Strong Endowment Growth

Diversification of assets helps charities achieve 11.7% gain

The University of Richmond’s $1.39-billion endowment, like so many of the nation’s largest endowments,

has become an investing hodgepodge — full of stocks and hedge funds, oil and gas investments, real estate, and private-equity and venture-capital funds.

But it contains very few bonds, once a staple in nearly all endowments. At the end of its 2006 fiscal year, Richmond held zero percent of its endowment in cash and just 2 percent in fixed income.

Herbert C. Peterson, the university’s vice president for business and finance, acknowledges that such an allocation could set Richmond up for the occasional rough patch. But he points to the university’s 13.2-percent average annual return over the past 10 years — which included the agonizing three-year stock-market slide from 2000 through 2002 — as evidence that Richmond’s effort to place its money in a diversity of higher-earning assets is working well.

“I don’t think so much about the one-year return as I do about the 10-year return,” Mr. Peterson says.

Diversification used to be simple. An investor bought stocks and bonds and hoped that the bonds zigged when the stocks zagged.

Today, the nation’s major endowments are making a big bet that widespread diversification among once-esoteric asset classes can take the place of cash and bonds in providing shelter from market downturns.

Alternative Investments

Among the 80 endowments in The Chronicle’s annual survey with $1-billion or more in assets, the median allocation to fixed income is just 12 percent.

Meanwhile, the median allocation to alternative assets — including hedge funds, private equity, venture capital, real estate, and oil and timber investments — is nearly three times as high, at 34 percent. (A median figure means that half of the organizations in the survey had allocations greater than that figure and half had less.)

So far that bet is paying off. All told, The Chronicle’s fourth annual survey includes results for 268 endowments at nonprofit groups, and those endowments enjoyed their fourth straight year of strong returns, earning a median of 11.7 percent on their investments in 2006.

That is the second-best return since The Chronicle began conducting the survey in 2003, lagging the median return of 12.5 percent in 2004.

Endowments of more than $1-billion did the best, with a median 2006 return of 14.6 percent. The smallest endowments in the survey — those worth less than $100-million — earned the smallest return, a median of 10 percent.

But the true test will come in the next downturn. Some hedge funds take approaches that are designed to produce positive returns regardless of what the stock market is doing, but such strategies may not prove as resilient as bonds and cash if the stock market plummets. What’s more, proposals under consideration in Congress may make some hedge-fund and private-equity returns taxable to endowments, potentially reducing the appeal of those alternative investments.

A ‘Long-Term Horizon’

The National Academy of Sciences, in Washington, which earned 18.1 percent on its $404-million endowment in the 2006 fiscal year, holds just 13 percent of it in bonds and cash, with the rest mostly in stocks and hedge funds.

“I don’t think there’s any doubt that there will come a time when bonds and cash are a nice place to be,” says Tom Pipich, an investment consultant who advises the academy on how to invest its endowment. “And when that time comes, I think it’s likely that the academy’s return isn’t going to be anything to crow about. But it is very difficult to try to anticipate those market turns.”

Not all endowments are cutting back on bonds and fixed income. Smaller endowments tend to have the biggest allocations to bonds. United Cerebral Palsy, an advocacy group in Washington, keeps 55 percent of its $7.1-million endowment in bonds. The endowment earned about 6 percent during the 2006 fiscal year. “We move very conservatively, which is natural for a small foundation such as ours,” says Stephen Bennett, the charity’s chief executive.

The endowment serves as a reserve fund that the charity can tap for large expenditures, he adds. Recently, United Cerebral Palsy used $1.5-million from its endowment to start a direct-mail campaign.

Bigger endowments rarely withdraw more than 5 percent or 6 percent of their assets per year. That allows managers to focus on very long-term investing, and they say that bonds simply don’t provide a high-enough return. High-quality bonds, with yields around 5 percent, barely provide enough income to cover what endowments and foundations pay out each year. When inflation is taken into account, most endowments are losing purchasing power on their fixed-income investments.

“If you think equities are going to do better than a 5-percent return — and almost everybody does — then why hold cash or fixed income if you have a long-term horizon?” asks Richard E. Anderson, a consultant at Hammond Associates, in St. Louis, which provides investing advice to roughly 100 college and foundation endowments.

