Special Report: Asset Allocation

The stumbling economy is fueling a quest for stability in endowments, which are taking a hard look at how they build and invest their assets. If they haven’t already, endowment officials are assessing investment strategies, shifting assets to investments they believe will be less volatile and encouraging donors to consider alternative gifts, such as real estate or art.

“It makes sense to have as many things in your portfolio that perform differently in different environments to protect you so you can weather different economic periods,” said Stephanie Lynch, chief investment officer for The Duke Endowment in Charlotte, N.C.

Endowment as sets, which soared during the late 1990s stock market boom, have taken big hits in the past two years as markets plunged, eroding earlier paper gains.

College and university endowments, for example, posted an average return of negative 3.6 percent in the fiscal year ended June 30, 2001, the first negative return since 1984, according to the National Association of College and University Business Officers (NACUBO) in Washington, D.C.

“For fiscal year 2002, it’s safe to assume that the rates of return will be similar, certainly negative,” said Damon Manetta, NACUBO’s manager for external affairs and media relations.

As of June 30, 2002, returns had fallen 5.4 percent for endowments at roughly 100 colleges, universities and independent schools, compared to a year earlier, according to a survey by the Commonfund Institute in Wilton, Conn. And the quarter ended Sept. 30, likely was “one of the toughest in many years,” possibly doubling the decline of the 12 months ended June 30, said John Griswold, the research group’s executive director.

In fiscal 2001, the average return on endowments of 617 foundations and educational institutions tracked by Commonfund fell to negative 3 percent from 13.2 percent a year earlier, he said.

“Since March 2000, when the market peaked, you’ve seen some vicious declines,” he said.

At U.S. community foundations, the median return on assets fell to negative 3.9 percent in 2001, the lowest annual return since 1992, when the Council on Foundations in Washington, D.C., began tracking community foundations’ investment performance.

Divvying up endowment assets among different types of investments is one of the most critical jobs facing board members in their fiduciary role, the Council on Foundations said in the most recent edition of its Foundation Management Series. Asset-mix decisions can affect up to 90 percent of a fund’s relative performance, it said, and “can have a much greater impact on the foundation’s long-term financial position than the performance of its individual investment managers.”

Domestic and international stock accounted for more than 60 percent of the total portfolios of all grantmakers in the council’s most recent survey, which reflected holdings on Dec. 31, 1999, while fixed-income investments accounted for more than 24 percent.

Family and independent foundations typically hold more of their portfolio in stocks, while community and public foundations typically hold less in stocks, the council said, and all grantmakers were allocating more to stock and less to cash and fixed-income than they were in 1997.

“We’re seeing a decline overall in equities and a rise in alternatives, including private equity, hedge funds and real estate,” said Griswold.

Equities, which represented roughly 65 percent of investments several years ago, generally have declined to 55 percent to 60 percent, he said. “People aren’t trusting the stock market now, so they’re letting their investment in the stock decline relative to other asset classes,” he said.

Many colleges and universities are shifting some of their endowment assets to bonds from equity, said Manetta. Among 610 institutions that NACUBO surveyed, bonds represented 24.9 percent of $236 billion in total endowment assets in 2001, up from 22.5 percent a year earlier.

“The volatility is not as great as stocks,” he said. “And there’s a guaranteed rate of return on bonds.”

The Massachusetts Institute of Technology in Cambridge saw its endowment — sixth-largest among U.S. colleges and universities — fall to $6.1 billion in 2001 from nearly $6.5 billion in 2000. While MIT won’t disclose details about its investments, they are “extremely diversified,” with a “substantial amount of alternative categories beyond the stock and bond market,” said Allen Bufferd, the school’s treasurer.

A long-term perspective and a clear formula setting an endowment’s payout are key challenges for colleges and universities, as well as for other charitable organizations, Bufferd said.

Like many endowments, he said, MIT sets its payout based on performance over 36 months. “If they’re disciplined about that,” he said, endowments “are usually able to weather most storms.”

The Charlottesville-based University of Virginia Investment Management Co. (UVIMCO), created in 1998 to manage the school’s $1.7 billion endowment, has been shifting investments away from public equity holdings, said Alice Handy, UVIMCO’s president.

A “continuous” investor in private equity, she said, UVIMCO also has put much of its portfolio into hedge funds, which endowment managers use to “hedge” their market risk because the funds invest both in stocks expected to rise in value and those expected to fall.

Heavy investments in venture-capital funds starting in 1998 reaped a windfall for UVIMCO in 1998, 1999 and 2000, when startup companies in which the funds had invested sold stock to the public for the first time or were acquired.

As a result, Handy said, private partnerships in which UVIMCO had invested — including real estate, oil and gas and private equity — had grown to 41 percent of its portfolio by June 30, 2000, while hedge funds represented 15 percent.

Today, hedge funds represent 50 percent of the portfolio, while private equity represents 19 percent, with the remainder in public equities — both international and domestic — and fixed-income investments.

“We essentially flip-flopped our private-equity and our hedge-fund position in a year’s time,” Handy said. “The university has been very consistent in having an equity bias in the fund and a long-term vision.”

Endowments tracked by Commonfund have shifted from traditional stocks and bonds to alternative investments, including private direct investments such as venture capital, private equity and hedge funds, said Griswold.

