Most endowment funds feel dreaded pinch of negative returns

For the first time in seven years, large U.S. endowments in aggregate produced a negative return after enduring a difficult fiscal year.

The returns of more than 80% of the 31 funds tracked by Pensions & Investments for its annual fall endowment story ended up in the red. Just six were in positive terrain as of June 30, the fiscal year-end for most American colleges and universities.

One-year returns for fiscal 2016 ranged from 3.4% for the $25.4 billion endowment of Yale University to -3.4% for both the $3.6 billion Ohio State University endowment and the $9.1 billion endowment of University of California. By contrast, returns of all of the 28 endowments in P&I's previous endowment report were positive for the previous fiscal year, ranging from 14.4% to 1.6%.

The average 12-month return for the large U.S. endowments in P&I's universe as of June 30 this year was -1%, compared with 6.2% for the prior year.

On a gross-of-fees basis, the Wilshire Trust Universe Comparison Service reported that fiscal year 2016 is the first since 2009 that the average return of its universe of U.S. endowments greater than $500 million was negative. The average return was -0.73%.

Netting out fees of the 445 endowments and foundations tracked by consultant Cambridge Associates Inc., Boston, resulted in a much sharper decline of 2.63% for the year ended June 30.

“You ended up losing money if you followed the endowment model in fiscal year 2016, a symptom of difficult market conditions. One-year returns were not spectacular by any measure,” said Christopher Hunter, managing director and global head of the endowment and foundation practice of Cambridge Associates.

The endowment model's focus on low-valuation securities hurt university and college investment pools since many underweighted U.S. equities at the beginning of fiscal 2016 because they were so overvalued. But “very unexpectedly,” U.S. equities ended up doing fairly well, Mr. Hunter said.

Given their decades-long investment horizons, “one-year returns are nearly meaningless” for endowments, said Kenneth Shimberg, the Boston-based chief investment officer of Mercer Investments' endowment and foundation practice.

“One of the advantages of managing an endowment is a pure investor mindset. We do things very long term and don't worry too much about a single bad year,” said Scott Malpass, CIO of the $10.4 billion endowment of University of Notre Dame, South Bend, Ind. The endowment was down 0.3% for the year, earning the No. 8 spot in P&I's current ranking. The university's annualized return was 8% for the 10 years and 11.3% for the 20-year period.

Like Notre Dame, all other endowments in P&I's universe providing data had positive returns for longer periods, with a 6.5% average for the 10 years and 9.7% for the 20 years.

Annualized 10-year returns of 29 institutions in P&I's list ranged from a high of 8.5% for both the $1.3 billion endowment of Bowdoin College and the $7.6 billion University of Virginia to 3.7% for Ohio State.

The spread of annualized 20-year returns was led by Yale's endowment with 12.6%, while the $1.2 billion University of Kentucky endowment took up the rear with 4.7%. Of the 13 endowments providing figures to P&I, all had at least $2 billion in assets except for University of Kentucky.

Average annualized returns of P&I's universe topped returns of Cambridge Associates' broader universe, which were 4.97% for 10 years and 7.54% for 20 years.

What is sobering for CIOs and investment committees is the difficulty many endowments have had — and will continue to have — in meeting their assumed rate of return over shorter periods between one and 10 years. P&I's review of university financial reports found that the objectives for most institutions is a real return of 5% over inflation as measured by the Higher Education Price index or the Consumer Price index.

For example, over the 12 months ended June 30, the HEPI inflation-adjusted benchmark return was 8.1%, while the CPI was 6.1%. None of the endowments on P&I's list matched the one-year return, but many use annualized returns over rolling five- or 10-year periods as their benchmark.

For 10 years, the benchmark return calculated using CPI was 6.8%, which was matched or exceeded by 11 endowments in the P&I ranking. No endowments matched or topped the 10.1% benchmark HEPI return.

Endowments were more successful in the 20-year period. All but one of the 13 endowments topped the 7.3% CPI benchmark return, and six funds matched or exceeded the 10.7% HEPI benchmark.

Sources expressed concern about endowments' ability to stay apace with their expected rate of return while trying to meet university spending rates should investment returns remain low for the foreseeable future.

Mercer Investments' return forecasts over the next seven to 10 years are fairly grim, Mr. Shimberg said. Passively managed U.S. fixed income is expected to return between 2% and 3% over the period, and passively managed global equity should range between 6% and 8%. Mercer predictions put the return of a passively managed 70/30 equity/fixed income portfolio below 6%.

“Achieving real, inflation-adjusted returns north of 6% is very unlikely over the next decade,” Mr. Shimberg stressed, noting that “the math is pretty simple. There really are only four levers an endowment can use in low-return markets: reduce spending; increase donations; take more portfolio risk in search of higher returns; and erode the corpus of the endowment.”

Endowment investment committees and staff are adjusting their collective mindsets about expected returns downward from the 6% to 8% they've used for some time, Mr. Shimberg said. Some institutions, which Mr. Shimberg declined to name, also are lowering their spending rates from the typical 5% rate — by 10 basis points per year, for example, over the next few years.

“Boards are getting antsy,” Cambridge's Mr. Hunter said, noting that his advice is to “stick to your asset allocation, rebalance to cheap assets, don't stretch for return by taking too much portfolio risk and maintain liquidity in order to take advantage of investment opportunities.”

Regarding his last point, Mr. Hunter forecast that “private equity and venture capital will continue to be major drivers of performance,” reinforcing the need for ready capital to invest as soon as an opportunity arises.

Mr. Malpass agreed that “the market outlook is even more difficult than it's been over the past few years.” He added that Notre Dame's endowment is keeping liquid assets at hand because “dislocations will happen during the distressed cycle we are entering and you have to be ready to be opportunistic.”

Because Notre Dame is fortunate enough to have “a lot of inflows because of excellent fundraising,” Mr. Malpass said the university's spending rate is being “modestly raised” to the high end of its permissible 4% to 5% range.