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Just When You Thought It Was Safe…

A year ago, investment returns were speeding along. But, the 2012 NACUBO-Commonfund Study of Endowments tracks a tougher ride.

By Kenneth E. Redd

*After several tumultuous years, the investment markets appeared more stable, and safe once again. Heading into FY12, many investors were optimistic about the rising stock markets and improved chances for economic growth in the U.S. economy. The Standard and Poor's 500 Index, a broad measure of the health of American stocks, had returned more than 30 percent during the July 1, 2010, to June 30, 2011, period, and most other indices also showed strong gains. Overseas, European leaders were continuing to tackle the government debt crisis in Greece and other countries and—while volatile—that situation appeared to be coming under control.

How quickly things changed. As documented by the 2012 NACUBO-Commonfund Study of Endowments (NCSE), the investment environment quickly deteriorated. At various points throughout FY12, the U.S. stocks experienced wild gains and losses, as the optimism of accelerated economic recovery gave way to continued anxiety about slower-than-expected growth and unemployment rates that remained above 7 percent. In addition, the European situation appeared to be worsening, as fear increased throughout the spring and summer that Greece would be forced to leave the euro zone; while Italy and Spain faced recessions so steep that those countries requested government bailouts. Once again, investors found the financial markets shaky and fraught with potential risk.

View Online NCSE Discussion

Participants in a February 12 webcast, "Understanding the 2012 NACUBO-Commonfund Study of Endowments," learned more about the study during an in-depth discussion of the results. Go to NACUBO Notes for instructions to access this and other NACUBO on-demand programs.

As a result, nearly every investment asset class showed reduced returns for FY12 when compared with the year prior. The S&P 500, which surged 30.7 percent in FY11, grew only 5.5 percent during the following 12 months ending June 30, 2012. The performance of international stocks was even worse. Due in large measure to the growing European debt crisis, the Morgan Stanley Capital International (MSCI) World Except U.S. Index dropped 14.1 percent in FY12, after jumping 30.9 percent during FY11. Only bonds showed any improvement from 2011 to 2012. With the U.S. economy continuing to struggle, the Federal Open Market Committee of the Federal Reserve Board of Governors held its federal funds rate steady at near zero, which helped the Barclays Aggregate Bond Index return 7.5 percent in FY12 compared with 3.9 percent the year prior.

In the face of these market conditions and divergent index returns, college and university endowments turned in an essentially flat performance for FY12. The 831 U.S. college and university endowments and affiliated foundations that participated in the 2012 NACUBO-Commonfund Study of Endowments reported an overall average return of -0.3 percent in FY12, a sharp reversal from the strong gains of 19.2 percent in 2011 and 11.9 percent in 2010.

Perhaps more ominous, several major economic issues that caused volatility throughout FY12 still have the potential to influence investment decisions and performance in FY13 and into the future. While improvements in the European situation have helped calm international markets, ongoing uncertainty about the direction of fiscal policy in the United States continues to be the source of investor anxiety. Volatility, which has been a feature of financial markets every year since the 2008–09 downturn, could continue into FY13 as well.

This year's overview of the results of the 2012 NACUBO-Commonfund Study of Endowments takes a look back at the investment strategies institutions used in 2012 and includes some emerging themes for FY13 and beyond. This year's review also assesses the challenges endowment managers are confronting in the first half of FY13 and how they plan to move forward in spite of these new obstacles.

Weak Performances Abound

Collectively, the 831 U.S. institutions that participated in the 2012 NCSE held $406.1 billion in total endowment assets. The average endowment among this year's NCSE participants was roughly $492.9 million, while the median was about $86.5 million. The flat investment performance, combined with withdrawals made for campus operations—such as student financial aid and faculty research—caused the median value of the endowments and foundations that participated in the 2012 study to drop by 3.1 percent from FY11 to FY12.

