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Business Officer Magazine

Recipe for Strong Returns

The 2006 NACUBO Endowment Study results confirm that a deliberate mix of sound allocation strategies and steady yearly adjustments benefits big and small endowments alike.

By Anna Jackson

If you care to crack open the full story, don’t ignore these details: how asset allocations compared for large and small endowments (see Table 2); and how performance varied by asset class (see Table 3). In taking a closer look at the data in Table 3, you'll see one compelling angle of this year's survey results: Data for participating institutions reveal that some smaller endowments have come up with recipes for performing more like their larger counterparts. Despite apparent advantages for larger endowments—bigger investment offices, top-notch managers, and more funds available in which to invest—small endowments are proving their ability to compete in various asset categories, particularly fixed income, real estate, and private equity.

The 2006 survey results mark the fourth consecutive year of positive returns, following investment losses in 2001 and 2002. As in years past, larger investment pools posted higher returns on average than smaller investment pool categories. Performance ranged from an average of 15.2 percent among institutions with endowments greater than $1 billion to 7.8 percent for endowments of $25 million or less. The historical data also indicate the continuation of several key trends. Among them: Allocations to equity and fixed income continue to decrease, while allocations to alternative assets—particularly hedge funds and natural resources—are on the rise.


Varying Blends of Fixed Income and Equities

During the past five years, investments in traditional asset classes have decreased among larger endowments, most notably in the area of fixed income. For example, in 2002, institutions with endowments greater than $1 billion had invested on average 65.6 percent of their pool in equity and fixed income. In 2006, this combined allocation fell to 57.4 percent, primarily due to the drop-off in fixed income allocation, which slid from 20.5 percent in 2002 to 12.5 percent in 2006. A sharp decrease in the fixed income category was also evident for investment pools of $100 million to $500 million. In 2002, average fixed income investments constituted 25.3 percent; by 2006, these investments dropped to 16.9 percent (see Table 2).

Unlike their larger counterparts, the two smallest investment pool classes—those with assets up to $50 million—slightly increased equity allocations. For investment pools of $25 million or less, equity and fixed income investments increased from an average combined investment of 86.4 percent in 2002 to 87.9 percent in 2006. While equity continues to be a strong performer, so are investments in alternative assets.

Alternatives: Still Up

The survey began collecting detailed information about alternative asset categories in 2002. The fact that allocations to these asset classes are on the rise is not news. With a general move away from fixed income, institutional strategies seeking greater diversification have been heavily peppering their portfolios with hedge fund investments, in particular. From 2002 to 2006, average hedge fund investments increased across the board for all endowment sizes. The largest increase was among investment pools of $500 million to $1 billion.In 2002, these endowments reported average hedge fund investments of 11.4 percent. By 2006, that allocation jumped to 17.4 percent. Institutions with endowments of $25 million or less actually doubled their hedge fund allocations during this same time frame—from 1.3 percent in 2002 to 2.6 percent in 2006 (see Table 2).

Investments in private equity and natural resources are also showing gains. In 2002, the average investment to private equity among all endowments was 0.9 percent; it climbed to 1.9 percent in 2006. Meanwhile, the average investment to natural resources nearly quadrupled—from 0.4 percent in 2002 to 1.5 percent in 2006. Not surprising, the largest endowments have turned to investing in private equity and natural resources more quickly than smaller endowments. (Endowments with $25 million or less in assets reportedly decreased natural resources allocations from 2002 to 2006, although the 2002 figure may be artificially high because of fewer reporting institutions.)

For the one-year period between 2005 and 2006 specifically, the most dramatic shifts in allocations occurred in natural resources and hedge funds. Average allocations to natural resources rose from 0.9 percent in 2005 to 1.5 percent in 2006. In hedge funds, the one-year results mirrored the five-year trend. Investment pools of $500 million to $1 billion had the largest increase to hedge fund investment, up to 17.4 percent in 2006. For the first time, average hedge fund investments outweighed fixed income investments for these institutions. This phenomenon has been true for the largest endowments since 2003, but the shift under way for investment pools of $500 million to $1 billion may signal a trend that will follow for smaller endowments in coming years.

