Performing Amid Uncertainty
Despite volatile markets, endowment managers stick to their asset allocation scripts. But, liquidity plays a larger role.
By Kenneth E. Redd
After taking a swan dive in FY09, financial markets began to regain altitude in FY10, as the Standard & Poor's 500 jumped 28 percent in the first nine months of the fiscal year (July 1, 2009, to March 31, 2010). Then the ascension suddenly stalled. The S&P 500 dropped 11 percent in the second quarter of 2010 in the wake of the debt crisis in Greece and a slower-than-expected U.S. economic recovery that featured continuing high unemployment and renewed waves of housing foreclosures, among other generally bad economic news. Still, the S&P 500's 14 percent total return for the full fiscal year was a great improvement over the 28 percent loss in FY09.
This overall performance in U.S. stocks masks some rather uneven changes in other asset classes. For instance, foreign stocks, as measured by the MSCI World Index, gained only 6 percent in FY10, while the MSCI U.S. REIT Index surged 55 percent; the price of gold (as measured by the SPDR Gold Trust) increased nearly 32 percent, while energy (as measured by the price of a barrel of crude oil) grew only 9 percent.
The divergent returns among asset classes and sudden swings in rates of return make clear that the financial markets will remain a significant challenge for investors in the near term, making investment decisions even more precarious than normal. In the face of this uncertainty, college and university chief financial officers and endowment managers will be pressed to position institution portfolios to achieve long-term growth, generate investment income to support campus operations in the short term, and protect against sudden market downturns. Managers' asset allocation strategies will play an even more vital role in keeping performance steady into the future while preserving liquidity for present needs.
While the forthcoming 2010 NACUBO-Commonfund Study of Endowments (NCSE) will provide a detailed look at college and university endowment investment performance, asset allocations, and liquidity concerns during FY10, what follows is an initial look at the actions CFOs and investment officers have taken to deal with recent market turbulence.
Holding Steady—for Now
Despite up-and-down markets, college and university endowment managers and their investment committees appear to have held to their asset allocation strategies during a rocky FY10. This continues a trend seen in FY09. According to the 2009 NCSE, only one third of the portfolio managers at college and university endowments changed or considered changing their asset allocations in spite of the steep market declines they suffered. Unlike other money managers, college and university endowment investment officials have a long-term time horizon in which to ride out sudden shifts in financial markets, which means they can keep to their asset allocation strategies even during periods of economic uncertainty.
That said, with 2009's poor performance and a series of adverse economic events in 2010 still fresh on their minds, investment pros and their advisory committees appear to be taking an even more active role in monitoring allocation decisions and their possible effects on current and future performance. For example, endowment managers at American University, Washington, D.C., have been “very attentive in speaking with our investment managers to make sure we are not overexposed to European banks or other high-risk sectors,” says Donald Myers, vice president of finance and treasurer for the university.
AU's endowment, which according to the 2009 NCSE totaled $312.4 million at the start of FY10, had a preliminary estimated investment return of 14.6 percent in FY10. While the endowment is already well diversified and has not made substantial changes due to the recent economic crises, Myers adds: “Our board of trustee's finance committee is very hands-on in reviewing the allocations and will make changes if necessary.”
Similarly, investment advisers at Roberts Wesleyan College and Northeastern Seminary, Rochester, New York, which had an $11.9 million endowment at the start of FY10, are taking a longer-term approach while monitoring current developments. “Although we ask many questions to assure appropriate investments, we remain focused on asset classes that produce good returns over the long term,” says James Cuthbert, senior vice president, treasurer, and chief financial officer. Roberts Wesleyan's endowment had a preliminary net investment return of 10 percent in FY10.
In essence, endowment managers who made portfolio changes in the past year did so based on long-term strategic planning rather than as a gut reaction to recent economic headwinds. Managers of the $38 million endowment at the College of Saint Benedict, St. Joseph, Minnesota, which returned 14.4 percent in FY10, have been making changes in its asset allocation for the past several years. These changes were made “not so much as a result of the market volatility, but out of the desire to strategically change the allocation,” says Susan Palmer, vice president of finance and administration.
Ohio State University, Columbus, also made asset allocation decisions based on long-term goals. “When I moved to the university near the end of calendar 2008, we made several changes that had been planned during the prior year or were identified as needed soon after I arrived,” says Jonathan Hook, OSU vice president and chief investment officer. “None of these changes were unanticipated.” The university's $1.6 billion endowment returned an estimated 15.5 percent in FY10.
Nonetheless, it appears that at least some of the changes in portfolio allocations during the year had the effect of reducing risk and volatility, at least in the short run. OSU, for instance, decided to reduce its endowment's exposure to some higher-risk assets. “We also shifted some of our long-only exposure to long-short,” says Hook. “We added fixed income of both domestic and global exposures. We also added exposures that we felt would benefit us should the environment become more volatile and remain that way. This was done to reduce risk and deploy capital with those whom we believed to be better managers.”
Palmer adds that her institution reduced its REIT (real estate investment trust) exposure in the real assets part of the portfolio as a result of market fluctuations. The percentage of REITs went from 30 percent of the real assets portfolio to 10 percent.