As Table 1 shows, endowments of all size categories had much weaker performance in FY12 when compared with the previous year (roughly 97 percent of the total survey participants provided their one-year net investment rates of return). The largest endowments (over $1 billion), which achieved an average FY11 one-year gain of 20.1 percent, saw their returns tumble to just 0.8 percent. The smallest endowments, those with assets below $25 million, saw their average returns drop from 17.6 percent to only 0.3 percent. While the returns for these groups were smaller, at least they remained positive.

Allocations to bonds and U.S. stocks were particularly helpful to smaller-sized endowments, which on average had 39 percent of their funds in domestic equities and 29 percent in fixed income.

The midsize endowments—those with assets ranging from $101 million to $500 million—incurred a -0.7 investment loss compared with a 19.7 percent gain in FY11, while institutions with endowments ranging from $51 million to $100 million realized an FY12 return of -1 percent compared with a 19.3 percent gain the prior year.

 Still, despite the one-year losses, it remains important for endowment managers to remain focused on the long term. "Despite the challenges of the past year, a longer-term time horizon shows that a number of endowments are still doing well enough to cover their spending and achieve inflation-adjusted growth," says Nicole W. "Nikki" Kraus, director of Hirtle Callaghan & Co., a Pennsylvania investment management firm with endowment, pension funds, and family foundation clients. "Endowments' longer-term time horizons give them a greater chance for higher returns," notes Kraus.

Indeed, over the past 10 years, in spite of the losses incurred in FY12, college and university endowments of all size categories achieved an annual 6.2 percent return on average, which was actually greater than the 5.6 percent 10-year average recorded in FY11. More importantly, the 10-year average annual return was nearly 1 percentage point higher than the 10-year average annual return for the S&P 500 Index of 5.3 percent. Endowments with assets over $1 billion did even better (7.6 percent average annual return over the past decade), while the smallest endowments bettered the S&P 500 by 
0.4 percentage points annually on average.

Seeking a Better Route With Bonds and U.S. Stocks

Given the short-term volatility, it should come as no surprise that the endowments that did best in 2012 benefited from their bond holdings, as Table 2 illustrates. Fixed income investments (U.S. and international combined), which accounted for 11 percent of total endowment assets (on a dollar-weighted basis) in FY12,  rose 6.8 percent during the year, slightly better than the 6.6 percent return in 2011. Endowments were also helped by a 2 percent average gain in their U.S. stock holdings, but this result pales in comparison with the 30.1 percent return seen in FY11. Domestic equities accounted for 16 percent of total assets in FY12.

Flashback ... 27 Years Ago

In a December 1986 Business Officer article reporting preliminary endowment returns ...

"A +27.1 percent total return on the average endowment pool for the one-year period ending June 30, 1986, marked the second best one-year return in a decade. ... Combining FY86's strong performance with FY85's +25.5 percent return produced the best back-to-back years since 1976."

The NACUBO Comparative Performance Study, a project of the NACUBO Financial Management Committee's Subcommittee on Investments, chaired by Leigh Jones of Berea College, Berea, Kentucky.

Allocations to bonds and U.S. stocks were particularly helpful to smaller-sized endowments (those with total assets below $25 million), which on average had 39 percent of their funds in domestic equities and 29 percent in fixed income. Bond holdings helped Greenville Technical College Foundation, Greenville, South Carolina, achieve a 1.69 percent return in FY12. "Bonds were buoyed by further declines in interest rates and continued demand for safety from investors," says Bob Howard, president of the $5.5 million foundation. The foundation's performance was also helped by investments in growth stocks, particularly high-tech companies. "The technology sector has performed well," Howard says, "and investors have been willing to bid up companies with earnings growth momentum."

Midsize endowments, such as that of the University of Denver, benefited from both timely allocations to relatively defensive assets such as stocks, and non-campus-based private equity real estate. "We added to equities, and the university's real estate portion of the endowment fund had favorable market adjustments," says Margaret Henry, controller and assistant treasurer. The university's $373.4 million endowment achieved an overall investment return of 2.6 percent.

