When it comes to managing endowments at institutions of higher education and trying to acquire good returns on investments, the task is fraught with unpredictability.
“No one can predict market changes reliably, and attempts to time the market have been repeatedly shown to fail,” advises a guide on investment management principles issued by the Commonfund Institute, a Connecticut-based asset management firm that seeks to educate institutional investors on current best practices.
The ups and downs can be quite dramatic, as evidenced in a recent NACUBO-Commonfund study that found institutions’ endowments returned an average of 2.4 percent — after fees — for the 2015 fiscal year, compared to 15.5 percent for the prior fiscal year.
But as challenging as the work of endowment management is inherently, the job is becoming more difficult due to different external forces that will demand considerable attention, skill and responsiveness for the foreseeable future.
For instance, on Capitol Hill, policymakers are exploring ways to address concerns that wealthy colleges and universities are “hoarding” money — as one law professor put it recently in The New York Times — through their endowments and not spending enough on student aid.
While proposed changes — such as imposing minimal payout rates of 5 percent and taxing endowments or endowment earnings — are aimed at wealthy institutions, observers say those proposed changes could potentially impact other colleges and universities as well.
Further, as institutions seek to create more diverse campus environments, endowments meant to benefit specific groups could face legal challenges from individuals who — in the same vein as the affirmative action case Fisher v. University of Texas at Austin — object to such things as being illegally exclusionary, experts warn.
Also, student-led movements calling for universities to divest from Israeli companies and for-profit prisons — the latter of which Columbia University did last summer — cannot be ignored.
With endowments and how they are handled attracting more and more scrutiny, experts say it is critical for higher education leaders to have a keen awareness of the aforementioned issues and to be able to develop a clear sense of purpose going forward.
“Institution leaders should be thinking carefully about all these issues, reviewing and developing policies, and preparing to articulate how endowment management practices and policies advance institutional missions and purposes,” says David Bass, director of foundation programs and research at the Association of Governing Boards of Universities and Colleges (AGB).
William F. Jarvis, executive director at the Commonfund Institute, says it’s important for fiduciaries to be clear about the purpose of the individual funds that make up the endowment, as well as how important endowment distributions are to an institution’s mission and fiscal health.
“If endowment distributions are destined for relatively marginal parts of the institution’s mission, or if they only account for a small percentage of the operating budget each year, with the rest being made up by tuition and fees, then the institution may not need to pay as much attention to the level or volatility of endowment returns,” Jarvis says. “But if endowment distributions are expected to make up a significant percentage of the operating budget, then the endowment will need to be well diversified, well managed and well governed.”
Adhering to principles
Along those lines, Bass, Jarvis and the organizations they represent say there are a few principles that must be adhered to in order to successfully manage an endowment.
Those principles include but are by no means limited to:
“Selecting investment specialists requires patience and skill,” states a Commonfund guide titled, “Principles of Investment Management for Long-Term Funds.”
“There are thousands to choose from, and because outperformance over long periods is rare, the investment stars of the moment do not always represent the best choice,” the guide states. “Indeed, performance in less than one market cycle (typically 5 to 7 years) could tell more about the firm’s luck than its skill. And past performance alone has never been a reliable predictor of future success.”
Commonfund recommends a highly systematized approach to selecting managers.
“The manager selection process should start with a list of candidates for a particular segment of the portfolio,” the guide states. It also recommends asking questions that cover topics that range from a firm’s investment style and philosophy to how it makes decisions.
Jarvis says boards of trustees — or their investment committees — must decide if they want to hire and fire managers on their own or hire a sufficiently skilled staff to handle the task, or consider delegating some of the responsibility to an outsourced chief investment officer, or OCIO.
While Congress, among other things, is exploring the prospect of imposing minimum payouts of 5 percent for endowments — the same amount required for private foundations for decades — colleges and universities have an interest in exercising restraint.
“Over the long term, spending restraint increases the likelihood that the fund will be able to grow in dollar terms and, perhaps, even maintain or increase its purchasing power,” the Commonfund guide states. “Analyses comparing spending rates of 4, 5 and 6 percent have demonstrated that, over a period of nearly 50 years, lower spending rates, by allowing for greater capital accumulation in the pool, result in a higher absolute dollar payout level.”
Jarvis advises: “In our current low-return environment, which is expected by many to last for several years, what is a prudent and sustainable payout amount that can support the current projects for which the donors intended the endowment funds to be used while still maintaining the purchasing power of those funds out into the future — the so-called intergenerational equity?”
Bass observes: “Ironically, calls for increased endowment spending are coming at a time when many investment professionals believe it is going to be increasingly difficult to generate investment returns over the long term that will enable institutions to meet their goal of 4 to 5 percent annual payout plus management costs and adequate appreciation to sustain the long-term purchasing power of the fund that will sustain the purchasing power of endowed funds.”
“Investment managers must be studied with an eye to more than just past performance and selected to effect a diversification that will optimize return while limiting overall portfolio risk,” the Commonfund guide states.
Jarvis says fiduciaries need to ask questions such as: “What is a prudent asset allocation for the endowment, taken as a whole?” “What level of diversification is necessary to give the endowment exposure to enough uncorrelated sources of return while still protecting it against the worst effects of economic and market downturns?”
The Commonfund guide advises further: “The asset allocation process is best carried out in a systematic, disciplined manner. Indeed, in agreeing on its planning agenda, the board should make sure it gives each trustee the opportunity to express both an overall vision and specific concerns.”