No Easy Answers
Campuses with modest endowments face ongoing challenges. In a tough market, business officers describe some key issues that top the list.
By Mike McNamee
|Endowment Management Forum: A Smart Investment|
At the upcoming NACUBO Endowment Management Forum, January 27–28 in New York City, experts will focus on higher education endowments and contemporary investment management issues and trends.
Developed and presented by veterans in college and university finance and endowment management, the program will cover the dynamic effects of the economy and financial markets on institutional endowments; asset allocation and diversification of investments; risk management; and keys to working with investment managers and consultants. Speakers include campus experts and financial and investment authorities on the major markets. Findings of the 2004 NACUBO Endowment Study will be presented and discussed. Attendees will have the opportunity to meet the experts, ask questions, and network with colleagues from around the country.
The forum is designed for chief financial officers, senior investment officers, treasurers, trustees, foundation officers, and professional endowment fund managers. Last year’s forum sold out, so it’s wise to register early. For more information, visit www.nacubo.org/programs or call 800.462.4916.
That’s life in the endowment business, with all the typical issues and concerns faced by any college or university business officer whose job includes overseeing funds invested on the institution’s behalf. But while all chief investment officers confront similar problems, the challenges are far greater at campuses with modest endowments. After all, an institution with less than $100 million to invest probably can’t afford much in-house expertise to follow the broad range of markets and asset classes that today’s endowments must employ. And with $10 million, $35 million, or even $95 million, you’re not going to have managers beating down your door—or, more important, beating down their fees—to get your business.
What are some of the top concerns for business officers overseeing small and medium-sized endowments? Here’s a look at four key issues—planning for the slow-growth decade to come, getting started in nontraditional investments, managing managers, and maintaining an asset allocation—from the perspective of some business officers and the consultants who serve smaller endowments.
Eking Out Returns
A year after the end of the three-year bear market, few sensible investors expect stocks to return to the boom of the late 1990s. Thoughtful market-watchers have a warning: Stocks will not boom, and what’s worse, they’re unlikely to even produce the returns that came to be seen as normal in the last half century. “We all tend to think that stocks should produce a steady annual return of 7 percent net of inflation,” says Forrest Berkley, head of global product management at Boston-based investment manager GMO. In fact, for the next 5 to 10 years the capital markets are going to deliver returns that are much, much worse than what we’ve traditionally seen.”
The reason? Much of the fat return from U.S. stocks since World War II resulted from a steady rise in the price-earnings multiple. As inflation waned and interest rates fell, investors went from paying $8 for every $1 in corporate earnings to paying $25, so stock prices grew more than three times as fast as earnings. Even after the bust, Berkley notes, today’s price-earnings ratio of about 23 is well above the historic average of 14. “U.S. equities are still pretty overpriced, even if they’re far short of the March 2000 peak,” he says. There’s little reason to expect that stock prices will go back to growing faster than earnings. And if stocks return to their historic relationship with corporate profits, Berkley says, “we could be looking at a drop of one-third in the market’s value.”
In investment terms, this outlook means that bonds—especially foreign bonds—could be much more attractive than stocks. For business officers overseeing a small or mid-size endowment, the prospect of smaller returns requires renewed attention to investment discipline, expenses, and spending policies. At Kent State University, Ohio, Director of Financial Affairs Geetha M. Thomas has put in place a new policy barring any draw from new endowment funds for 18 months, up from the old rule of 6 months. And she’s looking at Kent State’s policy of spending 5 percent of endowment based on a three-year rolling average valuation. “I worry whether 5 percent isn’t a bit too aggressive,” Thomas says. “I’d like to see the spending rate reduced.”
Saint John’s University in Collegeville, Minnesota, is already dropping its spending rate, from 6.25 percent of a three-year moving average to a new target of 5 percent. Says Carole T. Coleman, vice president of finance and administration: “It’s just prudent to decrease the draw.”
Breaking With Tradition
The prospect of slower growth from stocks and bonds is one of several factors driving business officers who oversee smaller endowments to take a hard look at alternative or nontraditional investments—such as hedge funds, private equity funds, venture capital, and natural-resource assets. Larger endowments have long incorporated these sorts of funds in their mix. But their cost—including extra layers of fees—added risks, and high minimum investments have deterred those with smaller endowments.
“We’re risk-takers, but we’re not big risk-takers,” says Carl W. Schreiber, vice president for financial affairs and CFO at Biola University, La Mirada, California. His $32 million endowment has “finally cracked the door” for nontraditional assets. But at Kent State, Thomas and her investment committee believe their $64 million fund is still not ready: “We’ll look into it when we hit $100 million”—a goal Thomas hopes to reach within two years, given Kent State’s current capital campaign.
