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Endowment Forum Explores Risk Allocations

With markets roiled by continuing turbulence, presenters at NACUBO’s 2009 Endowment Management Forum discussed risk and liquidity—and provided few suggestions on investment opportunities

By Mimi Lord

In the midst of one of the most severe bear markets since the Great Depression, discussion topics at NACUBO’s Endowment Management Forum, January 28–30 in New York City, understandably tended to focus more heavily on risk management, and particularly on liquidity management, than on investment opportunities. As a result of the significant investment losses incurred by most institutions, speakers discussed how endowment fiduciaries now are rethinking their overall approaches, with a greater emphasis on understanding the downside potential of each strategy rather than trying to squeeze the maximum return out of each component of the portfolio.

The results of the 2008 NACUBO Endowment Study, spanning the fiscal year ended June 30, 2008, and a follow-up study covering the five subsequent months of market turbulence, served as the backdrop for the forum. As detailed by Kenneth Redd, director of research and policy analysis for NACUBO, the average endowment lost 3 percent for the fiscal year ended June 2008 and another 22.5 percent over the five months ended November 30, 2008.

The follow-up study, conducted jointly by NACUBO and the Commonfund Institute, revealed not only the extent of portfolio declines during the fall of 2008 but also some of the operational effects on college campuses, including reductions in endowment spending to support overall campus budgets and scholarships as well as hiring freezes. According to the NACUBO–Commonfund Endowment Study Follow-up Survey, smaller endowments appear to have been affected more severely than larger endowments. For example, 25–30 percent of managers of endowments in the category of less than $1 billion indicated they expect to decrease the amount of spending from the investment pool during the current fiscal year, compared with 15 percent of endowments with more than $1 billion.

Multiple speakers discussed how globalization and the interconnectedness of markets contributed to the severity of the market’s collapse and resulted in a global economic downturn. Very few investment professionals, presenters explained, had sufficiently “stress-tested” their investment strategies and thus were poorly protected against a “Black Swan” event, in which essentially all asset classes except government securities and gold suffered exceptional declines.

Verne Sedlacek, president and chief executive officer, Commonfund, Wilton, Connecticut, provided data indicating the strong correlations of returns among the various subsets of the equity asset class and the fact that correlations are higher in down markets than in up markets. As a result, diversification within equities cannot be counted on to cushion the declines in a particular segment. Over the past nine years, the correlation of returns between the S&P 500 and the MSCI World Index in local currency has increased to .84 during periods of decline, compared with .59 over the previous eight years. Correlations between U.S. and global equity returns during up markets have also increased, from .29 in the period from 1992 to 1999 to .57 in the period from 2000 to 2008. Even among certain style segments of the domestic equity market, correlations tend to be higher in down markets than in up markets. The point, said Sedlacek, is that investors may think they have considerable diversification, but, as they have recently discovered, in down markets they have far less protection than they would have expected.

Because the July–November 2008 follow-up study excluded the performance of all alternative investments, such as hedge funds and private equity, the full extent of the damage to endowment values from the financial crisis remains to be seen. Given the fact that most alternative investments are relatively illiquid (meaning they cannot be converted quickly to cash) and a significant portion of the forum’s overall dialogue was focused on liquidity management, one could surmise that endowment managers have become increasingly concerned about the level and timing not only of alternative investment returns but of outstanding commitments as well.

Rethinking Portfolio Allocations

Bob Boldt, chief information officer and partner, Perella Weinberg Partners, Austin, Texas, suggested that endowment managers could benefit from taking a broader view of portfolio allocations. The traditional approach focuses almost exclusively on the dollar allocations to each asset class or subclass and attempts to find the best manager for each strategy. Equally if not more important, said Boldt, is an analysis of risk allocation. This risk-budgeting approach involves analyzing the likelihood and effect of a strategy falling short of the endowment’s minimally required returns. The greater the likelihood that a strategy would provide extensive losses, the greater the portion of the risk budget that would be depleted by that strategy.

