Endowments, foundations chasing active wave

While pension funds remain with passive equity management, a few midsize endowments and foundations are taking advantage of active management, riding the wave of volatility in equity markets and increasing their alpha.

“An investor is like a surfer,” said David Holmgren, chief investment officer, Hartford HealthCare, Hartford, Conn., which has a 60% allocation to growth equities that's entirely actively managed. “It's a bad day when a wave knocks you out; it's a good day when you catch a wave. So our belief is it's best not to be passively hanging out in the ocean but actively paying attention.”

Roiling equity markets in the past seven months have been a boon for active stock selection, experts said. And endowments and foundations including Hartford HealthCare, with $3 billion in assets, and the $2 billion Harry and Jeanette Weinberg Foundation Inc., Owings Mills, Md., have reaped the rewards.

“We're confident with our move to active,” said Jonathan Hook, CIO at the Weinberg Foundation, whose 35% global equity allocation has shifted to 10% passive management now from up to 30% passive management 14 months ago. “With the volatility we've seen lately and may continue into the future, along with tepid growth around the world, it's hard to see (equity) indexes doing exceptionally well. Times like this, manager talent will really show itself.”

Though pension funds seem to be sticking with passive strategies, consultants said they've been hearing from endowments and foundations in the $1 billion to $5 billion range about active management strategies such as concentrated equity and small-cap stocks, which lend themselves to more aggressive investing.

“Don't look at the larger endowments,” said Brian Caldwell, senior investment consultant, Willis Towers Watson PLC, Atlanta, an adviser to endowments and foundations. “The midsize ones, with a few billion in assets, they're the ones who really have to look at their liquidity needs.” Larger endowments, like those of Harvard University and Yale University can be heavily invested in alternatives because they have the size to lock up assets in illiquid investments and still have enough assets for liquidity, he said. “But for most endowments and foundations, liquidity is a big concern,” Mr. Caldwell said. “They have to be very aggressive.”

Since the flash crash of exchange-traded funds in August, volatility has soared, boosted by a plunge in emerging markets equity values amid China's economic and stock market woes and stagnant global growth. The Chicago Board Options Exchange Volatility index averaged 23.4% since Aug. 24, according to CBOE data, and hasn't abated so far in 2016, with the VIX at 24.8% through Feb. 29. That compares with the VIX's 18.17% from Jan. 1, 2015, through Aug. 23.

“If volatility picks up, sources of return lend themselves to more active strategies. And we're seeing that now,” said Sean Chatburn, principal, head of U.S. equity manager research, Mercer LLC, Chicago. “We think there's benefit through factor-based investing or stock-picking strategies. We think there are a lot of ways to capture alpha.”

Added Gretchen Curry, regional head, Northeast and Midwest non-profits, Cambridge Associates, Boston, “It's refreshing after so many years of clients asking about the shift from active to passive, they're now asking about passive to active. It makes sense that it's happening now.”

While the larger endowments and foundations are largely concentrating on alternative investments, Ms. Curry said midsize endowments and foundations with smaller investment staffs are now keeping their eyes peeled for active equity managers. “With endowments and foundations of this size, their investment staffs are generally small, so they are always scanning the landscape for good managers,” Ms. Curry said. “That's true today. Where can they find alpha? They've had their own kind of watch lists for these active firms, and now's the right time to act.”

Weinberg Foundation's Mr. Hook said his four-person investment staff selects its own managers but uses the database of its investment consultant, Albourne Partners Ltd. The foundation does employ larger equity managers, but also takes a close look at equity shops that manage a smaller amount of assets, sometimes as little as $500 million, but focus exclusively on one or two strategies successfully. “For us, we're looking for talent,” Mr. Hook said. “That can be a small firm with four, five, six investment professionals. We're looking for the talent of the team, and often for the talent of the individual.”

Mr. Holmgren at Hartford HealthCare said he's “definitely in the active camp for endowment structures like ours that allow and encourage a more dynamic oversight, because we know how good active can be for our performance and our mission's success.” Hartford HealthCare gradually reduced its passive equity portfolio starting in early 2014, eliminating it entirely as of March 2015. Hartford HealthCare's overall performance, with annualized excess returns of 180 basis points over its custom benchmark, “would be pretty hard to achieve in a passive setting,” Mr. Holmgren said.

Performance figures for the Weinberg Foundation have not been released for 2015, but Mr. Hook said he expects it to beat the -4.26% return of the portfolio's benchmark, the Morgan Stanley Capital International All-Country World index.

Volatility has played into the hands of many of these endowments and foundations at a time when returns were needed. According to the National Association of College and University Business Officers, endowment and foundation returns averaged a mere 2.4% for the year ended June 30, 2015, vs. 15.5% for the previous 12-month period.

Endowment and foundation interest in active equity could benefit two specific kinds of money managers, said Jeffrey B. Stakel, partner at money manager consultant Casey Quirk & Associates, Darien, Conn. “Alternative managers who want to go mainstream and look for a broader audience are creating long-only products that will benefit from this shift,” Mr. Stakel said. “Also benefiting will be specialist or niche firms that can target these kinds of strategies exclusively and can prove their investment capabilities; firms with less than $20 billion (in AUM). It's a lot more challenging for a broad-based manager to benefit. There are possibilities for both quantitative and fundamental firms that can prove they have high-quality capabilities in high active strategies.”

Pension funds generally are remaining in the passive camp, said consulting and pension fund sources.

“We're moving step-by-step away from active management,” said William Atwood, executive director of the Illinois State Board of Investment, Chicago, with $15.2 billion in defined benefit plan assets. “That has less to do with tactical issues and more with three reasons: Market inefficiencies, which make it hard to add value; fees, which make it even harder to add value; and identifying managers in advance who can do active management.”

However, Mr. Atwood said he's not ruling out some active management strategies. “On the flip side, I do think there are areas where we will look at active management, mainly in concentrated and small-cap equities. It's a work in progress. We will consider those kinds of allocations while still increasing our passive management.”

Hartford HealthCare's Mr. Holmgren said it will be hard for pension funds not to move more into active management as the year progresses. “Two or three years ago, everyone saw in the coordinated market action that passive beat active and the trend was then pensions' preference towards passive,” Mr. Holmgren said. “Now that active is outperforming passive, the trend has changed and I guarantee you that in 2016 you'll see more RFPs for active management.”