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Onward Bound

If careening markets seem like a walk on the wild side, an investment consultant might help guide you through endowment management territory.

By Kenneth E. Redd

*The volatile market swings that first appeared in 2008 continued to vex institutional investors in FY11. While the Standard & Poor's 500 Index of U.S. stocks gained a robust 30.7 percent from July 1, 2010, to June 30, 2011, the year brought deepening concerns about high levels of U.S. and European government debt, entrenched unemployment, and other issues that adversely affected most financial assets.

The increased turbulence renews the questions many campus endowment investment leaders and finance committees initially asked when the markets turned sharply negative in 2008:

  • Are our asset allocations and spending policies right for this environment?
  • Is now the right time to increase exposures to alternatives and other illiquid vehicles?
  • Are there new strategies that can be implemented to grow endowment assets while guarding against downside risk?
Read a related article, "Risky Terrain Ahead," in the November issue of Business Officer.

Viewing such precarious investment terrain, college and university endowment managers have increasingly turned to investment consultants—outside advisers who seek to provide additional expertise regarding portfolio construction, allocation rebalancing, and other services—to help answer these questions. From FY08 to FY10, the share of institutional endowments that engaged one or more consultants rose from 61 percent to 80 percent, according to the 2008 Commonfund Benchmarks Study and the 2010 NACUBO-Commonfund Study of Endowments (NCSE).

This rapidly rising reliance by many institutions on outside experts calls for a closer examination of the strengths and weaknesses these guides may provide to endowments of different sizes. Perspectives from seasoned higher education endowment leaders suggest that, in the right circumstances, consultants can play a central role in helping institutions travel through uncertain times. But it is also advisable for campus leaders to continue to rely on their own in-house resources to traverse this landscape.

Consultant Use Gains Ground

After the market downturns of 2008-09, the share of campus endowment offices engaging outside expertise jumped for investment pools of $50 million or less, as Figure 1 illustrates. For institutions with endowments of less than $10 million, for example, the proportion of those hiring one or more outside experts or consulting firms leapt from just 10 percent in FY08 to 49 percent in FY10. Among institutions with funds of $10 million to $50 million, use of endowments increased from 48 percent to 74 percent. On the other hand, for institutions with larger endowments, use of consultants remained largely unchanged. For example, the share of endowments of $1 billion or greater that used consultants rose from 61 percent in FY08 to 64 percent in FY10.

The types of outside services and advice campus investors seek vary by size, with more than three quarters of endowments below $1 billion retaining consultants to help with asset allocation and rebalancing activities, compared with 44 percent of those above $1 billion (see Figure 2). Endowments of less than $1 billion were also more likely to seek outside help with selecting investment managers and firms and to review investment policies, and to seek outside help in reviewing socially responsible investment (SRI) options and policies. 

Guidance Geared to Size

While many campus investment managers rely, at least to some degree, on consultants to help achieve their results, those in charge of investment pools in the $100 million–$500 million range appear to be particularly reliant on outside advisers. In 2010, 90 percent of the NCSE participants in this size category used consultants, and more than 90 percent of that group used consulting services for help with asset allocation, rebalancing, and manager selection.

Investment managers at midsized endowments may be more willing to seek advice from consultants because funds of this size are often large enough to consider investing in alternative assets and taking on other investing challenges, but may not be large enough to justify development of their own in-house expertise in evaluating these investment options.

For those managing midsized endowments, outside experts can provide a cost-effective way of accessing and evaluating alternative vehicles. "As the availability and use of alternative investments in portfolios has increased, our consultants provided expert guidance in evaluating these choices and monitoring the fund managers," says Judith H. Van Gorden, chair of the planning committee for NACUBO's annual Endowment Management Forum and former chief financial officer and treasurer of the Arizona State University Foundation, Tempe. The ASU Foundation had approximately $441 million in assets in FY10, according to the most recent NCSE survey.