The distribution of expected returns is not the only consideration in a risk-allocation approach; liquidity risk is another. “How much committed but uncalled capital do you have?” asked Boldt. “We can now imagine an environment with big capital calls [during which] we don’t want to sell other depressed assets to get the necessary cash.”

Other speakers also expressed the need to move away from the cubbyhole approach of specifying a multitude of strategies with designated dollar allocations. They referred to the “beauty pageant” obsession of endowment officers and committee members, who to try to select the very best manager for each designated strategy without sufficient consideration of the portfolio’s overall risk-return profile and the macro conditions or trends that could have far larger impacts on the portfolio.

In a panel discussion, Donald Lindsey, chief investment officer, George Washington University, Washington, D.C., and Larry Kochard, chief investment officer, Georgetown University, Washington, D.C., spoke about the importance of taking a macro view. Lindsey said that one of his such views—that we are living in a resource-constrained world—influences his favorable position toward certain energy-related investments. In the current environment, he finds bonds issued by energy companies to be quite attractive. Kochard said that he sees other similarly positive “theme” opportunities available today that can be obtained passively (using index-type securities) rather than through a lengthy manager selection process.

Lindsey and Kochard stated that the financial crisis was exacerbated by the high levels of leverage applied to investment approaches, and as a result we’ll see a renewed emphasis on the value of underlying “unlevered” assets. “Don’t worship false gods,” admonished Lindsey, referring to the damage caused by extensive leverage and other types of financial engineering. He specifically pointed to “portable alpha” as a strategy that was destined to implode due to too much leverage and illiquidity.

In a session titled “What To Do With Hedge Funds,” moderator Daniel Wallick, principal, Vanguard, Malvern, Pennsylvania, asked panelists if hedge funds “are doing what they’re supposed to do,” given the fact that they posted average declines of about 28 percent in calendar year 2008. Michael Roth, founding principal, Stark Investments, Milwaukee, Wisconsin, replied that it depends upon the particular strategies employed. He pointed out that hedge funds overall have held up considerably better than traditional equity portfolios, and that they should never have been expected to give full protection in a depression-type environment.  He agreed with other speakers, however, that certain well-publicized blowups and overall poor returns will undoubtedly result in more hedge fund closures and consolidations, as well as increased regulation and transparency.

Perils and Potential of Illiquid Investments

Despite the fact that hedge funds and private equity require greater attention to liquidity management, because of uneven capital calls and extended lockup periods, speakers in general said they remain committed to investing in them for their superior return potential compared with traditional investments such as stocks and bonds. Commonfund’s Sedlacek reviewed the steady growth in allocations to alternative investments (hedge funds, private equity, real estate, venture capital, commodities, and natural resources) among all size categories of endowments and noted the higher returns of portfolios with greater allocations in alternatives. In fact, the largest endowments’ percentage allocation to alternative and illiquid investments is three to four times greater than that of smaller endowments. Those larger allocations to illiquid investments contributed to the significantly better performance of large endowments (those with more than $1 billion in assets), which averaged 11 percent annualized returns, compared to the 7 percent returns of smaller endowments (less than $50 million in assets) over the 10 years ended June 30, 2007.

However, decisions about allocations and managers in the alternative investment arena, especially in private equity and venture capital, require far more attention than those in traditional investments, said Sedlacek, because the spreads in returns between top-quartile and bottom-quartile managers are so much greater. Unlike the past, when returns were augmented by leverage, he projected that future returns will be more tied to the economic recovery.

Jack Rich, senior vice president and chief investment officer, Abilene Christian University, Abilene, Texas, said he believes that smaller endowments wanting to add more alternatives to their portfolios should first examine their goals and then gradually implement greater diversification. His university adopted a goal of achieving sustainable, long-term returns of 5.5 percent more than the rate of inflation and undertook a 10-year program toward greater diversification. He cautioned against “blind adoption” of asset classes.