Campuses with smaller endowments considering alternative investments need to tread cautiously, says David Wagner, CEO of Evanston Capital Management, Evanston, Illinois. In standard asset classes—large- and small-cap stocks, growth and value approaches—managers tend to cluster together, achieving returns that tend to fall in a narrow range. But “dispersion of returns is much greater in alternative asset classes,” Wagner says. While a manager in the top 25 percent of equity funds might deliver only a few percentage points more return than his bottom-quartile competitor, the gap between top- and bottom-tier hedge and venture fund managers might be several times as great. The message: “Alternative investments pay off if you can get with a top-tier manager,” says Wagner. “But if all you can get is the average [return], they’re a lot less appealing.”
At Saint John’s, Coleman is boosting her allocation to hedge, mezzanine, and private equity funds, which is now about 5 percent of her $119 million in long-term investments, to 15 percent. But it’s a slow process, she warns. “Not only do you have to do more research [on alternatives], but these managers tend to call on your money slowly, over 12 to 18 months,” Coleman says. “You need to have an interim plan for the funds you’re going to invest. And nontraditional funds are very illiquid, so you’ve got to make sure you have other sources to meet your spending needs.”
Even so, Coleman says, nontraditional assets are now an essential part of the mix. “We can no longer just count on U.S. equities to carry us along,” she says.
For small campuses, the lack of staff and investment expertise can be the biggest challenge in running an endowment. Biola’s Schreiber is confronting that head-on: After more than four years of study, he’s hired an outside firm to select and oversee Biola’s fund managers. It’s part of a sweeping reorganization that combined Biola’s endowments with other university assets into a university investment pool. Biola also set specific goals for growing its endowment. These steps are old hat for larger funds, but many of Biola’s peers have yet to undertake them, Schreiber says.
“On our modest salary scale, we can’t hire an expert to keep up with the investment world,” Schreiber says. In selecting an investment consultant, Biola placed great emphasis on finding a firm that was willing to educate Schreiber’s staff and develop a close relationship with the university. “We needed a firm that was going to be around for us when—and in the ways that—we needed them,” he says.
Indeed, relationships sometimes are just as important as performance when institutions with smaller endowments hire consultants and managers. Kent State’s Thomas says her campus recently replaced a small-cap equity manager: “Performance was down, but they’d also had a shake-up that had cost them some of the portfolio managers we used,” she says. The changes “left us wondering whether they’re still really a small-cap value manager, which is what we wanted.”
When it comes to assessing performance, Thomas and her investment consultant take a two-pronged approach. For reporting to external audiences, they compare each manager’s returns to the appropriate benchmark for the asset class. “That’s easiest for our constituents to understand,” Thomas explains. But for internal evaluation, they also look hard at how the manager’s peers are performing and dig for explanations for any discrepancies.
The Right Mix
The six-year cycle of boom and bust from 1997 to 2003 drove home one lesson applicable to endowments large and small: Smart investing depends on diversification and the discipline to stick to it. Campus investment officers are renewing their emphasis on rebalancing, adjusting their portfolios on a regular basis to maintain a predetermined allocation of assets among bonds; domestic and foreign large- and small-company stocks; and alternatives.
Maintaining that discipline is tough. By its very nature, rebalancing means selling or downplaying the current “hot” investment and buying more of the laggard. If a booming stock market boosts an endowment’s equities from 65 percent of assets to, say, 70 percent, the chief investment officer is going to have to sell stocks—or sink most of the funds’ new money into bonds—to bring the endowment back to its target mix. It’s hard for most people to sell winners and buy losers. But those who didn’t in the late 1990s when stocks were returning 20 percent or more for three straight years took the biggest hit when stocks slumped in 2000.
So endowments tend to have their rebalancing policies spelled out clearly. At Kent State, Thomas pours new money into lagging asset classes to keep the overall stock/bond balance within 5 percentage points of target. Equity subclasses—a small-cap growth fund, for example—shouldn’t get more than two points away from their targets, she says. At Saint John’s, the investment committee does a “hard rebalance” (restoring all assets classes to their precise target level) once a year, Coleman says. In the subsequent quarters, the endowment tilts its flow of new money to keep various classes close to their targets. “You really need the discipline to stick to your targets,” she says.
To make rebalancing easier, Saint John’s has recently started using a “transition manager.” This is a Wall Street firm that executes trades for many brokers and mutual funds. “We try to rebalance without selling, with new money or when we change managers,” Coleman explains. “But if we have to sell off a fund, the transition manager first tries to find us a buyer among its other clients.” The result is a low-cost trade and smaller fees. “When your returns are squeezed, every basis point you can save on fees becomes critical.”
In the years ahead, tight returns are likely to be the rule. For campuses with small and midsize endowments, minding the basis points will be the new mantra of a tough investment world.
Author Bio Mike McNamee is a Washington, D.C., writer.
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