On the other hand, large declines in international stocks and lower returns in commodities and energy and natural resources reduced investment performance among all endowment size categories. International stocks, which accounted for 16 percent of total endowment assets during the year, experienced an average return of -11.8 percent return in FY12, compared with a 27.2 percent gain the year prior. Energy and natural resources returns were -0.8 percent in FY12 versus 23.5 percent in 2011.

"While our foundation was underweighted to international and small cap stocks," Howard says, "that exposure was a drag on the foundation's performance. Managed futures and an arbitrage strategy were also a hindrance." Henry adds that the University of Colorado's performance was hurt by "international equities, energy-related investments, and hedged equities."  

Time to Remap Strategy?

Hirtle Callaghan & Co.'s Kraus believes that when the negative results in international equities, hedge funds, and other beaten-down asset classes are weak, it is precisely the time for investors to strongly consider deploying new resources in these areas. "We took the contrarian view and advised our clients to take advantage of the volatility and purchase these assets while cheap to position for the future," she says. Investors who took such advice were soon rewarded. During the first six months of FY13 (July 1, 2012, to Dec. 31, 2012), the U.S. and European markets staged a rally, as job growth appeared to be accelerating in the United States, and leaders in Europe finally reached agreement on a sustainable path out of the euro debt crisis. The S&P 500 Index rose nearly 6 percent during this time, while the MSCI increased roughly 13.7 percent.

Despite the recovery, many alternative asset classes still trail the overall market. Hedge funds, for instance, rose just 5.5 percent overall during calendar year 2012, according to CNN/Money, while the S&P 500 Index increased 13.4 percent. Kraus believes these results demonstrate that institutions still have time to shift some of their assets to areas that may not have fully recovered their losses from the last fiscal year. "It is much better to buy assets when they are cheap and the fundamentals are otherwise good," she points out. "Commodities, hedge funds, and international equities have already come off of their lows and have the potential to realize great gains for patient investors."

At the same time bonds, which had outsized performance in 2012, may not continue to lead the way in 2013. "We recognize the risks that now exist in the bond market with historically low interest rates and the ever-present threat of rising inflation," Howard says. It thus may be time for endowment managers to consider lowering risk and positioning for further growth. 

 Some investment professionals appear to be heading in this direction. As the figure on page 21 shows, 13 percent of the endowments and foundations that participated in the 2012 NCSE changed or considered changing their asset allocation portfolios, compared with 15 percent in 2011. Among respondents who made or considered substantial asset allocation alterations in FY12 and FY11, roughly half did so to take advantage of emerging opportunities due to changes in asset prices (identified as "opportunistic"). The share who rebalanced to improve their prospects for achieving "risk reduction" increased from 74 percent to 79 percent. 

Greenville Technical College Foundation is one institution that has already made strategic shifts in asset allocations while remaining leery of the continuing risks of sudden downturns. "During FY11 our foundation increased diversification through the addition of multiple strategies," Howard says. "Knowing there was greater uncertainty, the driving motivation was further risk reduction. New strategies, including commodities, managed futures, and international bonds, were funded by a moderate reduction in exposure to U.S. fixed income. However, we have maintained a tactical underweight to international and small cap stocks. The main focus for us has been on the risks that still exist in Europe."

The University of Denver has also shifted its asset allocations to take advantage of new opportunities while lowering risk but also remaining somewhat cautious. "We still believe that valuations support full weighting in equities and underweighting in fixed income," Henry says. "We are still using international equities, energy-related investments, and hedged equities. But the university has also maintained an overweighted allocation to cash for some time. Our advisory committee's agenda will always address the decision to maintain the cash allocation, ideas to deploy the cash, and the timing of the investment."

