University of Colorado Foundation, advised participants to think carefully about the best use of their committees and staff. He cautioned against limiting committee members to board members or alumni and suggested that compensating investment committee members could be beneficial in raising their sense of fiduciary responsibility. Referring to institutions that lack conscientious, professional committee members and staff, Bittman stated his view: “It's malpractice to run a pool of institutional money without daily oversight.” Outsourcing investment operations, he continued, can provide greater investment expertise but has to be weighed against loss of interaction, which is more likely to exist between an internal team and the rest of the institution's operations.
MIMI LORD, a chartered financial analyst and chief investment officer, Spero-Smith Investment Advisers, Cleveland, is the 2007 recipient of NACUBO's Rodney H. Adams Endowment Management Award for contributions to the field of endowment management.