Endowment execs focus on liquidity, volatility in post-crisis market

Post-crisis pressure on U.S. endowments to provide a greater portion of the colleges' and universities' operating budgets has put a new premium on liquidity and long-term asset growth that's resulting in asset allocation changes.

Average cash holdings are up significantly, investment in long-only domestic equity is down, and allocations to alternative investments are rising, especially to more liquid vehicles and asset classes such as hedge funds, commodities, TIPS and other real assets.

Sources said chief investment officers are coping with two disparate goals in managing their portfolios: having enough ready cash to meet their institutions' higher spending rates; and growing the endowment in perpetuity.

Higher-education finance departments are feeling the stress of lower income from traditional sources — alumni donations, grants, tuition increases — while simultaneously coping with rising operating costs and higher debt levels. The upshot at many schools is a greater reliance on the endowment to plug holes in the operating budget.

As a result, CIOs are more focused than they were before the 2008 market crisis on maintaining liquidity and controlling volatility so the value of the endowment and investment returns are less vulnerable to market impacts.

The problem is that it will take a few years just to bring endowment pools up to their pre-crisis levels, said Verne O. Sedlacek, president and CEO of Commonfund, Wilton, Conn.

“Though 2010 was an excellent year in terms of performance, not all endowments are out of the woods yet,” Mr. Sedlacek said during a news briefing last month. He noted that assets of the majority of U.S. endowment funds still are about 25% lower than they were at the end their 2007 fiscal year. He predicted it will take “at least three or four more years of good markets before endowments return to their 2008 pre-crisis levels.”

At least one source is less optimistic.

Analysis of 110 years of market data indicates “it takes a fairly long time — decades, rather than years — to recover from a sharp market shock,” said Celia Dallas, co-director of research at investment consultant Cambridge Associates LLC, Boston. Ms. Dallas made her remarks in a presentation about volatility at the National Association of College and University Business Officers' January endowment management conference in New York.

In order to preserve the present value of the endowment, CIOs have honed in on volatility control and risk management.

“We've been talking to endowment clients about volatility since 2008 and have counseled that it is here to stay. The question is whether you can live with volatility and how you manage it,” Keith Luke, managing director at Commonfund, said during an interview in his office in Wilton.

Mr. Luke said endowment CIOs are dealing with volatility on the investment side through a renewed emphasis on tail-risk hedging to control the impact of market movements on the portfolio.

“Volatility's impact on the endowment portfolio “has real implications for how you can meet the spending rate set by the university. You have to control the risk of volatility through asset allocation, seeking truly non-correlated alpha,” Mr. Luke said.

And diversifying the portfolio and ensuring ready liquidity is what the majority of U.S. endowment funds have been doing, according to data from the 2010 NACUBO-Commonfund Study of Endowments.

The average asset allocation in the survey of 850 U.S. institutions did not change dramatically in the year ended June 30, with domestic equities at 15%; fixed income, 12%; international equities, 16%; alternatives, 52%; and cash and short-term securities, 5%.

But in the two fiscal years since the market crisis of 2008, endowment CIOs surveyed took steps to reduce the volatility of their portfolios. For example, a four percentage-point increase in cash was significant, especially since cash tends to be a drag on performance, Commonfund's Mr. Sedlacek noted during the news briefing. He considered this a sign that CIOs and boards are concerned about maintaining liquidity in their portfolios.

As part of the move to minimize volatility, endowment CIOs also reduced their domestic equity exposure eight percentage points as of June 30, from 23% as of June 30, 2008, and international equity dropped two percentage points from 18% over the same time frame.

Alternatives increased six points during the two years, which Mr. Sedlacek said reduces volatility through diversification.

The average investment return of was 11.9% in the year ended June 30, a significant improvement over -18.7% a year earlier. But long-term investment returns still are not high enough, John D. Walda, president and CEO of NACUBO, said at the news briefing.

Over the three years ended June 30, U.S. endowment returns still were negative, with an average return of -4.2%. Average returns went back into positive territory, with 3% over five years and 3.4% over 10 years, according to the study. Multiyear returns are annualized and net of fees.

Volatility, as measured by the difference in returns year by year, was fairly high, Mr. Walda said. The average return as of June 30 was -3.54% in 2001; -6.25% in 2002; 3.2% in 2003; 15.3% in 2004; 9.3% in 2005; 10.8% in 2006; 17.2% in 2007; -3% in 2008; -18.7%; in 2009; and 11.9% last year.