Potential Potholes Still Lie Ahead

The somewhat cautious approach that institutions may be taking is completely understandable. Even taking advantage of emerging opportunities to achieve better long-term results has to be placed in the context of the challenges that institutions face today. While the stock market has produced strong returns thus far in FY13, many economists believe that the tax increases included as part of the "fiscal cliff" deal that Congress passed in early January 2013 will reduce annual economic growth by as much as 1 percent. More importantly, Congress will have to confront spending cuts of as high as $110 billion that were temporarily delayed, as well as any fallout from the fight over raising the nation's debt ceiling. These and other fiscal policy debates could make financial markets very nervous throughout the latter half of FY13 and beyond.

 Access the Full NCSE Study Online

The 2012 NACUBO-Commonfund Study of Endowments (NCSE), based on responses from 831 U.S. college and university endowments and affiliated foundations, provides extensive data to help colleges and universities compare their results by endowment size and institution type. Tables, charts, and graphs include data on investment performance, asset allocation, spending rates and policies, institutional debt, management expenses, and governance issues.

The final report (Item No. NC-4065), available on NACUBO's Web site beginning April 1, is $100 for NACUBO members and $700 for nonmembers. Purchase of the study allows institutionwide access to the results. To order, go to www.nacubo.org/Research/NACUBO-Commonfund_Study_of_Endowments.html. Participating institutions and sponsoring firms receive free access to the Web-based report.

Besides the effects of economic and federal fiscal policy changes that institutions may endure, public and private higher education institutions also must contend with other issues. A recently released Moody's report suggests that for the foreseeable future colleges and universities will experience lower growth in revenue and greater resistance from families and students to tuition and fee increases. These additional factors will likely force institutions to control costs and generate additional funds to meet student and faculty needs.

During the fiscal crisis of 2008 and 2009, as endowments declined more than 18 percent and many state governments slashed education appropriations, a number of endowments increased their endowment spending rates. Given the recent slower growth of endowments, and continuing concerns of students and families about the rising costs of college, this option may no longer be viable.

"We have decided not to change our endowment spending formula," Henry says. "But we have looked at new ways of diversifying our revenue streams. Most likely the opportunities will come from cost containment and efficiencies coming from a review of our cost structure, increasing the utilization of the plant during summer term, and increasing the use of online and hybrid courses-and we will also be looking to increase endowment distribution through fundraising."

Public institutions like Greenville Technical College Foundation are also focused on raising revenue to meet their organization's goals. "We would like to use fundraising to increase our endowment's value," Howard says. "Our dream is to have an unrestricted endowment large enough to pay the foundation's operating expenses every year so that 100 percent of other funds raised can go directly to the college. However, we also will be seeking funds in 2013 for a substantial number of capital improvements at the college, so the requests for additions to the unrestricted endowment may take a backseat to requests for funds for these capital improvements."

Whatever strategies institutions use to generate additional resources and navigate through potentially perilous times, it is perhaps more important now than ever that college and university endowment professionals not become overly cautious when making their investment decisions.

Both Howard and Kraus emphasize that the involvement of institutional finance and investment committees is key in maintaining this long-term focus. "While being conscious of current events, the real focus for us is our investment policy," Howard says. "At least annually, the strategic validity of the investment policy is discussed; the intent is that the policy provides a sound framework for decision making in good times and bad."

Kraus is even more explicit in her call for colleges and universities to keep their eyes on the future. "It is extremely important for finance committees and endowment managers to have a consistently applied framework that governs the current and future directions of their investment decisions. The worst mistake investors can make is to overreact to short-term losses and volatile economic or political situations. Applying a disciplined approach that calls for you to buy assets when they are cheap and sell them when they recover is the most effective proven strategy for successful long-term portfolio performance."

KENNETH E. REDD is director, research and policy analysis, at NACUBO.

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For University Endowments, No Hard Landing

The negative one-year returns reported in the 2012 NACUBO-Commonfund Study of Endowments (NCSE) may be discouraging for institutional investment managers. Indeed, recently a number of industry observers and media critics of colleges and universities have viewed these results as a reason to attack the diversified "endowment model" of investing. These observers have concluded that because of recent lower-than-expected returns, it is now inappropriate for all but the largest endowments to invest in anything other than a portfolio of 60 percent stocks and 40 percent bonds (the 60/40 stock/bond portfolio) over multiple periods.

