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Business Officer Magazine

Cautionary Words From Market Gurus

Speakers at NACUBO’s Endowment Management Forum expressed concerns about excessive liquidity and leverage and offered their assessment of today’s greatest investment risks and opportunities.

By Mimi Lord

Words of caution are expected to some extent at nearly any investment conference. Some type of risk is always lurking around the corner, whether it be budget deficits, inflation, unemployment, economic overheating, the bulging older population, or geopolitical uncertainties. But market strategists speaking at the 2007 NACUBO Endowment Forum, held in late January in New York City, may have set a record for the overall scope and intensity of their caution about current investment prospects. In addition to the typical focus on global economic trends and relative market valuations, professional money managers appear to be fretting about another set of potential threats—those related to unusually high levels of liquidity and leverage in the financial markets.

An extended period of low interest rates and easy money has caused investors to keep buying and adding leverage to what have become untenable levels, noted Dan Fuss, of Loomis, Sayles & Co., LLP. Worldwide financial liquidity has soared due to globalization and improvements in financial systems and now exceeds the ability of central banks to control it, said Fuss. If a liquidity shock occurs when assets are highly leveraged, he said, redemptions may not be manageable and investors can “fall through the ice.” Fuss referred to the credit default swap market as an area of particular vulnerability.

Ben Inker, of GMO, and Louis Morrell, of Wake Forest University, echoed Fuss’s caution about the risks of excessive leverage. Inker questioned whether many buyout firms are actually adding any risk-adjusted returns or whether they’re simply augmenting volatility through leverage. Morrell noted that it has become extremely difficult for endowment officers to assess their portfolios’ overall level of leverage, since it can be camouflaged in hedge funds, private equity, and other alternative investments.

An Unsustainable Spending Cycle

In a session called “The Future Isn’t What It Used to Be,” Michael Metz, of Oppenheimer, provided a lively overview of events that have led to the current levels of liquidity and leverage and offered his assessment of today’s greatest risks and opportunities. After the stock market crash that began in 2000, he explained, the Federal Reserve Bank slashed short-term interest rates to 1 percent in 2003 and indicated its intention of keeping rates low for an extended period. Although a major impetus for the rate cutting was to boost corporate investment, consumers led the resulting buying spree, said Metz. Most significantly, consumers went on a home-buying splurge, which fueled the great real estate boom and kick-started the economy. As residential real estate appreciated in value, homeowners felt wealthier. Responding to this “wealth effect,” they increased their leverage through bigger mortgages and home-equity loans and boosted their spending in many other sectors. Scores of new derivatives cropped up, and individuals and institutions alike joined the contest for outsized returns. The trend toward performance-based management fees also helped augment the allure of leverage.

For a while, noted Metz, the spending-leverage-liquidity cycle was self-perpetuating. U.S. consumer spending led to enormous trade deficits that resulted in massive holdings of U.S. debt by developing and emerging countries, including China. The huge demand for U.S. Treasury securities helped keep interest rates low and contributed to further liquidity, leveraging, asset inflation, wealth effect, spending, and so forth.

“Now, that trend is over,” said Metz. “The central banks have realized that there’s too much leverage and risk of inflation.” Added Metz: “The net result, in my judgment, is that interest rates have begun a significant rise. The great bull market in the bond market, which began in 1981, is over.”

Two important factors will contribute to rising rates, predicted Metz. First, corporations, which have not needed to borrow in recent years due to strong earnings growth, will start to re-leverage. Second, emerging and developing markets no longer will be satisfied with holding so much U.S. debt and will shift into areas with potentially higher returns. To lure American investors, debt issuers will need to offer higher yields.  

Beware of Long Bonds and Poor Quality

Today, long bond holders are not being compensated for their risk, said Metz. “And lower quality bonds are even a worse speculation,” he warned, since buyers are speculating that there won’t be any credit stresses to bring about a return to normal spreads between lower-quality and higher-quality bonds. According to Metz, the only good buy in the domestic, fixed-income area is the two-year treasury note. With the inverted yield curve, it pays a higher rate than the longer-term instruments and lacks the risk.

Rather than hunting for yield in the dismal U.S. bond market, fixed-income investors are better advised to buy debt obligations in emerging markets where credit qualities are improving, said Metz. Those countries are experiencing fiscal improvements, growing interregional trade, and strong spending on infrastructure and consumer goods. In Metz’s opinion, the “big phenomenon of this century has been the transfer of wealth from the developed nations and most of Europe to the developing nations.” 

Predictions in Real Estate, Alternatives, and Equities

In addition to vulnerabilities in domestic long bonds, speakers noted considerable risks in several other areas.

