“The facts don’t speak for themselves; someone has to speak for the facts.”
Milton Friedman, economist
In recent months, a litany of editorials and academic studies have focused on the “state of the nation” for foundation and endowment investments, and more specifically, the role of alternative investments in these portfolios. To generalize broadly, the two industry approaches to investing the endowments of tax-exempt organizations are the traditional model (“60/40”) and the endowment model (“Yale University”). In contrast to the traditional approach, the endowment model espouses the utilization of more illiquid assets and investment programs such as hedge funds, private equity, and private natural resources. These programs are typically funded from the historical allocations to stocks and bonds.
In this piece, we review the data, and impartially, speak to the facts so that your organization is equipped to make an informed decision about adding alternatives to your investment portfolio.
Why are so many investment professionals, boards and investment committees concerned about recent investment returns? The answer to this question lies in the recent investment experience of institutions such as foundations and endowments, and to some degree, the history of institutional money management. As most readers know, the traditional model has its roots in a very straight forward equation that dominated the industry for many decades. The essence of that equation is a 60% allocation to the S&P 500 and a 40% allocation to the Barclays Aggregate Bond Index. To extrapolate, 60% multiplied by the long term historical return of the S&P 500 of 10% (.6 x 10%) plus 40% multiplied by the long term historical return of the Barclays Aggregate Index of 7% (.4 x 7%) equals 8.8%. It should be no surprise that this return neatly covers a 5% spending rate, 3% inflation and 0.50% of additional costs incurred by an institution. An institution could cover all explicit and implicit costs, and still generate a modicum of growth in the corpus of the institution.
Over the last five years, the straight forward 60/40 model has outperformed the endowment model (National Association of College and University Business Officers – NACUBO)1 of investing. In fact, you have to go back to the 10-year return to find a scenario when endowments have outperformed the traditional diversification model. With this in mind, the majority of the relative underperformance by the endowment model to public market indices on a short-term basis can be explained by allocations to alternative assets. As you can see in the table outlining current asset allocation trends across the NACUBO universe2, the largest institutions have the greatest allocation to alternative investments. These investments have generated meaningful long-term returns while reducing portfolio volatility, but have penalized performance in the short-term.
In a market where both core domestic equities and fixed income have generated sizeable returns (and volatility) in recent years, alternatives, and hedge funds more specifically, have been a hindrance to performance. Nevertheless, these lower returns have been delivered in an environment where alternative investments fulfilled their core purpose of reducing volatility.
Given the absolute level of interest rates, and thus the limited risk dampening benefits of fixed income, we believe allocations to alternatives are more important than ever in helping foundations and endowments realize their long-term goals and objectives. While these investments may have generated some relative return frustration in recent years; they continue to deliver sizeable benefits over the long-term.
A long-term perspective is what investment committees and boards must focus on as they consider the viability or utilization of alternatives in their institution’s portfolio. Without these investment strategies, institutions face the very real risk of experiencing comparatively greater loss over the coming years. A loss in the corpus’ market value or the opportunity cost associated with forgone earnings translates into real dollars that are not available for an organization to devote to its mission.
If your institution has not adopted alternative investment policies or is reconsidering the current allocation, we recommend the following steps to facilitate the discussion:
Roles, Responsibilities, and Benchmarking - Set benchmarking, monitoring, and review processes for the institution and the advisor or consultant. One of the greatest industry frustrations in recent years has been the lack of consistency on how alternative investments should be benchmarked and what responsibility the board/investment committee, versus the advisor or consultant, may have in monitoring of the investments.
"The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1." Warren Buffett
It can be challenging for investment committees to reach consensus on whether or not to add alternative investments into a nonprofit’s portfolio. Historical returns over the past 5 years were a drag on endowment performance. Organizations that value dampened volatility and risk reduction, might consider jumpstarting a discussion about the role that alternative investments could play in achieving their long-term investment goals.
1 Source: 2012 NACUBO/Commonfund Study of Endowments. Rates of Return as of June 2012; SunTrust Estimates. * Purely Index Level Returns, and thus, un-investable as no vehicle or advisory fees are embedded.
2 Source: 2012 NACUBO/Commonfund Study of Endowments. Rates of Return as of June 2012; SunTrust Estimates Alternative strategies are categorized in the NCSE as follows: Private equity (LBOs, mezzanine, M&A funds, and international private equity); marketable alternative strategies (hedge funds, absolute return, market neutral, long/short, 130/30, and eventâ driven and derivatives); Venture capital; Private equity real estate (nonâcampus); Energy and natural resources (oil, gas, timber, commodities and managed futures); and Distressed debt.
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