Some midsized endowments have also engaged consultants in evaluating their spending policies and other issues. This is the approach used by Auburn University and the Auburn University Foundation, Auburn, Alabama, with consultants who assist with the university's endowment, which was roughly $399 million in FY10. "Working with a consultant has led to in-depth discussions concerning asset allocation and spending policy," says Sylvia Huggins, director of the university's endowment investment office. "In a collaborative effort, our investment committee and consultant worked together to expand our investment policy, allowing for a broader diversification in our asset allocation."

Endowment managers at institutions with larger funds often take a much different approach to incorporating outside expertise into their endowment management strategy. Institutions with endowment pools of this size, such as Texas Christian University (TCU), Fort Worth, may use consultants in a limited capacity because their staff is often large enough to provide most if not all of the needed expertise in asset allocation and manager selection for alternatives and other investment ideas.

TCU, which had a $1.1 billion endowment in FY10, established an in-house investment office in 2006. "Since that time," explains James Hille, chief investment officer, "the role of the consultant has been strategically diminished from 'asset allocator and manager recommender' to primarily a data and research provider." But, even the limited participation has resulted in some benefits. "We now use outside assistance to gather data for peer and private equity comparisons, which are otherwise hard to come by," Hille says.

Pluses and Perils

While the NCSE does not ask institutions to report the amounts they spend for hiring outside help, it is likely that the associated costs have risen. So it is fair to ask if the benefits of engaging these firms and individuals make up for additional costs. As with many other issues, the answer appears to depend in large part on endowment size, with managers of various size endowments generally reporting both advantages and disadvantages.

Access to expertise. For smaller and midsized endowments, consultants may provide a cost-effective way to gain access to investment strategies that would otherwise be too expensive. "In my experience," says Van Gorden, "consultants were a good investment because they brought in-depth knowledge of the global economy and global capital markets. They were also able to translate this into an investment structure with risk characteristics appropriate for our institution. It would not have been cost-effective for us to duplicate the resources of a world-class consultant to support our portfolio of about $500 million."

Auburn's Huggins echoes these sentiments. "The use of a consulting firm has provided access to top-tier alternative managers who would not be available otherwise," she says. In addition, Auburn University's outside experts have provided "greater access to performance software, modeling software, due diligence work, manager databases, and best practices that are a benefit to our overall investment process and support our stated mission."

Consensus via communication. Van Gorden has found that, regardless of investment pool size, communication is a key factor in developing a successful partnership with outside advisers. At the ASU Foundation, endowment staff worked closely with consultants. "We considered them an extension of in-house staff," Van Gorden says. "We were all on the same expedition, navigating the same challenging landscape."

Pitfalls and performance measures. In contrast, for larger institutions the broad-based use of consultants may not be cost-effective. Hille points out that the investment ideas consultants offered his school were not always new or effective. "We engaged a consultant several years ago to assist with an asset-allocation study," Hille explains. "We found the recommended exercise to be antiquated and essentially useless. As a result, we've abandoned the traditional mean-variance optimization and have taken up in-house a more rational and flexible objectives-based approach."

Hille also says that, regardless of endowment size, hiring consultants is no guarantee for added protection against volatility or losses during market upheavals. "I do not know of any consultant or firm that provided any kind of advice to avoid or hedge against the [FY08–09] downturn. Asset allocation diversification is generally the consultant's primary risk management tool; but as we know, this failed in the downturn. Lessons about liquidity management have subsequently been learned the hard way."

One way to judge whether or not the benefits of consulting services are worth the fees charged is to conduct a review of provided services that includes a cost-benefit analysis and other evaluation criteria. Hille's experience suggests this exercise may save investment fee expenditures. "We've eliminated unneeded services, and fees were subsequently reduced by two thirds as a result of the periodic review."

Van Gorden further advises institutions to periodically evaluate proposals from several firms before hiring or retaining a consultant. "It is a good idea to go through a [request for proposals] process at least every five years-or sooner if there are issues or concerns-to see if the institution is receiving all the services it needs, and if the price is competitive."

Institutions can develop other indicators to judge the effectiveness of their consultants. Auburn University, for example, specifies in the consulting agreement the criteria used for evaluation. "The contract outlines the services to be provided by the consultant along with the respective fees," Huggins explains.  "Based on the outlined services, we assign a score for performance and provide assessment notes that explain the rating."

