Buffeted by Economic Headwinds
To no one’s surprise, the inaugural NACUBO-Commonfund Study of Endowments details an ill wind for investment performance in FY09. How can we gain equilibrium in FY10?
By Kenneth E. Redd
In the 18 months from the end of FY08 through the end of calendar 2009, investment managers braved a rash of economic headwinds unlike any other period in more than 70 years. Among the bad news: the bursting of the housing bubble, a deep global recession followed by a fragile recovery, persistently high unemployment, squeezes on credit and liquidity, and wildly gyrating stock prices.
So it comes as no surprise that FY09 was the worst year for investment performance in memory. From July 1, 2008, to June 30, 2009, the overall U.S. stock market, as measured by the Standard & Poor's 500 index, fell roughly 26 percent, and international equities, based on the MSCI World (Except U.S.) Index, fell nearly 32 percent. During the previous two fiscal years (2008 and 2009) combined, the S&P 500 fell approximately 40 percent. These back-to-back years of negative returns erased nearly a decade's worth of gains in U.S. stocks.
While their diversified investment portfolios helped many college and university endowments perform better than the market indices, it is clear that the deteriorating market conditions led to steep declines in endowment values that will continue to challenge endowment managers for the foreseeable future. On average, college and university endowments and affiliated foundations returned –18.7 percent (net of fees) in FY09. This return is the lowest recorded by higher education endowments since NACUBO began collecting data on their returns in the early 1970s; the previous record low, –11.4 percent, occurred in FY74. The negative return in FY09 comes after a –3.0 percent performance in FY08, as reported by the 2008 NACUBO Endowment Study (NES). For only the second time in the past 37 years, endowment returns were negative for two consecutive years (in FY01 and FY02, endowments returned –3.6 percent and –6.0 percent, respectively).
A New Research Partnership
The FY09 results are based on the inaugural NACUBO-Commonfund Study of Endowments (NCSE), a landmark research partnership between NACUBO and Commonfund Institute. Previously the two organizations conducted separate studies of educational endowments' investment performance, asset allocation, and related finance and governance issues. This new study merges the Commonfund Benchmarks Study of Educational Endowments and the NACUBO Endowment Study into one comprehensive annual examination of a wide variety of endowment and education finance-related issues.
“The new study provides thought leadership from the best minds on endowment management,” notes John Griswold, executive director of Commonfund Institute. “It will be the single source for institutions to benchmark themselves against their peers to achieve optimum results and support their missions.”
A record number of 842 U.S. higher education endowments and affiliated foundations—with endowment assets of more than $306 billion as of the end of FY09—participated in this new study. “It is the dedication of the endowment managers and their staffs at the participating institutions who, despite the many challenges they are facing, have made the extra effort this year to make this new project a complete success,” says John Walda, NACUBO president and chief executive officer.
Analysis of key findings of the 2009 study follows.
Steepest Losses for the Largest
While the data collected from the NCSE paint a picture of endowment investment losses that were steep for nearly all institutional participants, the largest endowments—those with market values greater than $1 billion—had a particularly jarring year. Due in part to FY09's negative investment returns, the number of U.S. endowments with values over $1 billion in 2009 (52) is noticeably lower than that reported by the 2008 NES (75). As the rates of return data in Table 1 show, after reporting an average gain of 0.6 percent in 2008, these institutions posted an average one-year investment loss of –20.5 percent in 2009. The loss among endowments valued between $501 million and $1 billion was nearly as great (–19.8 percent), while the smallest endowments (those with market values below $25 million) did somewhat better (–16.8 percent). While the average returns for the largest endowments for the past 5- and 10-year periods were positive in FY09, the results for each of these time spans were substantially lower than those reported in 2008.
A key reason the largest endowments posted deeply negative returns in FY09 is that their investments in alternative strategies—private equity real estate, hedge funds, venture capital, and so on—performed poorly during the economic crisis. In 2009, these investment vehicles accounted for 61 percent of the assets of the over-$1 billion endowments. As Table 2 illustrates, alternative strategies posted a –19.1 percent average return among the largest endowments in FY09. The smallest endowments actually had a slightly lower average return in this category (–19.8 percent), but these investments accounted for only 13 percent of their total assets.
Table 2 also shows that, with the exception of fixed income and short-term securities/cash, all asset classes had sharply negative returns in FY09. Domestic and international equities had average returns of –25 percent or less, and the alternative securities categories of private equity real estate and commodities and managed futures had returns of –30 percent or less.
While FY09 negative total returns are disappointing, it is noteworthy that endowment returns generally outperformed the S&P 500, the Russell 3000, and the MSCI World indices during the 1-, 3-, 5-, and 10-year time spans (see Table 1). The endowment results also mark an improvement from the first half of the fiscal year. An earlier NACUBO-Commonfund survey found that from July 1, 2008, through November 30, 2008, endowments had an average investment return of –22.5 percent. It is likely that endowment performance improved during the final quarter of FY09, as economic conditions appeared to stabilize and the S&P surged almost 37 percent.
