Investing

Fee-conscious smaller institutions see new avenue

Ashby Monk
Stanford University's Ashby Monk

The largest institutional investors tend to access separate accounts and commingled trusts for low-cost indexing of stocks and bonds. Smaller organizations, typically those with less than $100 million, are more dependent on mutual funds and exchange-traded funds and, in turn, to external fund-of-funds managers and consultants who have been plied for years by marketers of actively managed investment strategies.

But smaller foundations and endowments are just as interested in lower-cost solutions for their asset management challenges as their larger brethren.

“Change comes slowly for foundations and endowments,” said Ashby Monk, executive director of the global projects center at Stanford University. “We don't incent people running such funds to move quickly. We incent them to not move quickly, and we shouldn't be surprised when they don't move quickly.”

According to the Foundation Center, of 86,726 foundations operating in the U.S. through 2014, 98.7% had assets below $100 million.

Over the past 10 years, the use of passive equity products has doubled to 22% of all equity mutual fund net assets in the U.S., according to the Investment Company Institute. And, according to Morningstar Inc., 43% of assets in U.S. equity funds, 37% of assets in international equity funds and 28% of assets in taxable bond funds were passively managed as of June 30.

The drive for passive funds is reinforced by performance data. Over three-, five- and 10-year periods ended Dec. 31, 2015, returns of at least 80% of all surviving U.S. equity mutual funds underperformed their reference index, according to the year-end 2015 SPIVA US Scorecard from S&P Dow Jones Indices, a unit of S&P Global.

Ten-year performance for global equity and fixed-income funds reveal similar underperformance. Only specific areas of international equities and loan funds, separately, show midterm outperformance of the index by a majority of funds.

With fixed-income returns depressed by the global interest rate environment, and hedge fund and private equity fees and performance a top concern for even the largest institutional investors, controlling cost and mitigating risk through liquid ETF portfolios can give smaller foundations and endowments more certainty relative to major asset classes and more liquidity at the same time.

“For smaller foundations and endowments, there's no bandwidth, resources, or expertise to run the "Yale model,'” said Ben Carlson, director of institutional asset management for Ritholtz Wealth Management, New York. “If they are getting the leftovers in their illiquid and alternatives portfolio, why not move to a risk-focused portfolio of ETFs and index funds?”

In the most recent survey from the Council on Foundations, 10% to 12% of assets at smaller foundations was allocated to hedge funds, with and 7% to 12% to other alternatives.

Both Mr. Carlson and Todd Green, chief investment officer of Alesco Advisors in Rochester, N.Y., said clients often update their investment policy, spending and grant-making plans, and rebalancing and reinvestment calendar when shifting to a more liquid, ETF-focused strategy.

Mr. Green said his firm counts more than 90 institutional clients among its client base. Alesco's portfolios are allocated across 15 to 20 distinct asset classes, including equity, fixed-income and real-return investments, as well as factor-based funds, using ETFs with an average fee around 20 basis points.

Patrick C. Burke, managing principal of actuarial and retirement plan consulting firm Burke Group in Rochester, N.Y., has been involved in hiring Alesco to manage assets for local foundations at which he sits on the investment committee.

“Driving down fund and advisory costs is really the only place that we as investors have control and can help us get where we need to be,” said Mr. Burke. “Based on prior experience with consultants and active money managers, we just weren't convinced it remained the right way to go.”

Could fees be even lower should foundations and endowments one day decide to go to robo-advisers? Perhaps, said Margaret Hartigan, CEO and founder of New York-based Marstone Inc., an adviser-focused, white-labeled digital advice firm that in May announced a strategic partnership with Pershing LLC, a unit of BNY Mellon Corp.

“An automated investment platform could definitely be a great core solution for these clients in the future,” Ms. Hartigan said. Yet she echoes others observations that the foundation and endowment market is “very cautious.”

“Most foundations and endowments are not designed to be innovative,” said Stanford's Mr. Monk. “They are designed to be efficient, so any time you ask them to be the former it will inevitably contradict with the organizational DNA.” n

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This article originally appeared in the July 25, 2016 print issue as, "Fee-conscious smaller institutions see new avenue".