“The shift into alternatives is to provide higher return, more diversification, which means lower risk for the total portfolio, and hopefully more consistent return over periods of time,” he said.

More than one-fourth of the $182 billion in endowment assets of 617 institutions surveyed for the 2002 Commonfund Benchmarks Study, for example, are invested in alternatives, up roughly 10 percent from three years ago, he said.

Endowments, whether at colleges and universities or at foundations, he said, can have a tough job meeting minimum payouts that typically total 5 percent a year, based either on legal requirements or board policies, and derived from a three-year moving average of market values.

Endowments generally invest 60 percent to 70 percent of assets in stocks and, respectively, 40 percent to 30 percent in bonds, he said.

While stocks typically generate higher rates of return — 10 percent to 11 percent over the long term — they are more volatile than bonds, which generate returns of 5 percent to 6 percent over the long term, Griswold said.

“Bonds have cushioned the fall in equities,” he said, although the slumping economy has dimmed prospects for bond returns.

“There’s a likelihood rates will not decline further but instead will rise from this point forward,” he said, noting that bond prices — on which total returns are based — move in the opposite direction from interest rates.

“It’s very difficult to buy a bond that will guarantee you 5 to 6 percent, without taking some risk,” Griswold said. “The challenge is to provide a mix of assets that will provide that 6 percent.”

Foundations also are shuffling their investments.

The Duke Endowment, which three years ago adopted a more diversified investment strategy to reduce dependence on U.S. equities, has been increasing the share of its portfolio in alternative investments, such as hedge funds that seek to generate returns independent of the stock market.

“We like to make changes at the margins,” said Lynch. “We tend to move slowly and move in a conservative way.”

The foundation’s investment in private equity peaked at about one-fourth of its portfolio in June 1999, when assets reached an all-time high of $2.8 billion.

As the technology bubble burst, the foundation’s investments in private equity returned to more normal values, Lynch said, bringing its private-equity portfolio closer to the foundation’s policy target of 15 percent of holdings.

The foundation has not changed its overall investment strategy, which includes 70 percent equity, 20 percent long-term bonds and 10 percent in real assets such as real estate, timber, and oil and gas partnerships.

The long-term strategy has paid off, Lynch said. For the three years ended Sept. 30, the foundation’s annualized rate of return totaled 4.3 percent, compared to an average annual loss of 8 percent the foundation could have expected based on market benchmarks, she said.

“If you really look at the long-term perspective on when stocks do well and poorly, you’ve got to do a lot of things right to earn 5 percent year after year,” she said. “It’s just not something the average bear can pull off.”

The struggle to earn 5 percent, she said, provides a solid reason to avoid the impulse many foundations may have to shift too drastically from stock to bonds.

“If bonds are not going to earn enough over time to meet your 5 percent payout plus the natural rate of inflation, then in my opinion it’s just as risky to have too much in bonds and eat away your corpus,” she said.

Community foundations also are shifting their investments, and encouraging donors to consider alternative gifts.

The Greater Kansas City Community Foundation recently increased its equity holdings to 70 percent from 65 percent by converting its cash holdings, said Laura McKnight, senior vice president for development.

The foundation also is moving some equity out of indexed or “passive” funds, and into actively managed funds in which its investment managers pick stocks based on expected performance.

Actively managed equity has grown to 45 percent of the equity portfolio from 20 percent.

“What we’re trying to do is identify areas of the market that we think offer above-average returns over long periods of time,” said Pat Smith, assistant vice president for finance and investments. “The ‘90s were like nirvana for the indexes,” he said. “It’s our belief that the market is not going to repeat that anytime soon.”

To provide more professional services to meet growing interest among donors in making gifts of real estate, while also protecting itself from potential liability associated with gifts of real estate, the San Diego Foundation five years ago formed a Charitable Real Estate Fund, said Duane Drake, the foundation’s chief financial officer and the supporting organization’s treasurer.

While stock prices have been falling, he said, real estate in Southern California has continued to appreciate in value, offering donors a good option for making charitable gifts.

The foundation’s Charitable Real Estate Fund has received roughly 25 gifts worth more than $20 million since it was formed, or about 10 percent of total gifts over the same period to the $400 million-asset foundation, Drake said. Those gifts have ranged from homes and apartment buildings to a shopping center, parking lot and cattle ranch.

The real estate fund has its own board of directors, mainly real-estate experts, and assesses the proposed gifts and then manages and sells the property, with the proceeds placed in donor-advised funds.

“There is still continued interest in giving properties, given that properties have held or continued to increase, compared to stocks,” Drake said.

Foundations also are reviewing and sometimes replacing their investment advisers.

After seeing its endowment decline to $60 million from $65.5 million a year ago, for example, the Community Foundation of Greater Greensboro in North Carolina hired Cincinnati-based Fund Evaluation Group to help map its investment strategy, replacing Boston-based Cambridge Associates.

The foundation aims to work more closely with the new adviser, which she said represents more than 40 community foundations and will meet with the foundation and its donors, said Marie Schettino, vice president for finance and administration.

“We’re getting more involved with them,” she said. “We’re getting more proactive.”

Todd Cohen is editor and publisher of Philanthropy Journal. He can be reached at [email protected] .