With the release of the annual NACUBO-Commonfund Study of Endowments (NCSE) comes the obligatory comparison of 1-year returns. “How did we do relative to the 12.2 percent average return” is a question frequently asked at many committee meetings and while it is certainly important to understand what peers are doing, the most recent 1-year return may be the most overrated number in the 127 page study. If readers of the study can overcome the admittedly strong animal spirits of short term competition, they may find other data points that prove more relevant to their missions.

For example two such data points are the gaps between required returns, expected returns, and historical returns. As we explain below, the gap between these three measures is the widest it has been in a decade, which suggests that at some point colleges and universities will have to face reality.

Most educational institutions have a “required return” that they need to achieve in order to maintain intergenerational equity, or purchasing power, in perpetuity. That required return can be calculated with three fundamental inputs: spending, inflation and costs. For the purposes of this discussion, we exclude costs as they presumably net out in the reported performance numbers. Our CEO, Catherine Keating, has used the “CPI +5” mantra to define the long term return objective for many non-profits. CPI +5 is a great big-picture way to think about spending plus inflation, but we can get even more granular using NCSE data. The average effective spend rate reported for FY 2017 was 4.4 percent. We also know that the inflation experienced by colleges and universities is better captured by HEPI, or the Commonfund Higher Education Price Index, which measures a basket of goods and services consumed by higher education institutions. HEPI has historically run higher than CPI and, in fact, was most recently 3.7 percent. So a 4.4 percent effective spend plus inflation of 3.7 percent leads to a “required” return of 8.1 percent. And yet, when asked what their “expected” return is for the next ten years, the median response was 7.0 percent. This 110 basis point (1.1 percent) differential is the first “gap” that must be addressed.

The picture becomes even more complicated when actual historical returns are considered. While the average reported 1-year return was significantly higher in FY 2017 (12.2 percent vs. -1.9% in FY 2016), the 10-year historical return dropped to 4.6 percent from 5.0 percent. If colleges and universities have a “required” return of 8.1 percent and actual historical experience has been 4.6 percent, the implied gap is now 3.5 percent. At 350bps between historical actual returns and required returns, the spread, or gap, is the widest it has been in at least a decade using the same data and calculations.

CH1-The-Reality-Gap

The most recent 10-year return is definitely time point sensitive as the decline from 5.0 percent to 4.6 percent in FY 2017 was impacted by dropping a strong return in 2007 (17.2 percent) from the calculation. If we look back at the recent past, the average of 10-year returns since FY 2010 was 5.7 percent. The average required return over that same time period was 6.5 percent resulting in a gap of 85 basis points.

Whether the gap between what higher education institutions need to earn and what they have actually earned (or what they expect to earn) widens or narrows depends on myriad factors including, but not limited to, what institutions choose to spend and what future returns will be. Reducing the effective spend rate is one lever that will help to close the gap. Unfortunately this doesn’t appear to be the trend, as 65 percent of survey respondents reported increasing their spending and the average increase for those who did was 6.5 percent, higher than CPI and HEPI combined. Sophisticated models are not needed to illustrate the challenge with sustaining 6.5 percent increases in spending year-over-year. We have long argued for careful evaluation and review of spending policies, most recently with a blog on how susceptible spending policies will be to the next downturn. Many institutions are beginning to ask if their spending rates are too high for what they expect to be a lower return environment going forward.

At Commonfund we agree with the survey respondents that reported expected returns that are 100 basis points lower than they were five years ago (7.0 percent vs. 8.0 percent in FY 2013). Moreover, we believe that a passive portfolio of traditional stocks and bonds may not be able to deliver the 8.1 percent required return for the average college or university and as such encourage institutions to review their investment policies, evaluate their equity exposure, understand how diversified they are, develop and execute an illiquidity budget, and understand the risks they are taking to generate what is hopefully a level of return that can close the gap.

Authors

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Timothy T. Yates, Jr. is a Managing Director and responsible for custom solutions for clients across public and private markets. In this role, he leads a team of investment professionals that advise, implement and monitor custom investment solutions. He is also a senior member of the firm’s private emerging markets portfolio leadership team with a particular focus on Latin America. Tim joined Commonfund as an associate in the Commonfund Capital Associate Program. He later joined the Strategic Solutions Group, Commonfund’s OCIO platform, where he was responsible for the design, tailoring and implementation of total portfolio solutions.  Before joining Commonfund, Tim was an instructor of Spanish and Italian at Fordham Preparatory School. He holds an M.B.A. in Finance with a designation in International Business from Fordham University and a B.A. in Modern Languages from Trinity College. Tim is also a member of the investment committee for St. Paul’s Church in Fairfield.
Timothy T. Yates, Jr.
Managing Director
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.