All Oars in the Water
By consistently communicating five key areas of understanding, Abilene Christian University keeps the governing board and business office rowing together in effectively guiding its investment portfolio.
By Jack Rich
College, university, and other institutional boards face a world of increasing complexity, in which they must exercise their fiduciary duties. This is evident in all areas of institutional oversight, including academics, student life, finances, development, investment, and operational disciplines. Board members need to know more about increasingly multifaceted areas for which outcomes often are unknowable. With continuing uncertainties in the world markets, this seems especially true for endowment management.
At Abilene Christian University (ACU), Abilene, Texas, we have tried to identify the key information that all board members need to understand regarding the way the endowment is managed. By simplifying these themes and then communicating the information to the full board on a periodic basis, we free the trustees to focus most of their board time on the education of students.
Every endowment is different, but common to all is the critical need to build understanding and confidence in the investment management process. We feel that our consistent communication about priority endowment issues has allowed ACU to develop a progressive portfolio that has weathered the past few years with a minimal amount of disruption or consternation.
The ACU endowment consists of approximately $262 million in assets, more than 70 percent of which is in alternative investments. Our net investment returns over the past 3, 5, and 10 years have placed us in the top quartile of our peer group, based on the results of the 2010 NACUBO-Commonfund Study of Endowments. Over the past 15 years, we have evolved from a traditional portfolio with performance in the bottom quartile of our peer group to a high-level performer. A large part of our success has been the result of communicating with the board on key issues in a way that is understandable and that builds consistently over time, as the complexity of our portfolio changes.
We use several distribution methods to consistently communicate endowment priorities to our full board. Quarterly a brief, written report captures some of the important details, while we present other informational pieces in board sessions on an annual basis. The reporting process is dictated by board policy and can be supplemented by information that is relevant, based on current circumstances.
Providing trustees with financial information in the following five areas seems to have made a significant difference in the ability of board and endowment management staff to remain in sync:
- Investment goals and performance.
- Spending policy philosophy.
- Portfolio diversification.
- Risk management.
- Board oversight.
Investment Goals and Performance
Our primary investment goal is to achieve a return of 5.5 percent plus the inflation rate over a 10-year period (that is, 4.5 percent average spending plus 1 percent real growth). When we look at portfolio performance, this is always the most important benchmark. Focusing first on this target provides an opportunity to discuss with the board why this investment goal was developed and why it is critical to the university's financial health. Our basic reasoning is that if we consistently reach this goal, we will have real growth in the spending distribution available to the school.
As our portfolio mix begins to look increasingly different from that of our peers, the 5.5 percent long-term real rate of return expectation acts as a foundation for our investment philosophy. Since we do not manage to the average portfolio of our peers, we will seldom have average returns. By reminding the board of our long-term goals, we can focus on broader market conditions and our own expectations rather than on investment choices of our peers.
As an additional review of our performance, we also analyze our returns relative to a range of market indices. For example, we will compare our entire portfolio performance to a more traditional portfolio, with 65 percent invested in the S&P 500 Index and 35 percent in the Barclays Capital Aggregate Bond Index over 1-, 3-, and 5-year periods. On an asset class and manager level, we compare returns to appropriate benchmarks. We may compare a long-only domestic equity manager to the Russell 3000 or a long/short equity hedge fund to the HFRI Equity Hedge Index.
Although we emphasize our long-term real-return goal of 5.5 percent, we also compare our performance to our peers and to groups with larger endowments, such as institutions with endowments of $500 million or more. We find this comparison instructive to our process, providing useful information about what others are doing and what has been successful. Our board, like many others, has been sensitized to such peer comparisons with other endowments. However, just as comparisons of academic quality at colleges and universities based on U.S. News and World Report rankings are difficult, comparisons of endowment performance rankings can show wide disparity because of a diverse range of variables. Focusing first on our overall investment goal of a real return of 5.5 percent is a helpful reminder of what is truly important in managing our endowment.
Spending Policy Philosophy
Most investors understand the importance of trying to reduce portfolio risk (volatility) as a way of improving long-term performance. Our board feels it is equally important to minimize the volatility of distributions to our university stakeholders. Downturns in the markets in calendar year 2008 and early 2009 highlighted the problem of basing distributions solely on a designated percentage of endowment assets. Distributions could decline as much as 20 percent from peak years in an already difficult economic environment. If a university is partially dependent on endowment distributions to fund programs or scholarships, this can be problematic.