  • Domestic real estate, both residential and commercial—due to the overextended bull market.  Metz stated that it is premature to say that pricing adjustments in real estate will have a soft landing; he expects restraining influences on the economy for the next few years. He referred to commercial real estate as being at “the height of staggering speculation.” The only attractive real-estate sector, according to Metz, is agricultural, due to strong demand for animal proteins and biodiesel fuel, but he also cautioned that it’s difficult to find good managers in that area. 
  • Alternative markets involving extensive leverage. In this area, Metz voiced concerns similar to those of other speakers: “I think this great passion for alternative investments will not come to a happy end.” GMO’s Inker added that, with more than $1 trillion invested in hedge funds, it has become difficult to obtain alpha unless you can consistently pick above-average managers. As for beta, “You shouldn’t be paying 2 and 20,” he said (referring to 2 percent management fees on assets and 20 percent of returns). “Beta can be had for free.”
  • Traditional equities. Speakers were quick to point out the enormous gains scored in domestic small cap and value stocks, as well as by international equities overall. U.S. small cap value stocks provided compound annual real returns of 15.8 percent over the 1975-2006 period, said Inker, compared to the S&P 500’s 10.6 percent returns. GMO, which in recent years has accurately forecast the out-performance of small caps and internationals relative to the S&P 500, now contends that “most domestic and international equities are not priced to even beat inflation.” Inker walked attendees through the firm’s seven-year global equity forecasts, which call for negative annualized real returns as follows:
Index GMO’s Forecast Annual Returns
(after 2.5% inflation)
Standard & Poor’s 500 -1.8%
U.S. Small Cap -2.8%
Europe, Australia,
and Far East (EAFE)
International Small Cap -1.9%
Real-Estate Investment
Trusts (REITs)

While never reticent in expressing bearish sentiments for perceived over-valuation, Inker was particularly negative in describing the current investment environment as “depressing” and “extraordinary.” In summary, he said that “shorts” offer the best investment opportunities today.

Some Bright Spots

The brightest subset within GMO’s global equities outlook is that of high-quality domestic large caps, which are poised to return what would seem a “whopping” 2.6 percent annualized real return over the next seven years when compared to a forecast of negative 8.8 percent returns for low-quality domestic large caps during the same span.

Metz, while not as pessimistic about global performance as Inker, shares GMO’s view that U.S. Blue Chip multinationals have the best prospects among domestic equities. That outlook is in sync with his “transfer of wealth from West to East” depiction that calls for strong consumer growth in developing and emerging countries. The large U.S. multinationals, suggests Metz, stand to benefit from that consumer growth and perhaps from a change in investor psychology. North American energy exploration and development companies also hold appeal due to their tremendous cash flows. Internationally, Metz advises that despite the recent hefty gains, investors should maintain exposure in emerging markets. Among developed countries, he’s bullish on Japan, due to strong liquidity and growth in corporate earnings, and on Germany, due to under-leveraged consumers and strong capital equipment exports to Asia.

Metz’s broad-brush views were generally congruent with those of the sector experts who spoke in a session on real assets. Robert Gottlieb, of Bear Stearns, referred to gold’s value as a hedge against inflation, currency swings, and geopolitical turbulence; Christopher Mayer, of Columbia Business School, echoed earlier sentiments about over-valuations in real estate; and Robert Sinnott, of Kayne Anderson Capital Advisors, spoke about continuing demand and projected shortfalls for oil and gas production.

Institutional Asset-Liability Management

While discussions of investment prospects and performance took top billing, other sessions provided lively discourse about a variety of other endowment management issues. The topic of liquidity re-emerged in discussions involving institutional asset-liability matching, led by Verne Sedlacek, of Commonfund, and Leo Tilman, of Bear Stearns. Sedlacek advised institutions to analyze their liquidity needs before beginning asset allocation discussions. Once liquidity requirements are determined, endowment managers can think about other investments that are more illiquid and may provide higher returns over the long term. Sedlacek said that most institutions do not take full advantage of their ability to tie up funds for lengthy periods. According to Tilman, in a low-return environment it is particularly important for endowment managers to take a holistic approach that encompasses insights from asset-liability management, market risk management, and lessons learned from other industries.

