Independent schools have been faced with fundamental shifts in their business model and have adapted to stay true to their educational missions. This year has been particularly difficult for many schools with the onset of the COVID-19 pandemic.
Commonfund, in partnership with the National Business Officers Association (NBOA), recently released the annual Commonfund Benchmarks Study of Independent Schools (CSIS), which reports on investment and governance trends at independent schools in the U.S. and Canada. In this year’s report, we identify key data trends that have emerged from years of data collection and analysis, including looking at asset allocation, spending, gifts, and investment governance, and how these turbulent times are influencing investment policy decisions.
We decided to take the 2020 CSIS data, along with our deep knowledge of the Independent School ecosystem and the many strategic conversations with investment committee members and senior investment staff, and lay out some considerations to the following question:
What are some of the strategic decision-making considerations that investment committees and senior investment professionals at Independent schools are focusing on during these uncertain times?
Focus on long-term strategic investment objectives
Long-term strategic policy portfolios are typically aligned to support a school’s overall objectives. Return objectives can vary from institution to institution, although broadly, the overall objective is to achieve inflation + distribution or CPI + 5 percent which translates to an overall objective of 6.8 percent (5 percent distribution + 1.8 percent inflation or CPI). This is, admittedly, a tough bogey. Primarily, long-term perpetual pools need to have an equity bias, take advantage of diversification (which has been challenged in recent years as stocks have soared) and consider illiquid investments to take advantage of the liquidity premium, or extra return, that they offer. Also, while 2020 was a difficult environment, data shows that those independent schools that remained disciplined and at target through rebalancing/cash flows benefitted.
Policy Levers are a major driver of success
Broadly, for those investors that are comfortable allocating to illiquid strategies and have a defined liquidity budget, re-commitments to new investment funds have been strong across asset classes to include private equity and venture, allowing these investors to take advantage of recent dislocations. For investors that do not invest in private capital, committees are evaluating this asset class. We have experienced one of the longest stock bull markets in history and the expectation has been that this would end (at some point!), so finding alternative sources of returns is very much on the radar for smaller investors, which is consistent with the CSIS data broadly.
Interestingly, we have observed in the CSIS that smaller investors with higher allocations to U.S. equity markets and fixed income—mostly liquid portfolios—have been top decile performers. Although it is tough to make a case to fix what isn’t broken, we believe that long term there is compelling evidence that alternatives can be beneficial and generate alpha within institutional portfolios, driving long-term success.
Spending is one of the most powerful policy levers—most independent schools that Commonfund works with are generally in the 4 to 4.5 percent range. Pre-COVID, investors had frequent discussions on maintaining spending at these levels—could it be reduced? In that case, other revenue sources need to be found putting pressure on the development/fundraising side and other revenue sources. There have also been plenty of discussions on spending post-COVID—will it need to be increased and, if so, to what extent and for how long? 2020 was a challenging year for schools and this upcoming year will be critical as it relates to enrollment and fundraising. Spending, along with investment returns and gifts are the three major strategic buckets to consider.
The Study highlighted a decline in overall gifts across schools of all sizes. One of the Viewpoint articles in the 2020 CSIS, “New Gifts to Endowment: Why the Decline?”, explores the possible drivers of this wide-spread decrease, including tax changes, and especially this year, gifts specifically focused on supporting families, students and extended school communities impacted by COVID-19. Unrestricted gifts to the endowment have the largest impact on the long-term success of the endowment, but these gifts are the hardest to come by. All gifts are beneficial, but they have different impacts.
One of the best things a school can do is craft and implement an Investment Policy Statement (IPS) and commit to reviewing this critical document annually to retest the various objectives and assumptions. Do they still stand true? The IPS takes the emotionality out of these discussions and should help to avoid short-term reactions to volatile markets. Whether it is a single pool or multiple pools, the business office and Investment Committee(s) can use these documents to stay focused on long-term strategic objectives, especially during times of uncertainty.
There are many types of risk to consider, such as liquidity, oversight (especially in a virtual world), operational and the overall risk of not achieving the level of return needed to support your mission. In the event of a significant drawdown, how long will it take your portfolio to recover for the least amount of impact to spendable dollars? At Commonfund, we use various models to assist investors in defining risk, which can help Committees facilitate a discussion on what this means to their specific institutions.
Commonfund defines the endowment model as having an equity bias for growth, diversification to reduce risk and capturing the illiquidity premium. We believe in active management combined with passive strategies for specific reasons, i.e., for short-term liquidity or to access cost-effective beta (market returns), within our funds or client portfolios. In the 2020 CSIS nearly two-thirds of responding schools choose active management over passive in U.S. Equities despite the challenges of achieving outperformance over the past few years. The Equity Risk Premium (ERP), or the extra return that is available for investing in stocks, does still exist—it measures the implied S&P500 forward earnings yield vs. 10-year T-note yield—given that the recent decline in bond yields has pushed the ERP to increasingly attractive levels, the depth and duration of market disruptions will be a key driver of valuations going forward.
The CSIS and being a part of the NBOA community demonstrates that we can all learn from one another—markets are fluid and dynamic—often the best approach is maintaining discipline. Commonfund continues to believe in the long-term orientation of strategic asset allocation, especially for perpetual pools of capital that are designed to maintain intergenerational equity. While it can be tempting to tinker with portfolio allocations when there is uncertainty, we must remember that staying the course is also an active decision, and in the words of Commonfund’s CEO and CIO Mark Anson, “one that requires both patience and prudence.”
View our session from the 2021 NBOA Annual meeting where we discuss these topics in depth with Paul Silva, Chief Financial Officer, Cushing Academy.