Steering Your Investments
How best to stay on course with portfolio priorities? The 2007 NACUBO Endowment Study reveals the value of investing for the long haul.
By Karla Hignite
Despite double-digit 2007 returns, however, institutions on average did not outperform the S&P 500 or the Russell 3000 indexes.
Growing concerns about a weaker U.S. dollar and fallout from the subprime market that emerged during the second half of 2007 raise questions about what to expect for FY08. To better understand recent investment trends and the impact of current market conditions, Business Officer asked several experts to reflect on allocation and return data for the five-year period from 2003 to 2007 (see table, "Asset Class Allocation and Rate of Return by Asset Class, Fiscal Years Ending June 30, 2007–2003"). In addition to scrutinizing the numbers, interviewees predicted opportunities—and potential potholes—for the road ahead.
One marker of improvement in endowment performance in recent years has been the steady increase in the number of investment pools to surpass the $1 billion threshold. For 2007, that number jumped to 76, up from 62 in 2006. According to Brett Hammond, TIAA-CREF’s chief investment strategist, the real news behind this upsurge is the good growth it signals for investment pools across the board, with college and university endowments registering the best equal-weighted average return since 1998.
But these billion-dollar-plus endowments are by no means the norm. While they account for 71.3 percent of total endowment assets in the 2007 study, they represent only 9.7 percent of participants. A closer look at the past five years reveals what may be a more meaningful twist regarding college and university endowment performance. For traditional asset classes, such as U.S. equity and fixed income, large endowments don’t exhibit a particular advantage; in some instances, smaller investment pools have achieved higher returns. Even so, in 2007, larger investment pools continued to outperform smaller endowments overall. Those in the greater-than-$1 billion category achieved an average return of 21.3 percent, while investment pools of less than or equal to $25 million showed an average return of 14.1 percent.
One likely reason for this gap, says David Wagner, chief executive officer and principal of Evanston Capital Management, is that larger investment pools have remained more heavily weighted in alternatives and less so in traditional assets, compared to the smaller pools, “For traditional assets, such as U.S. and non-U.S. equity and fixed income,” says Wagner, “the dispersion of returns between the best, average, and below average appears tight. The five-year data indicate that you could spend a lot of energy looking for good managers in traditional assets; but, at the end of the day, the best will outperform the rest by only a small margin.” That doesn’t hold true for many of the alternative asset classes, notes Wagner, where the dispersion of returns is much greater.
These dispersion differences between traditional and alternative asset classes don’t surprise Catherine Gordon, principal with Vanguard Institutional Advisory Services. “Because there are many broad-based index strategies,” says Gordon, “it’s relatively easy for smaller pools to invest in U.S. stocks. But, when you move into the alternatives space, it’s all active management. You not only have to select the best managers, you also must have the resources to access those managers.”
Larger endowments, says Gordon, were the first to enter alternative asset classes; thus, they have more experience. They may also have a greater comfort level with the illiquidity of these asset classes, adds Wagner. “Institutions with smaller endowments tend to be more liquid—more invested in equities and fixed income—perhaps because they may be more cash dependent.” One implication for smaller investment pools that have difficulty gaining access to top-tier managers is that they may need to go slower, says Wagner.
Or, they may be better off looking for opportunities elsewhere, adds Kennedy. “Institutions looking to invest in asset classes, in which the difference in performance between the best and the weakest is significant, should ensure they have adequate resources to appropriately execute that strategy.”
Slow Lanes, Fast Lanes
While an overall trend toward alternatives is still present, evidence suggests that the shift may be slowing. The 2007 NES data reveal slight growth over 2006 in allocations to private equity, while allocations to natural resources remained roughly the same. “In the case of the largest endowments, where you see a leveling off within alternatives,” says TIAA-CREF’s Hammond, “it may be that [endowment managers] have reached the policy limits at which they’re comfortable with their allocations to these asset classes. Hammond says that smaller investment pools are still likely to increase their allocations to alternatives in the years ahead—in part to catch up—although their commitments in these areas may never match those of their more sizeable counterparts.
