Diversification Drives Endowment Growth

Wednesday, June 6, at 12 noon, U.S. Eastern time

To discuss the latest trends in endowment management and get a glimpse of the financial future, join Richard E. Anderson, a St. Louis consultant whose advises colleges and foundations on investing their endowments, and Christopher (Kim) Elliman, of the Open Space Institute, a New York nonprofit group that pursues environmentally sound investment practices. Peter Panepento, a Chronicle reporter who helped conduct our endowment survey, serves as moderator.

A transcript of the chat follows.

Peter Panepento (Moderator):
    Welcome to our conversation about The Chronicle of Philanthropy's latest survey on endowments. The Chronicle's 2006 survey found that 268 endowment funds earned a median of 11.7 percent on their investments in 2006. It was the fourth-straight year of strong gains for the market -- and it was fueled, in part, by a continued migration of assets into alternative investments such as hedge funds.

We will be taking questions throughout the hour and Richard E. Anderson and Kim Elliman are here to answer your questions and discuss what they are seeing in the endowment marketplace. You can ask questions by clicking on the link that says "ask a question."

Question from Will Thorpe, Mason Investment Advisory Services:
    What should smaller institutions (under $50M) do if they do not have access to the alternative asset classes that are driving the returns of the larger institutions?

Kim Elliman:
     This is more difficult, and obviously with a smaller portfolio one cannot get some of the diversified exposure, nor some of the choices that a larger fund might have. In the case of $50 million or less, I would recommend selecting managers with superior track records with whom you can meet and discuss your program restrictions and opportunities.

Question from Randy Richardson, The Breakthrough Collaborative:
    Most of our 29 sites have small annual budgets of about $250,000 - $500,000. A few of our sites have managed to raise endowments of $1 million or more, and these small endowments make a tremendous difference. They help diversify income, reduce fund raising pressure on a very small staffs, and/or help fund the improvement/expansion of programming. Questions: What are the factors that determine how and when a small nonprofit with a full-time staff of 1-4 employees should focus on raising an endowment? Should the organization ideally start without at least the seed endowment? Should the staff be able to raise a small surplus first?

Richard E. Anderson:
    I don't know that there is an answer for that. I think the correct response is to act opportunistically. Perhaps a board member can provide a starter donation

Question from Peter Panepento:
    Many organizations that manage endowments are grappling with the question of how to make sure their investments do not conflict with their missions. Kim, how does your organization approach this issue?

Kim Elliman:
    

We inform the manager what our mission is, and we try to meet with them, particularly with the investor, the stock picker, to ensure that our program and mission is clear. We want them to know what we affirmatively support as well as what we might want to avoid.

Question from Peter Panepento:
    Richard. We've seen a recent trend of endowment managers moving more of their assets into alternative investments. Is that trend likely to continue -- or do you see a swing into other asset classes moving forward?

Richard E. Anderson:
    Assets continue to move toward alternatives but at a slower growth rate. This lower growth rate is partly a response to the wonderful returns in the public equity markets -- particularly overseas.

I suspect that when the public markets correct -- and they will -- alternatives will again grow faster.

I think the largest institutions have a full plate of alternatives, but smaller institutions still have a ways to go.

Question from Peter Panepento:
    By being more selective in the types of companies you invest in, do you worry about earning lower returns on your investment? Can you be socially responsible in your investment approach and still earn a healthy return?

Kim Elliman:
     Of the 16 fund managers we employ, only one is a self-styled SRI, or socially responsible investor, with an environmental screen. Our investment committee worried that if we limited our manager universe of SRI managers only, we might suffer diminished returns. We choose, then, a different approach, which was select managers with superior track records, many of whom one or another of our investment committee had known and worked with. From that universe, we met, discussed our mission and the kind of stock which might be objectionable or permissible. We wrote some mission and program guidelines that tried to identify for the managers generic concerns and issues. We did not dictate a "green" screen per se, but tried to inform good managers what holdings/ companies we might want to exclude.

As a result, we have not seen diminished returns but superior returns. And as far as we can tell from looking at our holdings, our stocks, we have not sacrificed returns. To the contrary we seem to be doing quite well.

Peter Panepento (Moderator):
    We're at about the halfway point in this live discussion. I encourage those of you who have questions about endowments to click on the "ask a question" link above this post and jump into the conversation.

Question from Javier C. Camacho, Responsible Endowments Coalition:
    I guess my question pertains more towards college/universities. I am currently trying to increase the knowledge on college campuses on how student-led organizations can use their schools endowments for social responsible investing; however, many students become concerned with the fact that they do not have enough knowledge on how to handle money, much less invest it. With this concern, how would it be possible to go about increasing the popularity of socially responsible investing among student-led organizations on college/university campuses? Thank you for your time!

Kim Elliman:
     This is an interesting enterprise, and I wish you luck with it. You might think about proceeding by seeking out some SRI managers, and there are several who are quite willing to proselytize, in the best pedagogical sense of that word. In particular, I have found that Boston Common and Highwater Management have interesting and quite accessible approaches to the best practices among companies that help inform investment decisions. There may be other websites and information out there that I am not aware of, too. In the two firms I mention, above, their track records suggests that the investment process is not compromised but perhaps enhanced by using a green screen. I would think they would be happy to share data and philosophy and methodology.

