When Commonfund and the National Association of College and University
Business Officers (NACUBO) announced in late 2008 that we would join
forces to combine our two endowment studies, which had historically
been fielded and reported separately, we had high hopes for the
venture, but those hopes were tempered with caution. The financial
markets were already in the throes of what would prove to be the
steepest and most broadly based decline in decades, and some observers
feared that the “endowment model” of highlydiversified portfolio
investing that had produced outstanding average returns for educational
institutions during the 1990s and much of the 2000s would be abandoned
in favor of a return to more cautious, “traditional” approaches to
managing perpetual investment pools.
The early returns were not
encouraging. In a specially commissioned Commonfund survey for the
period ending December 31, 2008, we learned that educational endowments
had lost 24.1 percent of their value in the first six months of FY
2009. The public stock markets continued their decline through March,
and then began a strong recovery. By June 30, it was clear that, while
FY 2009 would still be a very painful year in investment terms, the
overall losses would rebound somewhat from the lows of December and
March.
The FY 2009 average loss of 18.7 percent reported by the
842 colleges and universities participating in the inaugural
NACUBO-Commonfund Study of Endowments (NCSE), therefore, while hardly a
relief, may signal a step on the road to a recovery in endowment
values. No one can predict when endowments will return to their
pre-crash valuations, but it seems clear that all were affected and
that, although the effect of the losses will be felt in institutions’
investment and governance practices for a long time, the learning
process has already begun.
Much attention has been paid in the
press to the fact that the typical pattern of returns was stood on its
head in FY 2009: Larger endowments suffered the deepest losses, while
smaller endowments did less badly. Endowments with assets over $1
billion, for example, returned -20.5 percent, while those with assets
under $25 million lost “only” 16.8 percent. Attributing these results
to specific investment decisions is not straightforward, but the
smaller institutions’ stronger preference for cash (allocations of 6 to
9 percent versus 3 percent at the largest institutions) and
fixed-income securities (allocations of 21 to 27 percent versus 10
percent at the largest endowments) undoubtedly played a role.
Overlooked
in this discussion, however, is the longer-term analysis. Over a
10-year period, the larger institutions had annual returns averaging
6.1 percent, while the smaller institutions returned 3.4 to 3.9
percent. Absent gifts to endowment, even a result of 6.1 percent
annually is not enough to sustain real purchasing power after inflation
and spending; on a relative basis, however, it appears that the
endowment model was able to deliver around 270 basis points per year of
extra value, even in the worst decade in memory for investors. The
compounded effect of these excess returns supported missions while also
building the value of those endowments.
Perhaps for this reason,
the data in the inaugural NCSE do not show a turning away from the
endowment model, defined here as a highly diversified approach to
portfolio construction with an emphasis on exploiting the tradeoff
between liquidity and long-term total return. While one clear lesson
from the crash is that liquidity is not free, the excess return to be
expected over the long term from a diversified allocation to
less-liquid investments remains.
NCSE data, for example, show a
51-percent average allocation to alternative investments on the part of
the 842 participating institutions. While this is a dollar-weighted
figure, reflecting the influence of the largest endowments, even the
average equal-weighted alternatives allocation—at 25 percent—is not
inconsiderable. What is not widely understood is that alternative
strategies as a group, while they did have negative absolute returns of
-17.8 percent as reported in the NCSE, performed their function of
protecting portfolio values from the larger losses that characterized
the broad public equity markets. This average return is 90 basis points
better than the average total NCSE return of -18.7 percent. Marketable
alternative strategies—a group that includes the hedge funds so
maligned in the popular press—returned -12 percent as reported by NCSE
participants, or 670 basis points better than the average. By
comparison, reported domestic equity returns for NCSE participants
averaged -25.5 percent.
Asset allocations, and the investment
returns that ensue, are the fruit of governance structures and
decisions. This year’s NCSE pays particular attention to governance
matters at the responding institutions.
As investment portfolios
have become increasingly complex, it has become necessary to consider
whether the traditional fiduciary model of a volunteer board and
investment committee, meeting four or five times a year and supported
by a small staff or a consultant, is adequate to the task. Quite apart
from the market losses experienced in FY 2009, some portion of which
will prove temporary, many institutions incurred irrecoverable and
permanent losses as a result of investments with fraudulent managers
such as Bernard Madoff and others. In this year’s NCSE, therefore, we
observe the relatively even—and low—average staffing level of 1.6
full-time equivalent (FTE) employees with some unease, particularly
when set against the alternative-investment allocations that we have
just reviewed. A degree of comfort may be provided by the fact that at
78 percent of institutions overall, the employee most responsible for
endowment matters has an MBA, CPA, or CFA designation. But again there
is a difference by endowment size, with these designations present at
87 percent of the largest endowments but at only 67 percent of the
smallest.
Only those institutions with assets over $500 million
have much more than one FTE staff member. At the under-$25 million
level, the staff amounts to a multi-tasking 0.3 FTE. But even in these
smaller endowments, the allocation to alternative strategies is 13
percent, which raises the question of how ongoing monitoring and due
diligence are to be carried out.