Whereas larger investment pools are still increasing allocations to private equity—which returned a healthy 19.8 percent on average for 2007—they took some money off the table in hedge funds, says Hammond. However, while the largest endowments seem to be decreasing allocations to hedge funds in favor of private equity, the smaller endowments are increasing commitments to hedge funds. This, says Hammond, indicates a greater level of comfort among even the smallest endowments in a category where they are able to buy funds of funds. He suggests that funding for those increases likely came in part from lower allocations to U.S. fixed income, a trend reported for all endowment categories.
In fact, says Hammond, perhaps the most striking trend evidenced across the board for the five-year period was a steady movement out of U.S. fixed income and U.S. equity into non-U.S. equity. A significant disparity continues to exist between the largest and the smallest investment pools in terms of percentage allocations to U.S. equity versus non-U.S. equity—with the largest endowments splitting their allocations roughly 50–50. But, the overall shift to non-U.S equity is consistent among all investment pool sizes, says Hammond.
Endowments have been rewarded handsomely by their steady move into this asset class. Non-U.S. equity was the strongest performing asset class for 2007, with a 28.3 percent rate of return across all participant pools, compared to a 19.3 percent return rate for U.S. equity. “I think this suggests that all are getting used to the idea of no longer being U.S.-centric with their investing,” says Hammond. “These are presumably long-term plays and don’t indicate a chasing of returns.”
Wagner agrees. “Although endowments have typically been domestically oriented, I think the trend toward increases in international investment will continue, fueled by the continued growth of emerging markets—most notably China and India. In several years, these markets will be huge compared to what they are even now,” says Wagner. “You can’t have your blinders on and think only domestically.”
Taking the Scenic Route
The shift toward greater allocations to non-U.S. equity also represents a mind-set switch, says Gordon. “The line between U.S. and non-U.S. has become increasingly blurred in recent years. We’re not going to change how we think about these portfolios or combine them into one global stock category tomorrow. Yet, given that many investors have non-U.S. stocks in their U.S. equity portfolios, it does raise the question of whether we’re evolving in the direction of global stock and global bond portfolios,” says Gordon. “When we talk to managers about how they view portfolios, we find they don’t feel limited to seek the best opportunities domestically if there is a more attractive drug company in Switzerland or bank in Japan.”
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The 2007 NACUBO Endowment Study, based on responses from 785 institutions, provides extensive data to help colleges and universities benchmark against their peers. The study (Item No. NC4019), available exclusively on NACUBO’s Web site, is $89.95 for NACUBO members and $335 for nonmembers. Purchase of the study allows institutionwide access to the results.
The 2007 NACUBO Endowment Study Executive Summary (Item No. NC4020) 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 $79 for nonmembers.
To order, go to www.nacubo.org. Participating institutions and supporting firms receive free access to the Web-based reports.
From an economic perspective, awareness is also growing with regard to the impact on the U.S. economy of worldwide demands for resources, says Gordon. “Several years ago,” she notes, “China’s need for steel was one of many factors affecting steel prices in the United States. Today [that demand] is a primary influence.”
Kennedy agrees that allocations to non-U.S. equity are likely to continue growing. In addition, he says, as more non-U.S. market opportunities develop, increased international investment will occur outside traditional asset classes, such as in real estate. “In part,” says Kennedy, “this points to the fact that we are in the midst of a slow repricing of U.S.-denominated assets. The United States has to keep attracting foreign capital. To do so, prospective returns must look sufficiently attractive to overcome a weak dollar.”
Despite the U.S. dollar’s current weaker status and the related impact on exports and tourism, Wagner envisions an eventual modest return to U.S. fixed income. It’s an asset class that all participant pools have drawn down during the past five years—for the largest endowments, to just shy of 10 percent. “While not in swells, and perhaps not this next year,” says Wagner, “even larger endowments are likely to put more back in fixed income once interest rates have peaked and as the credit cycle changes due to subprime challenges.”
Bumps in the Road
In fact, says Wagner, it would be difficult to deny that the subprime dilemma and the difficulty U.S. banks are now facing will have wide-rippling effects on the economy in at least the near term. “We’re only now beginning to see some of the cracks of an easy-credit era, in which underwriting standards got loose and lax with debt issued.” The full effects on institution investments aren’t yet evident, notes Wagner, since the end of FY07 for college and university endowments came right as news of the U.S. credit crisis began to wash over the economy. “Even though most institutions are more likely invested in commercial properties,” he says, “fewer home purchases mean fewer [sales of] new washing machines and other manufactured goods.”
