To Ensure We Endure
For four decades, NACUBO has tracked the evolving practices for managing college and university endowments. Two experts reflect on major trends during that time, including spiraling growth, changing asset allocations, and the increasing significance of investments to the overall financial picture.
By Kenneth E. Redd
In 1974, NACUBO conducted its first annual survey of college and university endowments (previous surveys were conducted by Dartmouth College, Hanover, New Hampshire). It was an inauspicious time to take on this project, as several adverse events were at play. During much of the early and mid-1970s, the U.S. economy was mired in a deep recession, as a result of the OPEC (Organization of Petroleum Exporting Countries) oil embargoes of 1970 and 1973. This was the era of the "misery index" (the sum of the nation's inflation and unemployment rates), which averaged 16 in the middle part of the decade.
FY74 experienced a particularly tough economic climate. Inflation-adjusted gross domestic product—a broad measure of economic activity—fell by 2.1 percent, while inflation climbed to 12.3 percent. Not surprisingly, in that environment the Standard and Poor's 500 Index returned roughly -14.5 percent that year. For FY74, endowments reported an average return of -11.4 percent, then a record low for the survey series.
"The greatest change has been in the much-greater diversification of endowment portfolios."
John Griswold, Commonfund Institute
However, the mid-1970s' sharp loss in endowments was not seen as a dramatic event, as most endowments at that time were relatively small. Just 136 schools participated in the first NACUBO endowment survey; and collectively these schools held less than $7 billion in assets (see Figure 1). Since then, endowment values and institutions' reliance on endowment earnings have grown dramatically, and the NACUBO endowment survey series—now called the NACUBO-Commonfund Study of Endowments, or NCSE—has become the largest and most widely used and recognized annual examination of higher education institutional investment performance. The most recent study provides information on endowments at more than 800 American higher education institutions that collectively manage more than $408 billion in assets.
Over the past 37 years, despite the challenges of the 1970s, institutional endowments have averaged an annual investment return of 9.8 percent (net of fees and management expenses), as the table "College and University Endowments" illustrates. While this performance overall has been very encouraging, throughout the history of the NACUBO endowment survey series there have been several periods of substantial gains and losses in investment returns. On the plus side, endowments produced particularly strong gains in the 1980s. From FY80 to FY89, on average, endowments reported an annual nominal return of 13.7 percent (net of management fees and expenses). In contrast, in the 10 years ending June 30, 2011, endowments returned on average just 5.6 percent annually, and during that time FY09 endowments recorded a new record low average annual return of -18.7 percent.
The NACUBO endowment survey series, started in 1974, is the most widely used and recognized annual examination of higher education institutional investment performance.
And yet, for the past four decades there is no question that endowments have grown in size, and that they have become a significant and growing component of financial focus for many colleges and universities. Endowment assets have played a key role in funding financial aid, faculty research, buildings and grounds maintenance, and other services. This increasing reliance on endowments has brought with it growing complexity, changes in endowment purposes and restrictions, and greater scrutiny and attention to governance and other issues.
To reflect on the evolution of endowments since 1974, Business Officer talked with two recognized experts: John S. Griswold is executive director of Commonfund Institute; and Judith H. Van Gorden, current chair of NACUBO's annual Endowment Management Forum, is chief investment officer and university treasurer emerita for the University of Colorado, and former chief financial officer for the Arizona State University Foundation.
Both Van Gorden and Griswold have rich experience in the field of endowment management. Griswold supervises the annual Commonfund Benchmarks Studies of the performance of educational endowments, foundations, operating charities, and health-care institutions; and he has authored many articles and book chapters on endowment management, governance, and the management of investment committees. Van Gorden has more than 30 years of cumulative experience in investment management at a number of public and private nonprofit universities, and is a recipient of NACUBO's Rodney H. Adams Endowment Award.
Here they talk about the trends and issues that college and university endowments have faced during the past several decades and suggest new challenges on the horizon.
The management of endowments has undergone—and to a great degree, is continuing to undergo—a truly extraordinary metamorphosis. Of all the changes we've witnessed over the past four decades, which has been the most significant?
Griswold: The greatest change has been in the much-greater diversification of endowment portfolios. In 1974, the typical endowment had 63 percent of its assets invested in U.S. and foreign stocks; 19 percent in bonds (U.S. and foreign); 13 percent in cash; and 5 percent in real estate, private equity, and other alternative strategies. In 2011, based on the NACUBO-Commonfund Study of Endowments, portfolios on average had 33 percent of their endowment assets invested in equities, 10 percent in fixed income, 53 percent in alternative strategies, and just 4 percent in cash [see Figure 2].
Over the years, expert investment managers have more successfully employed venture capital, private equity, and hedge fund strategies, as well as investments in real estate, oil and gas, and other commodities.
Van Gorden: Endowment managers turned to alternatives to achieve several goals, namely: to increase diversification and to achieve higher returns than the traditional public stock and bond markets would allow. Our endowment managers have achieved diversification by adding asset classes and strategies that reduce the correlations among the asset classes, which lowers overall portfolio risk and, over time, improves risk-adjusted investment returns. Over the past 40 years, there have been many periods of high volatility in returns, and alternatives have dampened this volatility in many cases.
