Volatility Dominates Endowment Forum Discussion
As endowment performance showed sharp improvement over the negative returns of the past two years, presenters at the NACUBO 2011 Endowment Management Forum focused on issues related to market volatility.
By Lisa Jordan
See also "Outlook for University Liquidity Management."
With market recovery and investment performance finally positive again, presenters at the NACUBO 2011 Endowment Management Forum expressed varying degrees of optimism, while focusing on issues related to market volatility. Braving a fierce winter snowstorm that blanketed the Northeast and shut down airports, 325 representatives from colleges, universities, and the investment industry attended the January 27–28 event in New York City.
The forum opened with an overview of results of the second annual NACUBO-Commonfund Study of Endowments (NCSE), presented by Kenneth E. Redd, NACUBO director of research, and William F. Jarvis, managing director and head of research for the Commonfund Institute. Data gathered from 850 U.S. colleges, universities and affiliated foundations participating in the study show that these institutions' endowments returned an average of 11.9 percent (net of fees) for the 2010 fiscal year—a dramatic improvement over the average —18.7 percent return reported in last year's study for FY09. (For more details on the NCSE, read "Breaking the Surface" in the March 2011 issue of Business Officer or see the press release .)
Jarvis called 2010 a "transitional year." Due to the steep losses of FY09, there was speculation that the endowment model was "broken." But the strong showing of institutional investors in 2010, Jarvis believes, demonstrates that the endowment model is "still alive and well," because the broadly diversified portfolios have the potential to outperform in the years ahead, particularly for institutions with larger funds that can be diversified across many more asset classes. However, due to the steep losses from the prior year, there is need for substantial rebuilding, as the typical endowment remains roughly 16 percent below pre-recession value.
Strategies for Managing Volatility
Despite the good news about 2010 returns, investors should not become complacent about volatility. Investors seeking to support spending needs while maintaining purchasing power need to adopt portfolios that are subject to relatively high levels of risk. Risk and return are inextricably linked. For such investors, "volatility is persistent and cannot be avoided," said Celia Dallas, co-director of research, Cambridge Associates.
Historical data show that bad performance periods are clustered together, which makes sense conceptually—the sources of sharp declines and their ripple effects are unlikely to disappear overnight. Markets are certainly vulnerable today, with possible headwinds including ongoing stresses in Europe, a hard landing in China, and geopolitical risk in the Middle East. Further, history shows that secular bear markets (a period of a decade or more in which valuations move from excessively overvalued to very cheap) typically do not end until normalized equity market valuations hit wipeout levels of middle to high single digits—levels we did not quite reach during the depths of the financial crisis.
Examining a chart showing 111 years of equity market returns from 1900 to 2010, Dallas demonstrated that equity markets have long endured frequent periods of high volatility, and that these declines tend to group together, with significant periods of time between tails. "Negative returns," she said, "are often concentrated, and difficult to recover from." The impact comes not just from the decline, but from the difficulty of recovery. Historically, recovery periods have lasted decades rather than years. Is it safe to sound the all-clear? Not yet, according to Dallas.
Keeping a well-diversified portfolio is just one strategy that investors can use to help manage volatility. However, Dallas suggested that during tail events, particularly when a common source lifts and then sinks all boats sharply, planning ahead by developing a contingency plan that is well understood and endorsed by key stakeholders, and that includes a strong process to mitigate behavioral risks and adequate protection against tail risks, can help steady the ship when a storm inevitably strikes.
Putting Volatility in Context
David Darst, managing director and chief investment strategist, Morgan Stanley Smith Barney, reviewed economic themes of the past several years. He called 2008 the year of money market funds, with bankruptcies, bailouts, and due diligence; 2009 was the year of quantitative easing, with stimulus measures, accounting, and stress tests; and 2010 was the year of sovereign credit concerns, involving monetary tightening and easing, inflation and deflation worries, and stresses on creditors and debtors.
What is happening in world markets today? Darst cited bearish factors, such as:
- An impaired employment picture with regard to jobs and underemployment.
- Deleveraging balance sheets by banks and households.
- Weakness in residential and commercial real estate.
- The financial condition of state and local governments.
- Lack of volume, quality, and leadership in the market rally.
- Risk of higher taxes, inflation, and interest rates down the road.
- The lack of resolution of the big issues: debt, deficits, derivatives, and the U.S. dollar.
On the other hand, there are bullish factors:
- Low interest rates and low inflation.
- Quantitative easing and federal fiscal stimulus.
- Favorable corporate profits for 2011 and 2012.
- Significant cash sitting on the sidelines, especially on corporations' balance sheets.
- Improving manufacturing, confidence, and commercial lending in the United States, and global GDP growth, particularly in emerging markets.
- Individual investor skepticism and funds flows.
Darst said the world is currently dealing with aftereffects of the recession. There has been a "stampede to thrift." There has been international monetary rivalry; global investors are particularly concerned about currency preservation and the future status of the U.S. dollar. Conflicts exist between the haves and the have-nots, between public and private employees, and between the baby boomers and the newly emerging BlackBerry generation.
What do we do about this? Darst proposed a focus on structural reform in America. The main issues that must be addressed are: education and infrastructure; savings and investment; debt and deficits; societal disparity and generational reality; and the value of money and global monetary system. Our country, he stressed, must be built on education and infrastructure-public schools are critical. Preservation of currency and the status of the dollar in the world are also extremely important.
As for what may come next, Darst concluded, "The mobile Internet is going to change everything." Endowment managers need to be aware of what this will do to different asset classes.