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The following firms contributed to the 2007 NACUBO Endowment Study. Without their generous support, NACUBO could not publish so comprehensive an analysis of endowment management practices.
Adds Kennedy: “This is the first crisis of the new era of structured finance, in which complex securities are proving illiquid and difficult to value. Those realities result in balance sheet problems that preclude banks from making additional loans. Going forward, we may see a slowdown in the pace of commitment to buyout funds, because prospective returns will be lower than when cheap credit was on tap everywhere.”
Yet, Kennedy and Wagner point to investment advantages as a result of the subprime fallout. “We are on the front edge of a very large opportunity in distressed securities.” The options will vary based on the resources and expertise available to institutions, says Kennedy.
It isn’t yet clear in which categories or subcategories these advantages will emerge—perhaps some in fixed income and some in hedge funds, says Wagner. He contends that while distressed investments may not provide the biggest growth possibilities, advantageous situations will arise nonetheless. Perhaps the easiest route for some institutions, says Kennedy, will be to implement allocations through multistrategy hedge fund managers. Kennedy’s caveat: As credit becomes more expensive and less available—and as this huge wave of distressed securities comes down the pike—endowment managers must exercise caution. “These investments will present a challenge similar to alternatives in that they will be very easy to do badly. So, it’s important to make sure that you have the capability to implement them effectively if you do them at all.”
Since the end of June 2007, the sub-prime market clearly has caused institutions to review what they have in their portfolios. However, argues Gordon, this doesn’t presage a change in overall asset allocation strategies or signal the need to do something dramatically different. Instead, she says, it reinforces the importance of diversification and transparency and of understanding how different pieces of your institution’s portfolio are working in concert. During the past 10 years, notes Gordon, a multitude of new products and strategies has been introduced to the market, keeping investment committees hard at work to understand the relative risks. With regard to the subprime market, questions of who ultimately owns the credit and who bears the risk have begun to swirl. “If anything, says Gordon, “recent months have reinforced the importance of due diligence with regard to manager selection and portfolio strategies.” She believes the market overall will continue to find more efficient ways to get returns and that investment committees must remain open to such innovative ideas.
Steady ’Round the Bend
If nothing else, the past five years have brought a general understanding and awareness of the sheer complexity of endowment management, says Kennedy. While it’s instructive to look at comparative data to provide a context for decision making, he cautions against drawing hard conclusions about what is “typical” among institutions. “Anyone who knows the endowment universe knows there can be tremendous dispersion around the averages, particularly among investment pools in excess of $500 million.” For instance, allocations to real estate and natural resources may easily have been two or three times as high for some institutions than the related averages suggest, says Kennedy. Investment staff and committee members must also look behind the data for observations about what paid off for investors. “For instance,” says Kennedy, “when you search for the more granular findings, you will discover that, overall, for the past five years, it paid to be in small caps rather than large caps and in value rather than growth.”
Investment performance for the five-year period can essentially be summed up in one word, says Wagner: consistency. Allocations remain largely as expected, he says, with larger endowments committing less to fixed income and U.S. equity and more to non-U.S. equity and alternatives than did smaller investment pools—and with all making mostly subtle changes to investment directions. By all appearances, and based on strong returns for the five-year period, the data also suggest that strategies that have worked well in the recent past should continue to work, says Wagner. “Overall, we’ve enjoyed a rather benign and supportive market for the past five years. With the exception of FY03, in almost all cases institutions achieved total returns that met standard spend-plus-inflation rates.”
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What strikes Kennedy is that, even for the largest endowments that are the most diversified, more than 50 percent of their allocations are to U.S. and non-U.S. equities and fixed income. The third largest endowment category (greater than $100 million to $500 million) allocated nearly 72 percent to these asset classes, he notes. “The reason to highlight this is that one of the most common mistakes an investment committee can make is to pay too much attention to asset classes that aren’t going to make that much difference to overall returns—and not enough attention to what will.”
Two questions remain constant for every investment committee in setting the direction of future returns, says Kennedy: (1) What will make a difference going forward? and (2) Do we have the necessary resources to take advantage of these opportunities?
KARLA HIGNITE, Kaiserslautern, Germany, is a contributing editor to Business Officer.
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