‘Absolute Return’

Many endowment managers are taking funds out of high-quality bonds and putting the money to work in other assets that may earn a higher return.

For example, the Field Museum, in Chicago, keeps just 11 percent of its $309-million endowment in bonds and cash and a huge amount in hedge funds — 43.5 percent. But more than half of the hedge-fund investments are in “absolute return” funds, in which managers use various strategies, including arbitrage and the exploitation of inefficiencies in the market, to try to generate a positive return each year regardless of whether stocks are up or down. The endowment earned 14.5 percent in the 2006 fiscal year.

“We view the absolute-return funds as a fixed-income substitute,” says Jim Croft, the museum’s executive vice president.

The University of North Carolina at Chapel Hill appears to have one of the larger allocations to bonds among college endowments in The Chronicle’s survey, at 17 percent.

But Jonathon C. King, chief executive of the UNC Management Company, says that less than a third of those funds are in the sort of high-quality U.S. bonds that once made up a significant portion of university endowments. The rest of those funds are in high-yield and international bonds, and in absolute-return strategies. Such investments are generally considered riskier than high-quality U.S. bonds, but over time they should generate higher returns, Mr. King says.

In the 2006 fiscal year, the University of North Carolina’s $1.69-billion endowment enjoyed one of the best returns among public colleges, earning 19.2 percent.

“Our premise is that we need to invest in asset classes that give equity-like returns and that reflect the long-term nature of our fund,” Mr. King says. “We believe that the primary risk-management tool is diversification. Twenty years ago, most people used bonds as a risk-management tool.”

‘Risk in All Directions’

Twenty years ago, talk about risk focused primarily on protection from investment losses. Bonds helped keep endowments aloft when stocks declined. But today’s endowment managers are just as focused on the risks of lagging behind their peers and market indexes during a rising market.

“I’m always thinking about risk in all directions,” says Jeffrey E. Heil, chief investment officer at the Doris Duke Charitable Foundation, in New York, which has assets worth $1.89-billion. The foundation, which earned 16.1 percent in 2006, has just 8 percent of its endowment in cash and fixed income.

“If we’re in a strong market,” he says, “the risk is that you’re not participating, that you’re in too conservative of an asset class.”

But many experts believe that future returns will not be as strong as those that endowments have enjoyed over the past four years. Mr. Anderson of Hammond Associates believes the strong returns generated by most asset classes in recent years have led to markets that are generally fairly priced or expensive. That means that endowments should expect only moderate returns over the next 5 to 10 years, he says.

The biggest endowments, which have the heaviest allocations to alternative investments and the most-sophisticated managers, might earn as much as 10 percent per year over the next 5 to 10 years. Smaller endowments might see returns of 7 percent, he says.

“Ten percent is doable for the top institutions,” he says, “but it isn’t a slam-dunk. It might be nine, or it might be three. We don’t really know.”

Professional Help

The variety of investing options available to endowments today can pose headaches for those who oversee them — especially when the stewards of an endowment are volunteers.

The United Way of Greater Rochester has one of the largest endowments among United Ways, and its returns in recent years have exceeded those of most of the other United Ways in The Chronicle’s survey. In 2006, the United Way of Greater Rochester earned 17.3 percent on its $124-million endowment, putting it in the top spot among the 13 United Ways in the survey.

Even so, Greater Rochester is for the first time thinking about hiring an investment consultant to advise the volunteer committee that oversees the endowment. (Ninety-four percent of the endowments in The Chronicle’s survey use an outside investment manager.)

The charity has put out a request for proposals, and it will evaluate whether the advice a consultant would provide would be worth the additional cost.

“We need more help with the analytical work that we want to do,” says Jodi Groden, chief financial officer of the United Way of Greater Rochester. “Right now, a lot of that burden falls on the staff and the volunteers. The fund is large enough now that we want to think about whether we need someone on board to help us.”

Some of the money flowing into hedge funds and other alternative investments has come at the expense of passive investments, like index funds that are designed to track broad stock-market indexes.

Indexing was all the rage in the late 1990s, helped in part by the strong performance of the Standard & Poor’s 500, which tracks the returns of the largest companies in the United States. But the relatively strong performance of hedge funds since 2000 has led many endowments to consider placing more money with so-called active managers, including those who run stock funds, hedge funds, and private-equity funds.

