Margaret Chen said endowments want to be ready for the next downturn.
What a difference a year makes. This time last year, endowment investment offices were trying to recover from a bad final quarter. Things are much brighter now, but endowments are taking the opportunity to get ready for the next financial downturn, while their institutions prepare for enrollment challenges that will impact spending and investment decisions in 2020 and beyond.
Like other institutional investors, endowments and foundations in 2018 faced one of their worst years since the financial crisis thanks to volatile equity markets. According to the Wilshire Trust Universe Comparison Service, they lost 7.52% in the fourth quarter of 2018, while data from the Northern Trust universe found median losses of 6.3% for the quarter and 2.6% for the year ended Dec. 31.
By June 30 of this year, the median endowment fiscal year return was positive again, at 4.9%, according to Cambridge Associates LLC. Even the largest endowments — like Harvard University, Yale University and Stanford University at $29.6 billion — recorded relatively modest returns of 6.5%, 5.7% and 6.5%, respectively.
Yet there were a few notable standouts. The $1.7 billion endowment of Bowdoin College in Brunswick, Maine, continued to outshine most of its peers, returning 10.9% in fiscal 2019. Brown University in Providence, R.I., had its best year yet, growing to a record $4.2 billion by the end of its fiscal year in June, with a 12.4% return that surpassed both its 5.8% benchmark and the 4.9% median.
Jane Dietze, Brown University vice president and chief investment officer, credited strong partnerships with investment managers and an emphasis on downside risk management, "which proved to be valuable in a volatile year for U.S. stock markets," she said, as the endowment outperformed the S&P 500 index primarily as the market declined.
One standout asset class was absolute return, which makes up 37% of Brown's portfolio. Those managers "exceeded even elevated expectations," Brown's 2019 endowment report says, beating the S&P 500 despite a net exposure of less than 50% to the market index.
To Margaret Chen, global head of Cambridge Associates' endowment and foundation practice in Boston, 2019 has been "a Teflon year, in the sense that unlike last year, investors have really shrugged off potential catalysts which could have hurt returns."
But worries about another potential market sell-off are changing that. "It all felt like it was a great party, but there is a lot of underlying concern," Ms. Chen said.
"Our crystal ball is just as fuzzy as everyone else's, but we know it's coming," agreed Timothy T. Yates Jr., president and CEO of Commonfund Asset Management in Wilton, Conn.
That has led many endowments to continue pushing into private markets.
"Everyone had a wonderful experience over the past 10 years, but now as folks look ahead, the public markets are more challenging," said Scott F. Perry, partner and co-head of investment consultant NEPC LLC's endowment and foundations practice in Boston.
The advantage of private markets has already been recognized by some of the larger $1 billion-plus endowments, which had 6% more invested in venture capital and another 6% in private equity in fiscal year 2019, according to NEPC's fall 2019 endowment and foundation survey.
Respondents to the 2019 survey covering the 12 months ending in September were 50 endowments and foundations, with 49% of them having more than $500 million in assets.
It is hard to ignore the results, with venture capital returning 14.6% in the fiscal year and global private equity coming in at 10.8%, NEPC found.
U.S. large-cap stocks were close behind at 10.4% last fiscal year, but endowments are now making sure their equities allocations are more neutral with a balance of countries and company sizes. They have also trimmed hedge fund exposure, with 37% doing so in the past year and 21% planning to do so in 2020, according to NEPC.
And "cash has become an interesting alternative. Access to liquidity and a very safe haven is something that we are seeing endowments doing," Mr. Perry said.
Still, he cautions that "private markets are not immune to compression in terms of return expectations."
The defensive moves are also prompting endowments to take a harder look at their illiquidity profile. "We are entering a period where everybody is expecting lower returns. That's where the illiquidity discussion comes in," said Mr. Yates of Commonfund, who has a big caveat for endowments thinking about more private investments. "Just because you take illiquidity doesn't mean you get the premium. There is great diversity in returns."
Commonfund managed $11.7 billion in endowment assets.
Mr. Perry of NEPC is seeing more endowments consider increasing their cash holdings to access liquidity "and a very safe haven," he said.
So far, Ms. Chen of Cambridge Associates said, "endowments have seesawed between capital preservation and seeking returns. This is a seesaw between taking risk and managing risk."
And there is more than just an economic recession for all but the largest endowments to worry about, endowment investment experts say. Colleges and universities face declining enrollment numbers due to demographics and a strong job market among other reasons. "We are in an enrollment recession," NEPC's Mr. Perry said.
"It feels like a lot of the conversations we are having are beyond investment," agreed Mr. Yates. "We really counsel colleges and universities to take a hard look and really try to get beyond just the investment situation and see if they are in a realistic operating environment, and what happens in a stressed operating environment. This whole crisis playbook stress test we are doing at the portfolio level and the institution level. It is easier to have that conversation when things are good," Mr. Yates said.
One tough conversation that investment consultants are having with schools is about spending policy, which doesn't typically get as much attention as asset allocation. "More and more colleges and universities are having conversations about whether they can adjust that spending lever," said Mr. Perry. "That's the debate that many boards and committees will be having" in 2020, he said.
Colleges and universities typically target their endowment spending at about 5% of the total endowment market value to protect the tax-exempt status, but some are spending more, said Rosalie Wolf, founding partner of Botanica Capital Partners LLC in New York, which provides governance and endowment consulting advice and services to investment boards and committees.
"Since current long-term market forecasts make it hard to generate adequate investment returns, higher spending is a real problem and increasingly boards are understanding that. Given the strong markets of the past decade, my worry is that when we have a downturn, there are going to be a lot of troubled colleges," said Ms. Wolf, a former corporate and large foundation CIO.
Schools and universities are also feeling pressure to do more sustainable investing, which often comes from students but also a desire to have their mission reflected in the investment portfolio.
"We finally hit that tipping point," said Mr. Perry of NEPC. "What we're seeing is more and more, especially in the college and university space, having some form of sustainability in their mission, even among groups that have never had any conversations about ESG."
NEPC developed an internal rating for each specific strategy to help benchmark managers, but it also gives schools something to communicate to constituents. Showing how each strategy addresses ESG has "been the eye-opening thing for endowment staff and boards. They are more interested in it and as such they're allocating time to really go through it," Mr. Perry said.
James Spidle, senior vice president with Breckenridge Capital Advisors in Boston, sees ESG growing in importance and the approaches moving beyond negative screens like no firearms or fossil fuels. "Forward-looking investment committees and boards recognize ESG as a priority for a new generation of stakeholder, including donors and board members. Over the years, we have seen endowments evolve their ESG investing approach from screening to embracing full ESG analysis as an investment thesis that drives rigorous research and seeks to maximize long-term, risk-adjusted returns," he said.
More schools exploring how to best to express their support for sustainable and impact investing "is a trend that will absolutely continue in 2020," said Ms. Chen of Cambridge Associates. With more market options to support that interest, "instead of a specialized area, it has become a mainstream topic."