Interning at Commonfund Institute has been a constant process of learning. Since starting my internship in early June, my knowledge has increased as my formal study of economics at UChicago connects with real-world applications of endowment management for nonprofit institutional investors. As an intern with the Institute, I had the opportunity to attend the 2023 Investment Stewardship Academy (ISA), a three-day workshop for trustees, committee members, and senior staff of nonprofit institutions, held on Yale’s campus in New Haven, Connecticut from June 20-23.
The program reinforced my knowledge about economic indicators, the general state of the U.S. economy and provided fundamental lessons in risk and portfolio management. As an economics major interested in a future career in finance, I found this fascinating, and thanks to ISA, I feel years ahead in terms of real-world knowledge.
Here are my five key insights from ISA 2023:
1. Considering the impacts of Banking Uncertainties
On the minds of many senior staff and board members is the banking crisis caused by the collapse of several banks, most notably Silicon Valley Bank. Understanding how the crisis was both impacted by, and influences, the financial climate is critical. For context, the Federal Reserve’s hike in interest rates collapsed the value of long-term government bonds which, like all banks, SVB was heavily invested in, contributing to the bank’s collapse. This ushered investors towards treasury bonds and other safer bets and prompted institutions to consider diversifying their banking relationships and revisit their cash management strategies. Finally, the shock on the financial system has further contributed to the slowdown in lending caused by recent interest rate hikes, which will not only impact the investment space, but will likely also have tangible impacts across the real economy.
2. Staying the course during uncertain times
ISA 2023 included ample discussions on negative economic indicators in today’s economy. Seeing as many of these indicators, such as an inverted yield curve, typically signal a recession, it is best that stewards of endowments take measures to hedge against the risk of an economic downturn, even if it never comes. The Covid crisis has created a rare and unpredictable set of economic outcomes, so forward-thinking institutional investors should create plans of action in the case of an economic downturn by assessing what has worked well or poorly in prior downturns, in terms of investments and governance. Lastly, it is important for investors in the endowment space to avoid being overcome by short-term thinking, as most endowments are invested on a perpetual time horizon. Therefore, even in the case of a drawdown, endowments’ mission goals should be mostly unaffected so long as their portfolio construction accounts for ample liquidity needs and stabilizing yearly spending policies are in place.
3. Balancing Risk and Return
Many conversations at ISA revolved around risk, considering several economic, investment, and mission related factors. There was, for example, talk about the Sharpe Ratio, a measure of performance relative to how much risk a portfolio takes on. Nevertheless, the main and most relevant discussion on risk was in a session entitled “Balancing Risk and Return”, which explored the three primary considerations for endowments developing their risk profile: mission risk, market risk, and liquidity risk.
Mission risk is defined as a challenge to an “organization’s ability to operate and execute on its objective,” representing a real-world challenge to the endowment fulfilling its purpose.
Market risk is representative of “idiosyncratic risks on the endowment portfolio,” typically originating from the unique asset allocation of a particular institution’s endowment.
Liquidity risk involves potential logistical difficulties that may arise before an endowment can take proceeds from gains in the value of its illiquid assets.
Institutions that set explicit definitions for their mission goals make mission risk, and consequently market and liquidity risk, easier to quantify. Multi-faceted risk management frameworks help ensure that mission-oriented organizations are poised to fulfill their mission today and preserve and carry forward resources for future generations.
4. The right inflation measure is an important consideration
Another topic at ISA was the impact of inflation on endowment and foundation investment portfolios. In the past, Commonfund has written about the importance of looking beyond CPI + 5 percent when calculating the returns needed to achieve intergenerational equity, instead recommending that higher education institutions replace CPI with the HEPI (Higher Education Price Index®). The HEPI, an inflation index calculated annually by Commonfund, reflects the inflation of goods and services needed to run a higher education institution. By using HEPI, institutions can more accurately keep track of the rate of inflation that will be part of their budget, ensuring they maintain the same purchasing power over time.
HEPI tends to be higher than CPI over time1, so the reality is that most educational institutions using the CPI + 5 percent growth objective are gradually falling behind inflation. To counteract this, endowments could consider decreasing their yearly endowment withdrawal percentage or increasing risk to bring higher returns. It is recommended that institutions outside of higher ed take on a similar perspective by investigating if CPI inflation is truly representative of their cost structure and spending needs. If this is not the case, it may be necessary to adjust return objectives to keep pace with inflation.
5. Paying attention to spending policy
Spending policy is a key component in managing the severity of potential drawdowns, “smoothing” out returns and generating more consistent income for the endowment’s mission. In the session, “Reimagining Spending as a Tool for Mission-Oriented Endowment Management” we primarily covered three of these spending methodologies: moving average, banded inflation, and hybrid.
Moving average is calculated by averaging out the endowment value for the past several years and then spending a set percentage of it. A key advantage of this spending policy over its alternatives is the simplicity of its calculations, making it a far easier pitch to boards seeking to decrease yearly volatility in endowment withdrawals. Perhaps due to this, the moving average method is by far the most common, being used for endowments of 75 percent of universities, 68 percent of independent schools, 79 percent of community foundations, and 40 percent of private foundations2. Despite its popularity, the moving average is still relatively volatile, as institutions usually calculate moving averages for the past three or five years, which provides less smoothing effect than the next two methodologies. Further, many institutions also neglect to adjust previous years’ total endowment value to inflation. This typically results in lessened yearly withdrawals, as previous year values are underestimated.
Banded inflation involves enclosing a yearly withdrawal of a set percentage of the endowment’s total value (e.g., 4.5 percent) inside a max band of +1 percentage point (e.g., 5.5 percent) and a minimum band of -1 percentage point (e.g., 3.5 percent). Every year, the yearly percentage withdrawn from the endowment will be adjusted to inflation. This option provides greater discretion on withdrawal amounts to institutions, ideal for institutions whose respective missions have volatile funding needs.
Lastly, a hybrid spending methodology is structured as follows: The previous year’s spend rate adjusted to inflation, be it CPI or HEPI, proportionally represents 80 percent of the annual spending. The other 20 percent of the yearly spending is based on a set percentage spend rate, assuring a very consistent return despite fluctuations in the endowment’s value.
Ultimately, fiduciaries were encouraged to give their spending policy the attention it deserves, as it is the link between the endowment and the institution and helps to manage risk while ensuring appropriate spending toward mission year after year.
I was delighted to have had the opportunity to attend the Investment Stewardship Academy and learn more about the endowment space, especially as a current university student. Reports show that 49 percent of university endowment-based spending is used for scholarships and financial aid3, which I personally rely on for my education. I am grateful to have met so many wonderful fiduciaries at ISA who make opportunities like mine possible, and hope that the lessons distilled in this summary can be as useful for institutions’ successes as they will be for my own.
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- NACUBO-TIAA Study of Endowments (2022), Commonfund Benchmark Study of Independent Schools (2022), Commonfund Council on Foundations Study (2022)