Nonetheless, the deep investment losses caused a number of institutions to cut budgets, reduce staff, and take other dramatic measures. “We do not minimize the pain that most educational institutions have suffered in the global financial crisis and economic downturn,” says Walda. “However, it is a testament to the skill of campus managers that colleges and universities have fared better than the returns reported by the major market indices, which demonstrates the importance of taking a long-term view in assessing endowment performance and the continuing viability of the endowment model.”
Spending Rates Hold Steady
The 842 U.S. institutions responding to the 2009 NCSE reported that the total value of their endowments fell from $398.6 billion to $306.4 billion—a 23 percent overall decline in value. The loss of endowment dollars had adverse effects on institutional liquidity and investment strategies. About one quarter of NCSE participants responded that they had experienced a liquidity squeeze due to the credit and financial market downturns experienced in FY09.
In addition, about one third of the respondents changed or considered changing their portfolio asset allocations during the year. Of those who at least considered these changes, 57 percent did so to reduce the risk in their investments and 34 percent did so to respond to concerns about liquidity. (For more information on risk in endowment portfolios, see “Risk Forecast," also in this issue).
Despite the decline in market values and changes in investment strategies, endowment spending rates remained steady from 2008 to 2009. Overall spending rates—the proportion of endowment dollars withdrawn to support institutional operations and to pay for investment management fees and other expenses—grew from an average of 4.3 percent in FY08 to 4.4 percent in FY09 (see Table 3). Average spending rates grew by four-tenths of a percentage point at the large endowments (those with market values of $501 million or more) but fell by two-tenths of a point at the smallest endowments.
More importantly, the survey found that about three quarters of the large endowments actually increased the amount of dollars they withdrew from their endowments, with the median increase at these institutions ranging from about 9 to 10 percent. Overall, about 54 percent of all respondents reported increasing their spending dollars during the past fiscal year. In addition, only about one quarter of respondents said they deviated from their spending plans for 2009 due to the lower return environment. This suggests that, for the most part, increases in institutional endowment withdrawals that were planned before the markets collapsed were undertaken despite various challenges.
Rising Institutional Debt
Another important issue covered by the NCSE is long-term institutional debt. In FY09, survey participants reported a median debt of $44.3 million, roughly 57 percent higher than the median debt level of $28.3 million reported in the 2008 Educational Endowments Report issued by Commonfund. As Table 4 illustrates, the institutions with the largest endowments carried the highest median long-term debt level ($863.1 million), while those with endowments below $25 million had the smallest ($15.8 million).
While long-term debt levels increased substantially, debt repayments are low relative to institutions' operating expenditures. On average, NCSE participants reported devoting only 5.6 percent of their operating budgets to debt service. Among the largest institutional endowments, only 5.1 percent was devoted to servicing long-term debt obligations. The data also suggest that the majority of the growth in borrowing occurred among the largest endowments. About two thirds of these institutions reported that they increased their long-term debt from 2008 to 2009, compared with 35 percent of all respondents.
Changes in debt took place during a time period when the Federal Reserve reduced the main interest rates it controls to nearly zero in an attempt to stimulate economic growth. As a result, record-low interest rates existed for most of the fiscal year. It is possible that a number of institutions with very large endowments took advantage of this low-rate environment by consolidating and refinancing their debt to ensure lower-interest payments. The increase in debt could thus turn into a positive for a number of institutions.
A Turnaround in 2010?
Another positive for endowment managers is that since the close of FY09, U.S. and global stocks have experienced a recovery period; for example, the S&P rose 22 percent during the first six months of FY10. Griswold believes this nascent market recovery could benefit institutional portfolios. “Based on action in world financial markets in the second and third quarters of 2009 and continuing improvements in 2010, we believe that educational endowments are continuing to recoup some of their losses.” Walda agrees, adding that “greater stability in world financial markets could benefit educational institutions enormously.”
There is evidence that institutional investors have rebalanced their portfolios, or will soon begin to do so, to take advantage of the market's recent positive moves. More than 40 percent of the endowments that changed or considered changing asset allocations in FY09 did so to add more to their growth assets, which suggests a growing confidence in stocks and other riskier investments. Additionally, about three quarters of all survey participants said they rebalance their portfolios at least annually, and 70 percent of those that rebalance do so based on changes in market conditions. This result also suggests many institutions could begin to benefit from any continuing upward movements in stock prices.
Despite more recent positive market gains, a number of negative factors could turn the markets downward once again. Economic growth remains weak, credit is still difficult to obtain for all but the most-creditworthy borrowers, and unemployment remains quite high by recent historical standards. What direction the financial markets and the economic recovery will take in this challenging environment is still unknown, but the results of the 2009 NCSE do indicate the need to stay focused on the long term while preparing for any new opportunities that may arise in the short run. The key finding from the next NCSE could show how institutions successfully rebalance their portfolios in 2010.
KENNETH E. REDD is director of research and policy analysis for NACUBO.