Jack Brennan, of Vanguard, stated that endowment committees often suffer from “performance envy” and make inappropriate comparisons between their endowment returns and those of Yale and Harvard. He offered the following seven questions for investment committee members to ask to help establish and achieve objectives:

  1. How do we define and measure success? Committee members need to develop clear goals and objectives that may be described in various ways that are appropriate to the institution, such as in absolute terms or relative to specific benchmarks. These goals and objectives need to be revisited periodically, added Brennan.
  1. How do we define and measure risk? Definitions may be expressed in qualitative and quantitative terms and could, for example, specify the maximum level of loss that could be tolerated over a two-year period. Are fears related to potential loss of principal or purchasing power? How would constituents react to certain levels of loss?
  1. Are we making realistic assumptions for future returns in the various markets? Brennan warned that extrapolation of past returns is a method fraught with problems. When choosing managers, what are the specific abilities that will allow them to provide superior returns?
  1. What is the right asset mix? The most appropriate asset mix may not lie on or above the efficient market frontier line, noted Brennan. Important qualitative considerations evolve through experience.
  1. What are the investment costs? According to Brennan, many investors tend to think that fees don’t matter as long as there’s alpha; but, in his view, fees always matter.
  1. Do we have a long-term asset allocation strategy and the discipline and patience to stay with it? Investors may incur considerable risks when changing strategies or neglecting to rebalance on a regular basis.
  1. Do we have the right team to implement the strategy? Most investment teams don’t have the expertise that’s found in the multibillion-dollar endowment offices—and, therefore, need to have some humility about their capabilities, cautioned Brennan.

In summary, while being aware of certain limitations, investment committees need to strive for the best returns that are congruent with the appropriate goals and risk parameters that have been established. And, they need to be aware of the consequences to the institution of both mediocre and superior returns, said Brennan. He referenced an institution for which the endowment had experienced strong performance and, as a result, the institution was able to increase its student financial aid budget tenfold. 

Update on Vanderbilt’s Asset-Allocation Model

In another session, William Spitz of Vanderbilt University provided an update to his discussion at last year’s forum regarding Vanderbilt’s evolving approach to asset allocation. At that time, he explained that the university had abandoned the typical institutional approach of pre-selecting a number of asset classes with specified allocations and then seeking managers to fill them. Instead, Vanderbilt had converted to an approach of seeking superior managers to deliver alpha, regardless of asset class, and then building the rest of the portfolio around those exposures. The conversion has resulted in fewer asset allocation categories with wider ranges of potential exposure, greater manager flexibility, and freedom to be opportunistic.

At the 2007 forum, Spitz reported that Vanderbilt’s asset allocation categories have been reduced further, from 10 categories to 6, as shown in the following chart: 

Vanderbilt University’s Asset Allocation (Current)

Category Target Minimum Maximum Benchmark

Global Equities





Private Equity




Cambridge PE/VC Index

Absolute Return




T-bills plus 5%

Real Assets





Fixed Income




Lehman Long Treasury





Blended Portfolio Benchmark

Total Portfolio



* 60% NCREIF Property Index; 20% NCREIF Timber; 20% S&P Energy

Spitz said that he’d like to see the asset classes collapsed even further—to perhaps three—which might be called return generators, inflation hedges, and deflation hedges. In response to an audience question, Spitz noted that this kind of approach of focusing on superior managers and giving them substantial latitude may not be appropriate for less experienced investment offices. However, he emphasized that the most talented investment managers increasingly will demand greater flexibility and that endowments that stick with the traditional “pigeonhole” approach of pre-specified asset allocations will “be leaving money on the table.”

Other Forum Session Highlights

Additional forum sessions offered insights into other areas of endowment management:

  • Brett Hammond, of TIAA-CREF, discussed results of the 2006 NACUBO Endowment Study. For details of the study, visit
  • David Salem, of TIFF, along with two college students, led a discussion about the need for endowment managers to stay focused on downside risks in the portfolio.
  • Judith Van Gorden, Arizona State University Foundation, and Geraldine Gallagher, Valencia Community College Foundation, led respective discussions about the particular challenges of larger and smaller endowments.  
  • Donald Trone, of Fiduciary 360, stressed the importance of fiduciary practices when implementing a nontraditional asset allocation. Before delving into alternatives, Trone advises that investment fiduciaries carefully question whether they have the time, inclination, and interest to perform adequate due diligence. A lack of process, he said, is the biggest obstacle to fulfilling fiduciary responsibilities. 
  • Louis Morrell, of Wake Forest University, and Elizabeth Williams, of Southern Methodist University, discussed performance compensation for chief investment officers that can include fixed salaries with bonuses for performance that exceeds a specified benchmark. At Wake Forest, said Morrell, the performance objective is to be in the top quartile of all participants in the NACUBO Endowment Study and in the top half of endowments with assets of $1 billion or more. He noted that, contrary to some of the pessimistic forecasts presented at the conference, Wake Forest’s 2007 capital market outlook calls for a portfolio return of between 10 and 11 percent, based on an asset allocation of 85 percent equity (including domestic, developed international, and emerging markets) and 15 percent fixed income.

MIMI LORD, an independent financial writer, assumes the chief investment officer position at Spero-Smith Investment Advisers, Inc., Cleveland, Ohio, as of March 1.