Volatility in the Global Markets
James Zukin, senior managing director and cofounder of Houlihan Lokey, began with an overview of the world's current financial situation: quantitative easing by the Federal Reserve, ratings downgrades, mounting government deficits, growing sovereign guarantees, China's raised interest rates, bailouts, currency wars, and trouble in the Euro zone.
However, he said, history repeats itself. The first corporate insolvencies harken back to the early 1700s—to John Law's Mississippi Company in France, which led to the French Revolution, and to the South Sea Company in Britain, which lead to the creation of an enduring financial market. "Crisis is the auto-correcting mechanism that pulls the air out of the bubble," Zukin said.
Today in global markets, Portugal, Italy, Ireland, Greece, and Spain comprise the PIIGS (indebted economies), while Brazil, Russia, India and China are the BRICs (fast-growing economies). The BRICs have explosive GDP profiles and favorable demographics, with very little of their funds invested internationally. Dramatic growth is expected in Russia and the country is attracting significant foreign investment.
China is set to overtake Japan as the world's No. 2 economy after the United States. It is the largest holder of U.S. national debt, yet it comprises a fraction of investment in the United States from the region.
One of the big questions today is what the global reserve currency will be: the dollar, yen, euro, pound, renminbi, Special Drawing Rights, or gold? Gold, according to Zukin, will not solve world issues.
Responses to Volatility and Liquidity
Panel discussions brought together endowment professionals from colleges and universities with representatives from the investment industry. Participants also had opportunity to share their experiences in roundtable sessions based on endowment size (small, under $50 million; medium, $50 million to $100 million; and large, over $100 million).
Managing liquidity means managing volatility, said Lyn Hutton, managing director and chief operating officer of Prager, Sealy & Co. Hutton moderated a panel discussion on manifestations of and responses to volatility that included Alice Handy, president of Investure, and Jonathan Hook, vice president and chief investment officer at the Ohio State University.
As Handy and Hook discussed their respective organizations' practices, risk loomed large. Hook noted that at Ohio State, only 3 percent of the operating budget comes from the endowment. When he arrived, he changed the practice of allocating 100 percent of the distribution at the beginning of the year to a monthly distribution, "budgeting essentially like a mortgage." Ohio State now views portfolios from a risk standpoint rather than traditionally, as asset silos. Handy said Investure looks at clients' portfolios according to various risk characteristics: geography, liquidity, leverage, capital structure, and unfunded private commitments.
How do institutions think about managing asset allocation risk? asked Hutton. Handy said Investure changed its guidelines statements for 2007–08 to caution clients: Given what you think you need to earn, you have to be prepared to take a 25 percent hit—and if you lose 25 percent, you need to communicate, communicate, communicate. Hook agreed with the importance of communication, that key players must be kept abreast of the situation.
In another panel led by NACUBO consultant John Lively, leaders from three colleges and universities discussed the integration of budget and investment policies, liquidity demands, governance issues, and management of debt and credit rating. Panel members were Jeffrey Amburgey, vice president for finance, Berea College, Berea, Kentucky; Jack Rich, chief investment officer, Abilene Christian University, Abilene, Texas; and Bob Huth, executive vice president, Middlebury College, Middlebury, Vermont.
Berea College, which accepts only low-income students and provides full-tuition scholarships for all students, depends on its endowment for 75 percent of its educational and operating budget. Middlebury College gets 21 percent of its budget from the endowment, and Abilene Christian's endowment funds 10–15 percent of the operating budget.
As a result of the financial crisis, Berea looked at asset allocation; the college also changed to a weighted average spending formula after creating a sustainable budget and continued to incorporate operating and capital reserves in its budget planning. Middlebury went through strategic planning and instituted cost restructuring and reduced staff. In 2000, Abilene Christian went to the Yale-Stanford spending model and reduced spending distribution volatility.
The crisis didn't change the liquidity needs at Abilene Christian, but it changed the approach. Through a modeling process, managers discovered that they need 15–20 percent liquidity, and they added a liquidity policy of 30 percent within 30 days. At Middlebury, liquidity has become part of routine analysis; managers stopped capital spending at prior rates, and started managing cash on a daily basis. Berea had plenty of liquidity and didn't have to sell distressed assets; the college also reviewed restrictions on many old endowment funds, discovering that the spending restrictions on some of the funds were at the discretion of the board after a number of years.
All three schools stressed communication. Investment committee meetings at all three institutions are open to the entire board.
A final panel on structural and governance issues was moderated by Richard Anderson, practice director for higher education, Hammond Associates. Panelists were James Forbes, managing director and head of Global Principal Investments, Bank of America Merrill Lynch; George Dunn, executive director, Convergent Wealth Advisors; and James Welch, managing director for portfolio management, Prisma Capital Partners.
An Optimistic Outlook on the Future
Luncheon keynote speaker Michael Jensen, former chief financial correspondent for NBC News, provided an optimistic perspective from his media background, but with a warning about developing problems in the Middle East. Among his predictions for the next 12 months: GDP will continue at a healthy rate, tax cuts will be extended, unemployment will end the year at 9 percent, the stock market will go up 9–10 percent, and housing will go up—but erratically and regionally. In terms of job growth, it will be three more years before the market is robust. Dark clouds besides the Middle East include government debt, states nearing bankruptcy, European debt crisis, and spending cuts.
Jensen echoed other speakers in calling attention to the importance of globalization and the Internet. However, he assured the audience that the United States would still be a major player in the world, with the biggest economy and the most clout. "We have the personal freedom and an economic engine designed around free enterprise that refuses to stay down," he said.
LISA JORDAN is associate director of communications at NACUBO.
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