However, by taking a longer view of the results, we know that these assertions are unsupported or simply incorrect. In fact, by taking the long view, we can easily conclude that all endowments have outperformed the overall market, and have an excellent chance to continue to do so despite today's challenging investment environment.

Look Well Beyond Today

Media observers and other commentators on college and university endowments make the all-too-common error of giving undue weight to short-term data. For instance, during FY12, endowments on average produced substantially lower returns than a simple mix of 60 percent stocks and 40 percent bonds, as measured by a 60/40 S&P/Barclays Blend Index (see table). And over the five-year period, the S&P/Barclays Index has produced a greater return than endowments of all size categories.

Using these time spans, the critics have concluded that the endowment model-the theory of investing over many years a significant portion of endowment across multiple traditional and nontraditional asset classes, such as marketable alternatives (hedge funds), private equity, and real estate-is now broken and that endowments should return to more simplified investment strategies primarily using the traditional asset classes of stocks and bonds.

However, what this analysis fails to note is that over the past 10 years endowments of all size categories easily outperformed the 60/40 benchmark, as well as several other indices.

Specifically, over the 10-year period ending June 30, 2012, endowments with assets over $1 billion outperformed the 60/40 benchmark by 200 basis points (2 percentage points) per year, and endowments with assets between $501 million and $1 billion outperformed the benchmark by 100 basis points per year. Midsize and smaller endowments also outperformed the 60/40 portfolio over the past 10 years. Even more importantly, institutional endowments of all size categories also substantially outperformed the S&P 500 Index-the standard benchmark many investors use to gauge investment performance-over the past 10 years. Endowments have also produced returns superior to the MSCI World Index, a measure of international stocks, by an average 60 basis points (0.6 percentage points) per year for the past 10 years. 

An Endowment Model Alive and Well

Why have endowments produced above-benchmark returns over the past 10 years? Generally, it is because the endowment model of investing calls for maintaining a disciplined, long-term approach despite volatile market conditions. In 2009, at the height of the market downturn, endowments had roughly 51 percent of their assets invested in alternative asset classes on a dollar-weighted basis; in 2012, they had 52 percent. This stability suggests that, unlike many other types of investors, endowment managers kept to their asset allocations during the rough periods. They did not abruptly change course during the down years of 2008 and 2009, and as a result recovered many of the losses they had incurred.

Just as importantly, by holding fast to their investment policies, they did not experience the dual costs of selling investments at a discount nor rebuying stocks and bonds that had regained their value.

One key reason the 60/40 benchmark outperformed in the recent past is because of the performance of bonds, which rallied during the 2008 and 2009 period as investors rushed to the safety of U.S. Treasuries and benefited from the historically low-interest-rate environment that has prevailed ever since. As the economy recovers and the benefits of low interest rates decline, it is less likely that bonds will repeat this performance, and thus holding to a 40 percent bond allocation may actually lead to even lower results in the future.

In contrast, the discipline of the endowment model, which focuses on long-term results while ignoring short-term market trends that might benefit from volatility or economic decline, proved to produce superior returns over the past 10 years. This continues to be the best chance for institutional investors to produce returns that most benefit their institutions and the students and faculties they serve. By keeping to this philosophy and not following a strict 60/40 benchmark that would be heavily weighted in bonds, college and university investors will have avoided the inevitable decline in treasuries and other bond instruments.

Far from being broken, the endowment model remains alive and well and continues to serve many colleges and universities. And despite the moderate loss recorded by this year's NCSE, the model continues to offer investors the best chance to provide consistent and growing support to their institutions well into the future.

JOHN S. GRISWOLD is executive director, Commonfund Institute, Wilton, Connecticut.

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