Trends to Watch

A broad look at returns from 2003 through 2006 reinforces this incremental shift toward diversification into alternatives. In FY03, institutions reported the highest returns in U.S. and non-U.S. fixed income—and negative returns, on average, in venture capital and private equity. But the scene changed in FY04. Institutions performed well in non-U.S. equity, U.S. equity, public real estate, and natural resources, with returns on average greater than 20 percent for each category. Meanwhile, the lowest returns occurred in U.S. cash and U.S. fixed income. The FY05 results were similar to 2004: high returns in public real estate and natural resources and low returns in U.S. cash and U.S. fixed income. For 2005 to 2006, investments to equity decreased slightly despite strong returns, while allocations to natural resources—which still account for only a small percentage of investment portfolios—increased for the one-year period. The results of the past three years indicate that natural resources will clearly be an investment to watch, in terms of both allocations and returns.

If natural resources and public real estate investments continue to outperform other assets as they have for the past three years, endowment managers will not likely curtail investments in these funds. Similarly, if fixed income continues to generate low returns, movement out of this asset could continue at a fast clip. Some investment trends may be less dependent on annual performance. For example, while hedge funds have not posted returns as high as some other asset classes, they have fared favorably. Because hedge funds have been consistent, they hold appeal for long-term strategies and will likely remain a popular alternative investment.

Small: The New Big Performer?

Participants in the 2006 study reported positive returns across the various asset types, with one notable exception. Endowments with assets greater than $1 billion reported negative returns of -0.5 percent in U.S. fixed income. The year’s big winners were natural resources and non-U.S. equity. In natural resources, the largest endowments posted the highest returns (40.1 percent) for any asset type. Returns in non-U.S. equity averaged 24.8-26.9 percent. Meanwhile, the lowest returns were reported in fixed income for U.S. and non-U.S. categories (see Table 3).

When looking at returns for specific asset classes, the notion that larger endowments outperform smaller endowments does not necessarily hold. In non-U.S. fixed income, for example, returns ranged from 1 percent to 4.8 percent, with the smallest endowments posting the highest returns. For U.S. fixed income, the smallest endowments posted the highest returns at 1 percent. Similarly, the smallest endowments outperformed all other investment pool categories in public real estate except institutions with assets of $500 million to $1 billion. These returns are good news for smaller endowments, considering that these institutions have larger portions of their investment pool allocated to fixed income than do larger endowments. The largest endowments outperformed the rest of the pack in only three categories: non-U.S. equity, private real estate, and natural resources. In private equity, the returns posted by the largest and smallest endowments were similar, but fewer than 10 institutions reported returns for the smallest investment pool category, so that figure may be skewed by one institution that fared particularly well. Even so, the message is clear: The largest endowments are not always the winners when it comes to returns.

Whether big or small, or somewhere in between, diversification—the time-tested recipe for healthy returns—ensures that endowment managers will remain vigilant about developing investment strategies from year to year that bear the right mix of asset allocations.

No Knee-Jerk Recipe Revisions

Order the Full Study Online

The 2006 NACUBO Endowment Study, based on responses from 772 institutions, provides extensive data to help colleges and universities benchmark themselves against their peers. The study (Item No. NC4017), available exclusively on the Web, is $89.95 for NACUBO members and $290 for nonmembers and will be available this month. Purchase of the study allows institutionwide access to the results.

The 2006 NACUBO Endowment Study Executive Summary (Item No. NC4018) highlights the data and analyzes survey results. The Web-based executive summary, which is intended for distribution to presidents and governing boards, is $29.95 for members and $50 for nonmembers.

To order, go to Participating institutions receive free access to the Web-based reports. Supporting firms also receive a complimentary copy of the report.

Jack Rich, senior vice president and chief investment officer at Abilene Christian University, Texas, says the university’s investment staff and 10-member investment committee generally don’t make significant changes based upon the prior year’s performance. For FY06, the university’s $228.4 million endowment posted a 20.5 percent overall return, outperforming the largest endowments. According to Rich, investments in natural resources were the primary driver of growth in 2006 and for the past several years. Even so, Rich reports only slight increases to the university’s target natural resources allocation for FY07. “We are still building out a diversified portfolio,” he says, “so we choose not to make tactical allocations at this point.”

Lisa McWherter is vice president for institutional advancement for Tri-County Technical College (TCTC) in Pendleton, South Carolina. She also serves as executive director of the college’s foundation and its $14.9 million investment pool. According to McWherter, the foundation watches returns carefully, while keeping their significance in perspective. The foundation board has struck a profitable weighting over the years between being fiscally risk averse and risk inclined, she notes. If the foundation’s nine-member finance committee becomes concerned with returns in a specific fund, they address those concerns with their managers. “Most of our investments are for the long-term,” says McWherter. “The finance committee is careful not to try to time the market.”