What's clear from a 10-year comparison is that college and university spending rates have not varied greatly despite fairly high volatility of investment returns.

Analysis of average annual spending rate and investment return data from the 2010 NACUBO-Commonfund Study shows that even in years of negative performance — 2001, 2002, 2008 and 2009 — spending rates were 4.9%, 5%, 4.3% and 4.4%, respectively.

The annual spending rate is defined by the study's researchers as the percentage of the beginning market value of the endowment that is withdrawn to support institutional expenditures. The rate is net of fees and expenses.

So despite strong average performance in the most recent fiscal year, the volatility of investment returns over the 10-year period means “endowment returns still are not sufficient to meet the needs” of the sponsoring institutions, Mr. Walda said. “An investment return of 3.4% over 10 years won't preserve endowment assets over the long term,” considering the possibility of rising inflation in future and an average target endowment spending rate of 5%, he said.

“Endowments exist to provide the institution with sufficient income in perpetuity. There has to be emphasis on very long-term returns,” Mr. Walda said.

The problem with trying to meet a 5% spending target is that “you really need an 8.5% return in order to hit that after expenses,” Heather Myers, director of endowment and foundation strategies for Russell Investments in New York, said in an interview. “It's going to be hard to meet this expected investment return, given lowered capital market return expectations.”

Cambridge's Ms. Dallas noted in her conference presentation that even extensively diversified portfolios still were hurt when asset-class correlations narrowed in the most recent market crisis.

“Diversification works about 95% of the time,” Ms. Dallas said, and in order to cope with the 5% of the time when it doesn't, many endowment CIOs are moving to “contingency planning.”

The goal is to build a diversified portfolio that works in normal market conditions and is flexible enough to be resilient in stressed environments, Ms. Dallas said.

That said, as evidenced by NACUBO-Commonfund data, many endowment CIOs are shifting away the famous “Yale model” that was developed by David Swenson, CIO of New Haven, Conn.-based Yale University's $16.7 billion endowment.

That model largely eschews liquidity concerns and concentrates assets in less liquid alternatives such as real estate and private equity, said Daniel Wallick, principal, Vanguard Investment Strategy Group, a unit of The Vanguard Group of Investment Cos., Malvern, Pa.

Mr. Wallick said the endowment world's pre-2008 “blind emulation” of the Yale approach “has passed.”

“Liquidity was largely ignored before the 2008 crisis. A lot of endowments had liquidity problems because their portfolios were heavily weighted to private equity and capital calls had to be met. The situation back then has made a lot of endowment CIOs consider the impact of alternatives on their portfolios now.”

“Everyone wanted to look like Harvard College. Now, everyone wants to look like a community college. There is much less interest now in peer rankings,” George Dunn, executive director of Convergent Wealth Advisors LLC, Washington, said in a presentation at the conference.

Mr. Dunn recommended CIOs add target ranges to existing asset classes and to amend endowment investment policy statements to allow investment in new asset classes “so you're ready to jump on opportunities.”

The endowment of Ohio State University, Columbus, has established “bands” around target asset allocations to enable investment staff to manage the $18.9 billion endowment tactically during difficult market conditions, Jonathan D. Hook, vice president and CIO, said during a presentation at the NACUBO conference.

“We had to provide trustees with a lot of education about this concept, but having done that, the decision to provide more flexibility in managing the portfolio was not that difficult,” Mr. Hook said.

Portfolio volatility was reduced within the equity portfolio, Mr. Hook said, by converting “a big part” of the allocation to long/short equity hedge funds, global macro and foreign exchange.

About 3% of the OSU operating budget comes from the endowment.

Abilene Christian College, Abilene, Texas, did not have liquidity constraints within its $290 million endowment during the market crisis, but the crisis did “change how we think about liquidity,” Jack Rich, senior vice president and CIO, said at the NACUBO conference.

Between 10% and 15% of ACU's operating budget comes from endowment distributions.

Mr. Rich said investment staff considered capital calls and necessary distributions from the endowment over a three-year period and created three “liquidity columns” within the portfolio: investments that can be redeemed in under 30 days; between 30 days and one year; and in more than a year.

“This approach does impact how we pick managers. For example, we pick hedge fund managers with shorter liquidity terms. It also influences how much we have in traditional, long-only equity managers,” Mr. Rich said.