Hope this helps. Of course, a certain amount of knowledge about the market would make the decision richer and more productive.

Question from Peter Panepento:
    With the Finance Committee looking at ways to potentially change the taxation rules for overseas hedge funds, are you noticing any reluctance among organizations that manage such funds to continue with those investments? And if changes are made to the tax laws, will that affect the allocation of assets of those that invest in hedge funds?

Richard E. Anderson:
    There is no reluctance yet.

I would suspect that existing investments will be grandfathered.

Question from Loren Loomis Hubbell, Montserrat College of Art:
    Greetings, Dick.

I'm wondering where you are seeing (or where you are recommending, if different ) asset allocations these days ... and in particular the use of non-traditional investments. Since your answer may vary by size of endowment and tolerance of volatility, how about choosing 50-ish and a 200-ish size pools?

Richard E. Anderson:
    Loren, good to hear from you.

We continue to recommend alternatives for smaller endowments. Obviously, fund of funds help facilitate that process. However, a $200 M endowment with a 15% commitment hedge funds could implement it directly if they had appropriate advice from their committee or elsewhere.

We are, of course, mindful of the money pouring into alternatives and caution mandatory. Nonetheless, the public equity markets are very expensive if profit margins mean-revert -- and they always have.

Question from Joe Scialabba, Independent Catholic Foundation for the Diocese of Altoona-Johnstown (PA):
    Would you consider looking at private equity before hedge funds for the alternative investment portion of a portfolio, especially if the organization is not qualified ($25 million or above) and may have to deal with unrelated business taxes by using hedge funds?

Richard E. Anderson:
    The advantage of hedge funds is that they have liquidity. If hedge funds have to pay a tax on income generated from leverage, you can always exit.

I would start with where you feel you have the expertise.

Both hedge funds and buyouts funds are swamped with assets but we still find attractive managers. As always it pays to diversify by type of manager and, wrt private equity, by vintage year.

Question from Larry Gloss, Gloss and Company Fundraising, Consulting Firm:
    Based on the high level of returns would you recommend organizations forming a new unrestricted endowment or board directed fund," since they may not want to be limited to using only 5% to 6% of the interest each year?

Richard E. Anderson:
    Is this question related to "under water endowments" and restrictions on spending?

Question from Peter Panepento:
    Which is a tougher sell for donors: donations directed to your endowment or donations for your current operations?

Kim Elliman:
    Donations to endowment are much tougher. It is easier to point to a specific project, or in our case, a piece of land and ask for money to support an acquisition. It is harder to ask someone to give us money to invest, and only spend 5% of that sum to buy land. It is a deferred act, deferred gratification, which in our culture is less satisfying. Still, we prefer the certainty of knowing we have money to pursue opportunities, and in the land business those can come up unexpectedly. So it is comfort to us to have an endowment, and I will keep asking for endowment funds.

Question from Peter Panepento:
    How much, if any, of an endowment's assets be allocated to traditional bonds and cash? Do these investments make sense in the current marketplace?

Richard E. Anderson:
    There is no precise answer to this. The problem today is that global liquidity seems to have squeezed the risk premiums -- how much investors are likely to earn above cash -- to most assets classes to very low levels. If this is the case, than relatively small allocations to traditional investments are called for. However, as I've indicated in other responses, alternative managers are flooded with money. In this environment it is important to diversify as much as possible. However (three handed economist here), if a committee is not comfortable in selecting alternatives, then they will have to reman with a heavy dosage to public equities. Are picks for over weights in this arena are large high quality growth in the US and abroad and emerging markets. Use caution in emering as they have had a major run-up.

Question from Peter Panepento:
    Kim. You've mentioned the fact that you meet individually with the people who are managing your investments before you begin a formal relationship. What do you hope to learn about those managers and stock pickers during those meetings?

Kim Elliman:
    Another good question. I think we want to learn how the investor thinks about the world, what might his/her investment philosophy be, what opportunities he/she sees in the world. What the investor makes of all the information, the surfeit of information, we have about the world, economy, and companies. It seems to me that investing is both art and science, and the science part is reductive, to some degree, to websites and written presentation. It is the art, the humanity if you will, of the investor that comes out in the face to face interview.

Question from Peter Panepento:
    Richard: You've mentioned that the market inevitably will return to its mean performance. The stock market has been particularly hot recently. Do you see any signs of a correction coming and, if so, how do you prepare your clients for it?

Richard E. Anderson:
    It is not hot performance that "facilitates" corrections; it's valuations. Many current valuations are not out of line. However, profit margins have never been this high as a percent of sales (9 1/2%) and have been this high only once as a percent of GDP (7%). That peak occurred in 1966 Five years later the S&P had earned a 3.4% compound return.

If capitalism works, then companies should expand and profits fall.

For protection I like hedge funds that earn their money by not relying on equity market returns (beta)i.e., not much with long/short stock pickers. We also use a manager that is specifically buying protection in the credit markets. In addition, we try to ring out extra risk -- no high yield or REITs and very limited exposure to small-caps.

Peter Panepento (Moderator):
    This concludes today's live chat about endowments. We'd like to thank all of you for joining us and Richard E. Anderson and Christopher (Kim) Elliman for answering your questions.