The TCTC Foundation posted a 9.4 percent return in 2006—above average for its asset class. This healthy return was bolstered by strong performance in natural resources and private equity. Yet, the college foundation’s portfolio is similar to that of other endowments of $25 million or less, with relatively low exposure to alternatives, says McWherter. The foundation made only slight adjustments for FY07 target allocations, with the most significant changes slated for U.S. equity and U.S. fixed income investments. According to TCTC President Ronnie Booth, the foundation’s strong 2006 endowment performance is an indication of the diversity of investments held, the finance committee’s commitment to a sound investment strategy, and a long history of responsible investing.

Multiple Allocation Mixes

While the TCTC Foundation was a new participant in the survey for 2006, its leaders have studied the results of the annual survey for several years. According to McWherter, the foundation’s allocation is roughly 60 percent equities, 35 percent fixed investments, and 5 percent real estate. To establish this strategy, the finance committee researched best practices and used allocation planning tools. When considering new investments, the finance committee will work with the foundation’s investment managers to determine whether a particular investment is prudent. While the foundation does not have benchmarks for alternatives per se, the finance committee studies historical performance of similar funds to get a sense of how a new investment might perform. In terms of future investment directions, McWherter anticipates that the foundation’s finance committee will continue to look at available options and gravitate toward progressive strategies as researched and recommended by both the board and the foundation’s investment firm managers.

Thanks to Our Study Sponsors

The following firms contributed to the 2006 NACUBO Endowment Study. Without their generous support, NACUBO could not publish so comprehensive an analysis of endowment management practices.

TIAA-CREF Asset Management

Iridian Asset Management LLC
John W. Bristol
Smith Barney’s Consulting Group
Trusco Capital Management

Callan Associates Inc.
Fayez Sarofim & Co.
Prime, Buchholz & Associates Inc.
State Street Global Advisors

Goldman Sachs Asset Management
Mellon Asset Servicing
Morgan Stanley

Lazard Asset Management LLC
The Northern Trust Company
U.S. Trust
Virchow, Krause, and Company LLP

Abilene Christian’s current asset allocation has evolved during Rich’s tenure. When he joined the university 15 years ago, the endowment was comprised of 85 percent fixed investments and 15 percent equities. Through concerted efforts, the university developed a more diversified investment philosophy. To establish a sound allocation strategy, staff and long-time committee members met with their consultant, reviewed the advice of experts, and used various investment tools to test asset allocations and project returns and risk. In 2000, the university began investing in hedge funds and venture capital. By 2004, Abilene Christian had adopted a heavier exposure to alternatives. The endowment now consists of approximately 50 percent equity, 20 percent inflation hedge, 20 percent absolute return, and 10 percent fixed investments. The university also adopted a 10-year strategic plan that included moving Rich to the investment office from his previous post as executive vice president and chief operating officer.

Beyond different asset allocation strategies, the TCTC Foundation and Abilene Christian also take different approaches to endowment management. According to Rich, Abilene Christian carefully considers how to minimize overall risk by reducing manager risk. To do so, the university has hired managers with good track records and ensures that no single manager has inordinate responsibilities. This approach brings an additional diversification benefit to the fund, argues Rich. Conversely, the TCTC Foundation has opted to forge a strong partnership with one corporation for its consulting and management needs. Says McWherter, through regular communication, the college benefits from a continuous dialogue about investment strategy. 

One Part Past, One Part Future

Both Abilene Christian and the TCTC Foundation will continue to carefully measure new opportunities against their current investment mix, exercising patience as they assess long-term results. Both institutions posted returns in natural resources investments—in excess of 80 percent—in funds that each institution has held for more than 10 years. McWherter and Rich say they also remain keenly aware of NACUBO Endowment Study annual results, comparing the year-to-year performance of their endowments against that of their peers to search for clues about adjustments that they might make.

Even as investment professionals sift through historical data and study the strategies of their peers to develop an investment blend that yields favorable returns, a level of uncertainty always exists about the next trend. At any time, asset allocations could take a major turn if market conditions change or if institutions find other options to the increasingly popular alternative assets. For now, dedication to a progressive investment strategy is paying off for institutions like Abilene Christian, with consecutively high returns in recent years. Those involved with the endowment are keeping expectations in check, says Rich. “We are very pleased with our returns this year, but that doesn’t mean our circumstances couldn’t change next year.”

ANNA JACKSON, Chicago, covers higher education business issues for Business Officer.