Van Gorden also used a similar annual rating system. "We shared the results of the staff feedback with the investment committee and sought its input as well."

What's Around the Bend?

Market gyrations since the beginning of FY12 have been even more pronounced, with the S&P 500 experiencing several days of gains and losses of 3 percent or more in the first three months of the fiscal year that began on July 1, 2011. Overall, the stock index was down 14 percent in the first quarter of the current fiscal year. Continuing volatility, along with escalating troubles with international and national sovereign debt—and U.S. and world economies that may be heading for a "double-dip" recession—suggest that many endowment managers will rely even more strongly on the guidance of their consultants. "I think increased market complexity and globalization will continue to drive this trend," says Van Gorden.

Exactly what assistance consultants can and should offer to institutions in this shifting and unpredictable terrain will very likely depend even more upon endowment size. For smaller institutions (those with $500 million or less in total assets), these consultants can provide a valuable service. "It is important that someone at the institution assumes responsibility for managing the investment process and for understanding the institution's portfolio and investments," Van Gorden says. "If no one on staff has the time or resources to do that well, then consultant support is a reasonable and viable option."

However, as institutions increase their endowment size, they may want to consider developing more in-house talent to provide added flexibility and expertise that may bring even greater returns. The goal, of course, is for the move to pay for itself. This is sometimes the thinking behind creating a chief investment officer position. (See "Appointing a CIO: Ready or Not?" in November 2007 Business Officer.)

As Hille suggests, over-reliance on consultants may bring additional perils. "The advantages [of using consultants] are the economy of scale that you gain and potential access to well-scrubbed managers. However, the disadvantages of over-reliance tend to be median returns that result from excessive diversification, managers with too much in assets under management, and a lack of opportunistic flexibility."

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

Endowment Expertise: Inside or Out?

Are you considering hiring a new consultant or increasing your use of outside investment advisers for endowment management? Judith H. Van Gorden, chair of the planning committee for NACUBO's annual Endowment Management Forum (February 8–10, 2012, in New York City), offers the following suggestions that institutions, regardless of their endowment size, should consider when selecting outside persons or firms to help with investment management.

Look for consultants who:

  • Provide options on overall portfolio construction that are tailored to your preferences and risk tolerance.
  • Have access to a wide range of investment managers across all asset classes who are unconstrained in the ability to recommend best-in-class investments to the client.
  • Do not have conflicts of interest with their clients.
  • Demonstrate significant experience in their work with clients similar to your institution, who can recommend their work.
  • Show the ability to construct meaningful benchmarks and measure portfolio performance against those benchmarks at appropriate time periods, short- and long-term.
  • Are knowledgeable about the fiduciary responsibilities of investment committees and institutions and actively support the institution in meeting these obligations.
  • Offer a competitive fee structure.

Sylvia Huggins, director of the endowment investment office at Auburn University, Auburn, Alabama, advises that institutions make sure their prospective consulting firms are experienced in working with endowments of their school's size and demonstrate an ability to work collaboratively. "Evaluate whether or not the overall investment philosophy of the consultant and firm is in line with that of the investment committee and staff. At the same time, encourage creative investment thinking by all parties. In addition, devise a process in which the consultant and firm accept fiduciary responsibility, along with the board, over the endowment investment process."

Avoiding actual or perceived conflict of interest is the most often cited caution when determining whether to engage new consultants. But there are other potential pitfalls to watch for as well during the selection process, particularly when determining consultants' compensation. "My experience with consultants is that the business model is flawed more often than not, so be aware of the incentives," advises James Hille, chief investment officer for Texas Christian University, Fort Worth. "Because most clients are extremely fee-sensitive, consultants who charge the higher fees are faced with the tall order of demonstrating a relatively high level of service or investment performance.

"On the other hand, fee pressure can force the consultant to go for economies of scale. Firms that try to minimize their own costs using this approach will then need to convince the institution client that it will still receive focused attention and tailored solutions, rather than a cookie-cutter, middle-of-the-road product."

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