All Eyes on Liquidity
While many endowment managers and investment committees have kept focus on their long-term asset allocation strategies, they've also had to remain mindful of lingering concerns about generating endowment income to meet short-term budget targets for their colleges and universities. Worries about liquidity are relatively new to higher education endowment investors. In the years before the 2008 market collapse, many institutions rushed into illiquid assets such as hedge funds and private equity real estate. These and other “alternative strategies” accounted for 51 percent of total college and university endowment assets in FY09, up from less than 33 percent in 2001.
“Liquidity is something that the industry as a whole should never have ignored, but many did because the returns from these instruments were so strong in the past decade, especially from investment strategies such as private equity and real estate,” Hook explains. “Plans overcommitted so that they could reach their target allocations, and for many years they were able to fund new commitments with the distributions coming in from more mature funds.”
FY09 brought a reversal of fortunes for private equity, real estate, and other illiquid strategies, as these and most other alternative asset arrangements suffered double-digit negative returns. As a result, about one quarter of all 2009 NCSE participants said they suffered a liquidity “squeeze”—a temporary shortage of cash needed to meet operating expenses—and 70 percent said they had taken some action to mitigate or prevent a liquidity problem from occurring in the future. In addition, of the institutions that changed or considered changing their asset allocation mixture, about one third did so because of concerns about facing a liquidity squeeze at some point in the future.
About one quarter of all 2009 NCSE participants said they suffered a liquidity "squeeze" and 70 percent said they had taken some action to mitigate or prevent a liquidity problem from occurring in the future.
While improvements in the investment environment appear to have alleviated major concerns about liquidity, the issue did have effects on endowment draws, institutional budgets, and asset allocations at some private nonprofit universities and foundations. “We did not make any unanticipated changes to [our] asset allocation structure,” says Michael Pimenov, endowment manager for Carnegie Institution for Science, Washington, D.C. The institution's endowment achieved an 11 percent investment return in FY10. Adds Pimenov: “We did, however, face difficulties in adhering to our rebalancing policy as diligently as we would have liked because of liquidity constraints and the speed with which markets changed direction.”
The College of Saint Benedict reduced its endowment draw for 2010, in part because of the investment losses suffered in FY09. Yet, as Palmer points out: “Because our endowment is relatively small, the impact on our budget has not been significant.” Additionally, the board of trustees has “returned to the board-approved spending policy for FY11” thanks to improved investment returns, notes Palmer.
For Roberts Wesleyan College, other financial constraints besides liquidity have become an issue. “Our endowment is small, funding about 2 percent of operations,” says Cuthbert. “Volatility and liquidity are not issues for us because we remain focused on the long term, but the higher education market for new students has become even more competitive, putting less-endowed colleges like ours at a disadvantage because most of our scholarships are unfunded.”
For many public institutions, while loss of endowment income was not a pressing concern, sharp declines in state appropriations may continue to adversely affect state support of colleges and universities. Ohio, like nearly every state, entered FY11 with a substantial budget deficit, which may make it even tougher for OSU and other public institutions to preserve their state funding. Hook notes: “All public universities will be under pressure over the next several years as their host states have to deal with their particular budget issues.”
Studying New Opportunities
Perhaps the lesson many endowment managers learned from the 2008–09 declines and the volatility of 2010 is to take advantage of improved market returns and attractive valuations of illiquid assets while minimizing any chances of facing a sudden shortage of cash or any other crisis. American University is taking this approach to heart. “The university has entered into a direct private equity and hedge fund program this year,” says Myers, “and the investment committee and management are regularly reviewing the asset allocation to less-liquid assets, to make sure that adequate liquidity exists now and in the future.”
Brookings Institution, Washington, D.C., which also did not report a major issue with liquidity during the market meltdown, remains vigilant of any possible future concerns in this area while seeking new investments in alternative assets. “Liquidity requirements and concerns have not changed our current allocation decisions,” says chief investment officer Catherine Piez. “However, our heightened awareness of liquidity crises has led us to create a set of reports and models to monitor our liquidity going forward. These allow us to consider the potential impact in advance of making new commitments to illiquid partnerships. But yes, we have continued to make new commitments,” explains Piez. The Brookings Institution endowment had an estimated 15 percent investment return in FY10.
AU and Brookings Institution are not alone in believing that the volatile environment is a chance to take advantage of investment opportunities in FY11 and beyond. Of the endowments that changed or considered changing their asset allocations in 2009, 29 percent did so to take advantage of new investment opportunities. OSU has likewise positioned itself for this approach. “We are not interested in deploying our funds with passive strategies where we will only receive [average market returns], positive or negative,” says Hook. “We believe the better managers will be able to earn greater returns in the near future.”
While such confidence is reassuring, it is measured by an uncertain future in the short run. No matter how endowment assets are positioned, they will have to perform at a time when higher education budgets are stretched, economic recovery may remain slow, unemployment may remain high, and other crises could be right around the corner. As Hook concludes, “The environment is not very certain for any of us at this point, and we are expecting to have to work hard and work smart to assist our institutions and move them forward.”
KENNETH E. REDD is director of research and policy analysis for NACUBO.