For many institutions,
consultants have been relied on to fill in the gap. Consultant use is
widespread, with 80 percent of institutions using consultants for
advice on investment matters. Even at the smallest endowments,
consultant use is at 62 percent, while at the very largest endowments
it is only slightly higher, at 65 percent. Consultant usage is in the
90 percent range at endowments with assets between $100 million and $1
billion, and in the 70 to 80 percent range at endowments of between $25
million and $100 million.
What do endowments use consultants
for? The three most heavily used services are asset
allocation/rebalancing (86 percent), performance attribution and
measurement (84 percent), and manager selection (83 percent). An
increasingly popular service is outsourced investment management, used
by 29 percent of institutions overall but by 48 percent of those with
assets under $25 million. Unsurprisingly, only 9 percent of those
institutions with assets over $1 billion use consultants for this
purpose.
A consequence of the growth in alternative investment
portfolios has been the use of increasing numbers of managers,
particularly those hired directly. While the average number of
domestic-equity managers, at 3.9, and fixed-income managers, at 2.2,
may be considered reasonable, it is difficult to imagine how
endowments, thinly staffed as we have observed them to be, are able to
monitor and perform continuing due diligence on the 10.3 direct
alternative managers that they report having, on average. To be sure,
the number of direct alternative managers used by endowments with
assets under $100 million is 2.5 or less, but at endowments over $100
million, the number quickly increased to double-digit figures.
In
this environment, the composition and qualifications of the investment
committee’s members can make a significant difference. Average
investment-committee size remains relatively steady at 8.1 voting
members. Large committees are not the rule even at the very largest
endowments, where investment-committee size averages 9.8 members.
Institutions with assets under $25 million have investment committees
that average 6.9 members.
More important than the number of
members is their experience and capability. Around half of
investment-committee members on average, or 4 members out of the 8.1,
are investment professionals (this number rises to an impressive 7.8 at
the largest endowments, but is only 2.4 at the smallest).
Investment-committee members with alternative strategies experience
average 2.5 (4.6 at the largest endowments, 1.5 at the smallest).
Non-trustee members are present as well—an average of 1.4 members—while
the number of investment-committee members who are alumni of the
institution averages 4.1. Only 2.9 members on average possess MBA, CPA,
or CFA designations.
Conflicts of interest are an area of
increasing focus on the part of legislators, regulators, and the
public. It is therefore encouraging to report that 97 percent of
institutions overall have a conflict of interest policy, a figure that
remains between 88 and 100 percent across the various endowment-size
categories. In over two-thirds of cases, the policy applies both to the
board and the investment committee, and in 86 percent of cases it also
applies to senior staff.
Just under 60 percent of institutions
overall permit board members to conduct business with the organization.
This is a source of potential risk, so the fact that an almost equal
percentage have a process for resolution of conflicts is both
reassuring and to be expected. In about one-third of these cases the
process involves both recusal and disclosure; in 16 percent it calls
for disclosure only; 7 percent use recusal only.
Even now, more
than halfway through FY 2010, the process of deriving lessons from the
financial crisis and applying them to the governance of endowments is
only beginning. Covered in another section of the NCSE is the unhappy
fact that, with nearly all institutions reporting some endowed funds
below their value when originally donated, some 22.4 percent of
endowments on average were underwater as of the end of FY 2009. Under
previous law in most states, spending from these funds would have been
curtailed or prohibited, but with the new Uniform Prudent Management of
Institutional Funds Act (UPMIFA) now the law in all but a few states,
boards have been authorized to spend, subject to a specific set of
standards, from these funds. Some 83 percent of respondents report that
they have discussed a new accounting standard regarding the
classification of assets in their endowments for purposes of UPMIFA,
and 76 percent have performed the required classification of assets.
What
is still unclear, of course, is what the future holds for endowed
institutions and their ability to support their missions going forward.
While reported effective spending rates remained relatively steady at
4.4 percent in FY 2009, nearly a quarter of institutions said that they
had experienced a liquidity squeeze during the year, and the same
proportion said that they had deviated from their spending plan due to
the lower-return environment. The impact of the severe losses on these
institutions’ ability to support their missions is only beginning to be
understood, and it remains to be seen what future adjustments will have
to be made in investment, governance, and spending patterns as
financial markets, and the global economy, continue on their path of
gradual recovery.
It is very clear, however, that the structure
of endowment investing is being re-examined from top to bottom. This is
salutary, particularly to the extent that it results in better
understanding and control of the risks being taken in complex
portfolios. But if one of the tasks of an endowed institution is to
maintain the purchasing power of the endowment for future generations
while spending to support current programs, a highly diversified
approach such as the endowment model will be an essential tool.
Simpler, less-diversified portfolios may have an appeal in the
aftermath of the bruising market shock that dominated FY 2009, but
history shows that they cannot provide the excess return necessary to
achieve the key goal.
As the largest and most comprehensive
survey of higher education endowments ever undertaken, the NCSE
provides a set of standards that describes, for better or otherwise,
the world actually inhabited by boards and investment committees of
institutions of higher education. We are grateful to our true partners
in this effort—the participating institutions, their staff and
boards—and hope that the report will provide the perspective and
factual grounding to help them to do their important work in the months
ahead.