Endowment distributions at ACU contributed 12.4 percent to the university's overall budget in FY10. A 20 percent decline in our distributions would equate to about $2.5 million. In a world of tight budgets and increasing demands for academic excellence, this level of decline would create significant budgeting issues for us. Over a 10-year period, our spending methodology evolved from a policy to spend all investment income (then about 8 percent), to the more-typical practice of spending 5 percent of a three-year moving average, and finally to our current method. Our goal at each step was to reduce the volatility of distributions. Our current policy, which is somewhat of a hybrid (known as the Yale or Stanford model), is based on a combination of previous-year distributions and current endowment size. It provides that spending may be as low as 3 percent of the endowment when investment returns are rising to as high as 6 percent when returns have fallen. By allowing the spending rate to be variable, distributions are more stable. Figure 1 illustrates the impact our policy has had on distributions over the past few years.
As the figure shows, spending dropped less than 2 percent in the worst year, even though endowment assets declined as much as 18.8 percent. You can also see by looking at the final column in the figure (Distributions as a percent of previous year-end) how our spending as a share of the previous year-end endowment moved during the indicated time.
We review the spending philosophy annually with the board. But, since board composition changes over time, we know it is important to continually reiterate our spending philosophy. By consistently communicating our approach, we can reduce trustees' concerns when they see spending, as a proportion of the endowment, move closer to one of our extreme limits (3 percent or 6 percent). The consistency of distributions, despite changes in total endowment assets, provides a more stable environment for university financial planning.
The benefits of portfolio diversification are widely understood by most boards. We communicate to our full board on a quarterly basis our specific portfolio allocations compared with our targets. Staff is responsible for rebalancing the portfolio, but it is easy to tell by reviewing the comparative portfolio diversification whether or not we are operating within approved limits.
Figure 2 shows our asset and liquidity allocation targets and ranges. Since we operate a relatively illiquid portfolio, we sometimes provide the board with additional explanation and the opportunity for discussion, if we see we are approaching or exceeding policies targets. However, because of the illiquid nature of our portfolio, we have built flexibility into our policy to allow for periods of market disequilibrium.
We talk annually about why diversification is important and use this explanation as a tool for the board in understanding why we have developed the particular portfolio we manage. Over the years, our consistent focus on asset allocation has allowed us to grow increasingly complex with our investments. As the board has become more knowledgeable, they've supported the increased diversity of our investment portfolio.
With the past few years of market turmoil, our focus on communicating the various forms of risk to the board has been a key part of our investment management process, allowing investment decisions to move forward with confidence even in times of such great uncertainty. Many of the tools and reports we have developed to monitor and communicate risk are a direct result of board input. We think about and monitor risk in a number of areas, including: liquidity, leverage, geopolitical issues, asset allocation, and manager risk. We then use these monitoring tools to report the various risks that we take and our perceived level of risk at any given time.
At a glance, a board member can determine whether the portfolio is within policy limits and, if not, how the administration will respond. The board can also see how our relative risk profile has changed over time. The following risk management tools are in place:
Figure 3, Summary of Four Elements of Allocation Policy and Related Risk. This figure shows our risk position compared with our established policy regarding liquidity, leverage, geopolitical issues, and asset-risk allocation. If we are within policy limits our risk position is deemed "Acceptable." A brief explanation for the board is sometimes included, if there is a significant event that merits discussion. If the portfolio falls outside of policy parameters, then we will "Monitor" the area of concern until we are back within limits. We will generally add a more detailed explanation and plan to reach policy limits if we are in a "Monitor" position.
Figure 4, Relative-Risk Profile for the Portfolio. This is another example of how the board has influenced our discussion of risk. The concept of tracking our portfolio risk over time grew from a discussion in a board committee meeting. Although we were looking at leverage and liquidity changes over time, we had no context for the way these two factors interrelated.
Based on our committee discussion, we developed a relative-risk profile for our portfolio, which included both risk levels and liquidity stress tests.