Griswold: In addition, many alternatives are less liquid than traditional investments, and, generally, investors are paid a premium for accepting lower liquidity in portfolios. The globalization of financial markets has also had an influence over this period—access to nondomestic investments in both traditional and nontraditional asset classes has increased, and asset allocations in these categories have increased along with access.
Van Gorden: We should also emphasize that this proliferation of asset classes and investment opportunities has been driven by changes in the underlying financial markets themselves. There is now greater availability and timeliness of data and information regarding the capital markets, investments, and investors. It is now much easier and much less expensive for endowments of all sizes to invest in a wider variety of asset classes. Lastly, some alternatives offer better protection against inflation than traditional asset classes.
How has the introduction of new asset classes in portfolios influenced changes in institutions' investment management practices?
Van Gorden: Over the past four decades, endowment management has moved full circle. It began as an activity well integrated with the university administration; became a more separate and independent activity; and, with the financial crisis of 2008–09, reverted back to a well-integrated activity.
Griswold: In addition, the size and qualifications of staffs and investment committees have changed dramatically. Bankers and brokers on college and university boards and investment committees who used to work with bank trust departments have been replaced by institutional investment managers and sophisticated private investors with extensive financial experience. Institutions' in-house staffs have evolved from multitasking business officers to trained and dedicated investment professionals. There is a much greater degree of professionalization on the institutions' staffs and on boards. As the expertise and professionalization of investment committees and investment offices has increased, so has the knowledge of the different investment categories.
The 2008–09 financial crisis seems to have had an even bigger effect on endowments than the recessions of the 1970s and 1980s. What big changes have endowments undergone since emerging from the worst of the 2009 downturn?
Griswold: There is an even greater emphasis on governance. The traditional model of portfolio management used throughout the 1980s and 1990s involved the investment committee in all phases of management: investment policy development, asset allocation, manager selection, and even security selection, with some help from the chief business officer and perhaps a consultant. Today's more complex portfolios have led to the establishment of in-house investment teams and management companies, and the appointment of "outsourcing" firms. In each case, the investment committee retains fiduciary oversight, but delegates the day-to-day oversight of the portfolio to dedicated internal and/or external teams.
Van Gorden: Additionally, since 2008, increased national media attention and state and federal legislative committee scrutiny have focused on endowment management and governance processes. This added attention is a byproduct of not just the crisis, but also the far-reaching scandals we saw with the likes of Enron and Madoff.
The headline risk associated with conducting this business is greater now than ever. One benefit of this increased attention has been that the necessary points of integration and contact—between institutional administration and investment administration—are better understood now, and are becoming well imbedded in both the financial management and investment processes of the institution. This greater integration has helped to ensure that governance groups are proactively thinking about meeting standards of fiduciary conduct and providing oversight that stands up to a high level of scrutiny by a wide range of constituencies and interested parties.
You both alluded to the fact that many more endowment managers rely on outside advice (through consultants, advisory firms, and so forth) than they have in the past. In fact, the 2011 NCSE found that 81 percent of institutions use consultants to help perform one or more investment functions (such as manager selection) and 39 percent have substantially outsourced most or all of their investment functions. What have been the advantages and disadvantages of the use of consultants? In what ways do you think this practice will change in the future?
Griswold: Consultants in many cases have been tasked with keeping abreast of trends in the market and identifying fund managers who are likely to perform the best in the current market environment. From a governance perspective, such experts often aid in decision making, which helps institutions establish an independent point of view from a source outside the investment committee—and, if a decision goes awry, to be able to easily change advisers! At the same time, investment committees may not use the consultant in the right way (that is, they may become too dependent or not dependent enough); and consultants may be very expensive. Costs and fees are a drag on performance, raising the required return (and attendant risks) necessary to meeting the endowment's objectives.
Van Gorden: One critical advantage offered by consultants, especially for smaller endowments, is a wider range of expert resources at more affordable costs. Most institutions can't afford to replicate these resources in-house. But one growing disadvantage has been the reduction of uniqueness in investment strategy and manager choice; that is, institutions are seeing consultants offer similar options to all their other clients, which diminishes any chance of attaining exceptional returns. Despite this trend, consultants will continue to be an important resource for endowments, especially as the number of managers continues to grow, and the investment strategies of these managers diverge and become increasingly complex. There may be more specialty consultants-as we've seen with the growth of hedge fund consultants, for example—as a subset of the investment consultant category.
Looking ahead, what do you see as the primary challenges investment managers will face over the next two or three years? And what related portfolio changes will endowment managers make?
Van Gorden: It's going to be difficult to earn enough to support both the current spending needs of the institutional beneficiaries and the reinvestment required for future spending to keep pace with inflation. As a result, investment opportunities beyond the borders of the United States will take an increasing share of the portfolio assets. Finding these opportunities, and monitoring the activities and results of these managers, will require additional and, in some cases, different resources.
Griswold: Given the continuing anxiety about economic conditions and the general consensus that returns in most investment strategies will be below average for the next several years, the challenge to fund managers will be to take enough risk to generate sufficient return in support of their institutions' missions. In the past, endowment managers have been able to deploy more of their assets into alternatives to help generate higher returns. However, as the 2008–09 financial crisis showed, the returns of many alternatives sometimes move in concert with traditional investment classes. Safe harbors may be harder to find in the future, should greater volatility return.
KENNETH E. REDD is director of research and policy analysis at NACUBO.