Endowments Seeking Alternatives, Ditching Fixed Income

Financial managers of endowments and foundations have moved away from fixed asset investing to the more lucrative but volatile areas of venture capital and alternatives such as hedge funds, real estate and private equity.

The largest danger afoot is being a passive investor, according to Monica Issar, global head, J.P. Morgan Endowments & Foundations Group, and Anthony Werley, the organization’s chief investment officer. They highlighted three trends they see developing during an hour-long webinar called “Generating Opportunities in a Volatile Market: Trends in Endowments & Foundations.”

Those trends are: diversifying and preserving returns in a rising interest rate environment; intelligent sourcing alpha in a lower return environment; and, managing multiple objectives in the face of industry pressures.

While the past few years have been good times for endowments, returning an average 15.5 percent for 2014 and 11.7 percent for 2013, there might be a few waves of volatility as this economic cycle matures. Werley said that changes in the bond market could take one of the “pillars of enthusiasm” out of the economy ushering in more than a “standard correction.”

The top areas of return were seen in venture capital (23.3 percent); domestic equities (22.8 percent), international equities (19.2 percent) and private equity (16.5 percent). Fixed income lagged at 5.1 percent.

Alternative investments, such as hedge funds are growing in endowment portfolios, making up 57 percent of funds with assets greater than $1 billion and 44 percent of endowments with assets of between $501 million and $1 billion, according to a study by NACUBO-Commonfund.

Issar and Werley mentioned three focus areas for endowment and foundation investing:

  • Adding Alpha: In a market with normalized return expectations, it can be difficult for investors to find alpha. Manager selection becomes more critical in a lower return environment. Consider strategies supported by a robust research platform that can deliver alpha;
  • Managing Volatility: With expected volatility, the risk profile of passive investments will likely be set by the market. Investors seeking a new foundation for their portfolios might consider their tolerance for volatility. Select assets based on their contribution to the overall level of volatility in the portfolio. Consider active investments that employ a disciplined, consistent valuation methodology; and,
  • Diversifying Across Style: Diversifying across style or market caps can help add alpha or mitigate volatility in equity allocation. In a more volatile environment, consistency of results becomes increasingly important. Consider active investments that are style pure, well-diversified and aim to provide a consistent experience.

Werley said he’s bullish on commercial real estate. All categories have low-, mid- and high-risk areas. A mid-risk commercial real estate play might bring back 10 precent. Werley projected that there are probably six years left in the real estate economic cycle.

Another area that might be low-risk/medium- to high-reward is infrastructure debt. They cited a McKinsey study that showed $36 trillion was spent on infrastructure from 1996 through 2013. The projection is that $57 trillion will need to be spent between 2013 and 2030.

Werley also likes private junior debt in a six- to seven-year time window. He suggested that the “the jury is still out on new economy” and social economy plays. While he didn’t identify specific investments, current high returns on those types of investments might not be replicated.

An absolute return on investment hurts portfolio liquidity and ties the hands of financial managers seeking flexibility to jump on opportunities, they said. Cash does have a role as a fixed income tool and in creating a risk profile for investing, Werley said.