- Risk levels. Using a scale of 1 to 10 (with 10 being the highest level of risk), we assigned weights to levels of perceived risk. For example, if 30 percent of our portfolio was liquid within 30 days, then it was assigned a neutral weight of 5. However, if our liquidity were to drop to 20 percent, it would be given a scale weight of 9. As Figure 4 illustrates, while our liquidity risk was increasing in 2008, the amount of leverage in our portfolio was decreasing. The increase in liquidity risk was somewhat offset by the decrease in leverage risk. Throughout the 5-year period shown, our overall risk stayed relatively neutral even though the types of risk we were taking changed.' A chart of this type provides a somewhat simplified view of risk. However, it can give a board a quick overview of relative risk in a form that is easier to understand than more complex risk measures. Although this scale is unique to ACU and our risk policy, it can easily be adapted to reflect the risk profile of any portfolio.
- Liquidity stress tests. When market values fell sharply in late 2008, many university trustees began to focus on portfolio liquidity and liquidity needs. Although we had tracked liquidity in our portfolio for some time, we developed several new tools to provide the board information for making decisions. One tool was the development of a liquidity stress test. In this case we assumed that all of our private equity commitments were called within the next 12 months and that we needed enough liquidity to meet our distribution needs over the next three years. We compare the calls on our liquidity against the liquidity that we were confident would be available in the next 12 months. Further, we reduced our assumed liquidity by 25 percent and 50 percent and applied the same calculation. By looking at this measure, we were able to quickly determine that, although uncomfortable at the time, we did not have a particular liquidity problem. At a recent meeting the board agreed to reduce our short-term liquidity targets based on a long-term history of our stressed liquidity. We could see that even at the worst point, in March 2009, we had sufficient liquidity to deal with projected needs over the next three years.
Figure 2, Asset and Liquidity Allocation. As our portfolio has become more weighted toward alternative strategies, liquidity management has become more important. We recently developed a schedule that combines the concept of asset allocation with liquidity allocation. The first few columns of Figure 2 show a typical asset allocation view of the portfolio. The last three columns take our same asset classes and allocate assets based on liquidity needs. Currently, we are near our policy limits on both short-term liquidity and long-term illiquidity. For example, if we chose to increase our private equity exposure, we have to consider both asset allocation guidelines as well as liquidity constraints.
A robust but easy-to-understand view of our risk profile, using these various tools and reports, has allowed our board to make decisions with more confidence. The development, over time, of tools to measure and discuss various types of risk has made it easier to consider an increasingly illiquid portfolio. We feel that our willingness to have significant illiquidity has been rewarded in our returns.
Clearly, the board of any institution has a fiduciary responsibility to appropriately manage the endowment. Yet the complexity of a modern portfolio requires a great deal of trust in policy and in those overseeing the investments at the board level. Confidence in the process, or lack thereof, will dictate the ability of management to develop portfolios that maximize investment returns within acceptable levels of risk.
ACU takes a number of steps to ensure that the board of trustees is confident in the exercise of its fiduciary responsibilities. For example, by board policy, a quarterly update is provided to all board members detailing key performance, diversification, and risk parameters. In addition, the board of trustees must approve all investment policy changes. Since we allow a majority of investment committee members to be nontrustees, we also require that all committee members be approved by the full board.
At each meeting, the committee reviews a governance checklist to ensure that we have taken required and appropriate steps at the designated times. Listings include required Form 990 reviews, conflict-of-interest forms, periodic policy reviews, and so on. (See sidebar, "Governance Checklist," for a detailed example of items that we routinely review.)
An Effective Endowment Crew
I have often noted that the secret to our positive investment process and performance is the way that our board engages with our endowment staff. These two groups synchronize their efforts with maximum results.
As for governance, the board and investment committee are committed to three major attributes. First, the board provides management with a committee that has appropriate expertise in the investment field. Along the way, as the board changed and we lost some key investment committee members, trustees restructured the governance process to allow outside expertise to be included in the oversight function. Second, through that restructuring process, the board has allowed the investment committee to maintain continuity over longer periods of time. This is important given the growing complexity of our portfolio. Finally, our board and investment committee are engaged in ongoing education in the discipline of endowment management.
On the institution side, we've focused on the five key themes outlined earlier. In keeping our eye on those horizons, we've helped develop a board that is knowledgeable and engaged in the management of our endowment. With everyone pulling in the same direction, it's a process that has served us well.
JACK RICH is chief investment officer, Abilene Christian University, and president of Abilene Christian Investment Management Co., Abilene, Texas.