Jeremy Crigler, chief investment officer, Tulane University, New Orleans, discussed some of the differences he has experienced at Tulane, with its $800 million portfolio, compared with much larger endowments at Duke University, Durham, North Carolina, and Cornell University, Ithaca, New York, institutions where he previously worked. He noted, for example, that it’s more difficult to produce original research at a smaller endowment, given the limited staff resources, and that the implementation of certain strategies may need to be simpler. At Tulane, the endowment has adopted a fund-of-funds approach for part of its private equity allocation instead of direct investments that larger endowments often prefer. And, for certain other asset classes or strategies, it employs only one manager, whereas larger endowments would engage multiple managers. On the other hand, he said he enjoys the greater openness and cooperative relationships among smaller endowments. Portfolio changes require “an informed process for decision making,” he said, adding that “setting modest goals and meeting or exceeding them over time can provide very powerful results.”

Uncharted Territory Ahead

While various speakers mentioned that the prospects for future investment returns appear very attractive following the market crash, few speakers in the general sessions ventured to make specific investment recommendations. One exception was Stephen Walsh, chief investment officer, Western Asset Management Company, Pasadena, California, who referred to the opportunities in the corporate arena of fixed-income markets as “extraordinary” and “phenomenal.”

Walsh explained that as a result of the tremendous stress in the credit markets, the collapse of Lehman Brothers, and widespread fears of a systemic financial collapse, volatility in the fixed-income markets recently reached six times its normal level. Investors fled to safety, driving the treasury market up 13.5 percent in 2008 while high-quality corporate bonds lost about 5 percent and high-yield bonds lost nearly 25 percent.

He also described the severity of the current recession, noting his expectations for two to three quarters of economic declines and continued weakness in the housing and auto sectors. In addition, he said, consumer debt is high, and emerging markets have not been spared from the downturn. However, in Walsh’s view, the current valuations in the corporate bond market have discounted a far bleaker outlook than he believes likely, even in his most pessimistic scenarios. In short, he said the 550 basis-point spread between investment-grade corporate bonds and treasuries is too wide, implying a 34 percent default rate on quality corporates over the next five years. While default rates undoubtedly will go up, said Walsh, an assumption of 34 percent is far too harsh.

Walsh said he is greatly encouraged by the Federal Reserve’s massive creation of money, the government’s guarantees on certain bank debt and purchases of commercial paper and mortgage-backed securities, and the coordinated global steps to reduce interest rates and inject capital into the financial markets. He said there will be an “enormous supply of treasuries” in the market and that he would not expect them to continue as the top-performing asset class this year.

Cliff Asness, president and managing principal, AQR Capital Management, Greenwich, Connecticut, said he and most other asset managers had been humbled by the recent market destruction. He advised that it’s important for investors to step back and think about the factors that have changed and those that have not changed. Among the former, he said that market prices have declined and expected returns going forward have increased. Among the latter, he said it’s important to remember the following: (1) your original reason for investing (such as to provide sustainable returns above the rate of inflation); (2) the principle of rebalancing to bring allocations back to target ranges; (3) the ongoing need for diversification to improve the risk-return profile; and (4) the practice of buying more when assets are cheap and selling when they’re expensive. In addition, Asness cautioned participants to avoid overreacting to changing market conditions and selling at the bottom. Sedlacek echoed Asness’s comments about rebalancing: “If you don’t rebalance, the market will rebalance for you.”

In the closing session, Roger Ferguson, president and CEO, TIAA-CREF, New York City, refocused attendees’ attention from the current market turmoil to a much longer-term issue: investing in human capital through education. He agreed with earlier speakers’ comments regarding the need for greater risk management, regulatory reform, and corporate governance. At the same time, he said, “Financial officers must stay focused on the ultimate purpose of endowments: to support excellent education that promotes critical thinking and creativity.”

MIMI LORD is chief investment officer of Spero-Smith Investment Advisers, Inc., Cleveland, Ohio. She is the 2007 recipient of NACUBO’s Rodney H. Adams Endowment Management Award for contributions to the field of endowment management.