For example, the National Academy of Sciences had as much as 60 percent of its endowment in index funds in the late 1990s. Now the endowment has only 15 percent to 20 percent in such passive investments.

“It wasn’t a global ‘macro’ thought that indexing isn’t worthwhile,” says Mr. Pipich, who has advised the academy on its investments for more than 20 years. “It was the finance committee getting more and more comfortable with the idea of taking the risk of active management.”

The composition of the endowment at the Robert W. Woodruff Foundation, in Atlanta, couldn’t be further from an index fund. Roughly 85 percent of the foundation’s $2.2-billion endowment is invested in Coca-Cola stock — and that concentration paid off in 2006. The company’s stock returned 23 percent in 2006, powering the foundation to a 21-percent overall return.

“Historically, the Coca-Cola Company has done very well and provided a strong return for its shareholders,” says J. Lee Tribble, the foundation’s treasurer. “There have been more up years than down years.”

Keeping Mission in Mind

A growing number of foundations, colleges, and nonprofit organizations are taking into account their mission when choosing investments for their endowments.

The Boston Foundation, which has a $770-million endowment, recently began “shorting” the stock of the companies in its investment portfolio that have holdings in businesses with ties to Sudan. (When investors short a stock, they sell stock they don’t yet own by borrowing it from a broker. The investor’s expectation is that the stock price will go down and they will lock in a profit by buying it back at a lower price and returning it to the broker.)

Foundation officials argue that companies operating in the country are implicitly helping the Sudanese government, which has been accused of supporting genocide in Darfur. The foundation’s move will affect investments worth about $1.5-million. Because its investments are part of pooled funds operated by financial managers, the foundation decided to offset those holdings by taking steps to diminish their value.

“It eliminates the economic gain we would have gotten from these companies,” says Paul Grogan, the Boston Foundation’s chief executive. “This should be seen as an extremely rare occurrence. This is an egregious situation. We’re not looking for opportunities to regularly engage in [strategies] like this. But the board really felt that is virtually in a category by itself in the world.”

The Doris Duke Charitable Foundation, which in April started a $100-million effort to accelerate the development of “climate-friendly technologies,” makes sure the managers of its timber funds invest only in certified timber. (The certification means the wood comes from forests that are managed for sustainability.) The foundation also has invested in a private-equity fund that focuses on alternative energy. “We think it will get a good return, and we also think it’s heading in the right direction environmentally,” says Mr. Heil, of the foundation.

Face to Face

The Open Space Institute, in New York, tries to stay away from investments that run counter to its mission — protecting scenic, natural, and historic landscapes. The environmental organization decided about five years ago to work only with money managers who are able to personally meet with its investment committee and talk about their holdings, says Christopher (Kim) Elliman, the institute’s chief executive officer.

“In one case, we were able to interview an investor who was going to make a major investment in coal mining,” he says. The organization persuaded the manager not to make the investment.

The Open Space Institute also holds no real estate, in part to avoid relationships with companies that build on formerly undeveloped land. Mr. Elliman says he believes such policies have slightly curbed the endowment’s returns. But the $179.1-million endowment has performed well nonetheless — posting returns of more than 16 percent in 2006, 12 percent in 2005, and nearly 15 percent in 2004.

Other organizations have chosen not to do such screening of investments. One might assume that the National Academy of Sciences would be interested in mission-related investing, given that its members are distinguished scholars engaged in scientific and engineering research.

But Mr. Pipich, who advises the committee that oversees the academy’s endowment, says the topic has never come up. “It’s difficult enough to try to make investment decisions for a large portfolio as a committee,” he says. “To add on to that a vague set of criteria that might be shifting as new facts emerge — there hasn’t been any appetite for having that as an explicit part of how the portfolio is put together.”

It is also difficult to trim winning investment categories, and put more money into those that have lagged, but many experts believe doing so is the secret to investing success. That strategy helped the Missouri Botanical Garden maintain a high allocation of international stocks, even while the U.S. market was booming. In recent years, international stocks have outpaced U.S. equities, and the botanical society is reaping the benefits. In the 2006 fiscal year, the $91-million endowment earned 15.2 percent.

Says Michael S. Olson, the group’s controller, “You have to put faith in your allocations.”