Endowments' battle to maintain real value

Endowments are not immune to the challenges facing other institutional investors in a low yielding, volatile market. Even the high-yield haven of alternatives is losing its shine, with the illiquidity premium on offer diminishing as money continues to flood into the asset class, arguably driving down returns.

The days of double-digit real returns for endowments, therefore, seem like a thing of the past, even for those usually known for their investing prowess. Certainly, many endowments are experiencing falling returns: Bloomberg reported that university endowment returns for the first six months of fiscal 2016 showed losses of as much as 6.1%.

For endowments, this is a significant problem. Given that colleges typically spend between 4% and 5% of their endowment annually — on scholarships, hiring professors and upgrading facilities, among other areas — annual returns need to exceed this to avoid cutting into the supporting endowment's principal.

At the same time, the U.S. faces an educational crisis. Tuition costs have increased in real terms to such an extent that they might be reaching a ceiling of resistance. Without continual tuition increases, endowment spending might have to be relied upon to plug any funding gaps. And if the economy sours, a double whammy of a drop-off in donations can be expected.

The upshot is that the real value of many endowments has been shrinking in recent years — therefore failing to deliver on the promise of maintaining or increasing the real value of the pot for future generations.

What can be done in the face of these challenges?

A significant step in the right direction would be for endowments to improve how they define and manage portfolio risk over time — and how they use this information to inform asset allocation and manager selection decisions.

Traditionally, many endowments have measured risk by dollar exposure to certain assets or sectors at a single point in time, asking questions such as, “What is my dollar exposure to a fall in the U.S. equity markets?”

But how meaningful is it to measure such risk at one point in time for an endowment that has the objective of lasting generations? Also, point-in-time risk can change rapidly; even hourly for some hedge fund trading strategies.

To align with this, endowments should supplement traditional risk measures with those more appropriate for longer-term horizons in order to enhance their understanding of the complete range of factors affecting portfolio performance. Undoubtedly, return-based risk — as measured by factors such as volatility, correlation, value-at-risk and factor analysis — can help fund managers make changes to the portfolio mix to mitigate the impact of hypothetical stress events.

Take the two portfolios below: the chart on the left shows the traditional approach of calculating dollar exposures and the other looks at exposure by VaR.

The results show a number of important differences. Indeed, the traditional method shows only 12.6% exposure to private equity, while from a risk perspective, private equity returns have a much higher impact on overall return, 28%. The picture is much the same with respect to the fund's exposure to commodities or real estate — significant information that can feed into asset allocation decisions.

Such an approach also allows the asset allocation to be calculated by risk factors – a method that Harvard University recently adopted to manage its endowment.

This method can also be an incredibly useful tool for analyzing the impact on the portfolio of changes in the endowment's mix of investment managers.

To date, analysis of new managers has often been a backward-looking exercise, analyzing past performance and back-testing how the endowment would have performed if the manager had been included in the endowment portfolio to date. While this is useful, it can be supplemented by a forward looking stochastic projection of portfolio value.

After all, the key question is “what is the future impact on my portfolio of adding manager X?”

Today, developments in technology allow analytics platforms to implement much more sophisticated analytics than has ever been possible.

For example, endowments can utilize a fully blown economic scenario generator, which can project various economic and financial variables, such as inflation, unemployment and oil prices. A VaR approach to risk can translate these economic projections into return and volatility projections for fund managers, allowing much better analysis of future performance and the impact of stress tests.

In the current environment, these improved risk management paradigms will be vital if endowments are to maintain real spending and preserve intergenerational equity for future generations.

Darius Grant is head of endowments and foundations at RiskFirst, based in Greenwich, Conn.