Q&A: Tips on Investing Endowment Funds

Related articles: View all of the advice and commentary from this special supplement on endowments

Colloquy Live: Join a live, online discussion with John S. Griswold Jr., a top official at Commonfund, which manages endowments for hundreds of colleges, about how to start or run an endowment in an era of market volatility, a predicted rise in interest rates, and other challenges, on Thursday, May 27, at 1:30 p.m., U.S. Eastern time.
John S. Griswold Jr. is senior vice president for marketing services and external relations at Commonfund, in Wilton, Conn. The fund manages about $29-billion for more than 1,500 colleges, universities, and other nonprofit institutions. Before joining Commonfund in 1992, Mr. Griswold spent seven years as a partner at the Jefferson Financial Group, where he helped to develop hedge funds for individual investors and small pension funds.

Q. When should a charity create an endowment?

A. Now is always the right time. You do endowment fund raising differently than for annual subsidies. You should go to your most reliable donors and talk to them about raising money for an endowment. You’re trying to provide for the long-term stability, so you need people who are dedicated and knowledgeable about the organization, and usually that is individuals. Usually endowments are built through planned gifts — long-term gifts. Talking to those givers should not be in place of the work to raise annual gifts, and often those people will give for both. If you’re talking about planned gifts, they’re usually down the road, so you need to get started early. The payoff might be 10 or 20 years away.

Q. What advice do you have for charities as they go about investing their endowments?

A. Developing an investment policy is the first step, assuming you have something that’s investable — more than $10,000. To put together an investment policy, you have to state the objective of the endowment and how it serves the mission of the institution. How much is going to be taken out each year? You need a return objective. What is your risk tolerance? You might say, “We can’t stand a loss of more than 20 percent in any one year,” and given the markets, that is not an unreasonable statement. Then you get into how you diversify the portfolio.

Then you should get into more technical issues as to how it will be managed. Will it be managed internally or externally? The policy should discuss issues of asset allocation: how much will be in stocks, bonds, alternatives, etc. If managed externally, how are you going to carry that out? And then what sort of reporting is required? Who needs to receive reports? How are they generated? What are the roles of and responsibilities of the various people involved in investing? That all needs to be put down in writing, and it should be a dynamic document, not just written down and put on a shelf. Situations change, and it needs to be revisited once a year.

Q. Does the size of the endowment dictate different investment approaches?

A. Yes. But even small endowments should diversify their holdings. One of the biggest mistakes they make is to put all their return expectations and take all their risk in one place. But the very small endowments — up to $25-million — cannot directly access many alternative investments, like private equity or hedge funds. So many of the smaller endowments invest in pooled funds. In that way they can access strategies that allow them to diversify, reduce their risk, and increase their return without being so large. Even small endowments should be diversified and invested in several different asset classes. Size is not an excuse to stay with a simple 60-40 stock-and-bond portfolio. There are plenty of pooled funds available to allow them to diversify, as long as the fees are reasonable.

As the endowment gets larger, it can still benefit from outside advice — from managers, consultants, and nontrustee members of investment committees who are expert in certain asset classes or strategies. In general, very large endowments can access more investments. But even large endowments have trouble getting into private funds that are closed or have limits on the amount they will accept from a single investor.

Size is not necessarily better. It does allow you to learn about certain strategies more easily, but at a certain point, size can be a detriment. If you’re looking for inefficient markets to invest in, large amounts of money entering those markets can reduce the return available. Often there are capacity constraints in many of the strategies that are most attractive. Most of the top managers that offer venture capital only want $20-million or $30-million — the same is true of many hedge funds — but these very large endowments might have as much as $2-billion to put to work, so a very large size can be difficult to manage.

Q. What are three of the biggest mistakes charities make in investing?

A. (1) Governance. They don’t set up the type of structure — a proper oversight structure — with a strong chair and a well-balanced investment committee. Have a plan — a governance model and a written investment policy — so that no matter who is managing the endowment, they can rely on a road map. The investment committee should have no fewer than four and no more than eight members, unless you are invested in specialized strategies that require specialized knowledge. You don’t want a group so large that all decisions become mush.

(2) Another big mistake is concentration of investments. They don’t diversify enough. Diversify, diversify, diversify. You need to take risks to get return. Endowment managers should not avoid risk, but manage it. On the other hand, there is a point at which you can overdiversify, so don’t put money into so many different places that even great returns don’t impact the total portfolio return that much.

(3) They don’t rebalance. If you don’t take money away from winning strategies and put it in the lagging or out-of-cycle strategies, that can reduce your long-term return. When you diversify, you try to combine asset classes that have different return cycles so you can smooth out the ups and downs in overall portfolio returns over time. If you don’t rebalance, you’re not taking advantage of that cyclical design.

Go ahead and rebalance, and also make strategic decisions. For example, most economists think we’re about to enter a period when we’ll see a rise in interest rates, so you should consider reducing your allocation to fixed income, and put that money into strategies that might benefit from an increase in interest rates, like real estate or interest-sensitive stocks. Look for opportunities to increase return or reduce risk by making strategic decisions based on long-term trends, but don’t try to time short-term swings in the markets.

Q. What steps must an organization take to protect itself when the stock market is weak?

A. Diversify. Look for asset classes that tend to be resistant to sharp declines in the market. Some people think we’re in for another tough time in the next few years. The best protection is to diversify into different asset classes and strategies that can do well in varying times.

Q. Does it make sense for organizations that don’t have an endowment to wait until the economy strengthens to start building one?

A. No. Endowments are long-term investments in an organization. Those donors should be into donating at any time. It’s never too early to start.

Q. Are there any investments that charities should steer clear of, depending on their size?

A. Small endowments should always strive to invest with the highest quality managers, either directly or through a fund of funds. If they cannot access or meet the investment minimums for the highest quality managers, they should avoid that asset class altogether. No one should invest in strategies they don’t understand. Beyond that, they can invest in whatever gives them adequate diversification, and gives them a good return for an appropriate amount of risk.

Q. When can an organization start spending a portion of the endowment income?

A. It can start right away if the need is there. A spending policy can be applied to a $10,000 endowment. It may be wise to build a small endowment rapidly by not withdrawing anything until the amount to be withdrawn is significant relative to the operating budget, but the need may be pressing. The traditional policy of spending 5 percent of a three-year average failed a lot of nonprofits last year. Their dollar spending dropped precipitously following three years of subpar performance of their endowments. A “last year’s spending plus inflation” approach may be more promising for the long term. Spending policy is something that needs to be looked at annually — in other words a more dynamic policy and not the “set it and forget it” policy as it had been in many institutions.

Q. Is it possible to build an endowment that is too big?

A. I’m not persuaded that there is any such thing as too big. If you keep your program expenditures so small that you are just piling money on money, or if you’re building a huge pot of money, you can be criticized for not spending enough now. You want to keep things in balance, not shortchanging today for the future. Realistically, if you’re interested in growing the quality of your organization, it’s difficult to say at what point your financial resources are too large. Too big is a concept that no one has tested.

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Section: Endowments
Volume 16, Issue 16, Page B22