Endowed Funds Performance and Spending Criteria

1. Endowed Funds Performance and Spending Criteria Steve Birkhofer

2. Endowed Funds Performance & Spending Criteria • Snapshot from 2012 NACUBO study: • Eight hundred thirty-one U.S. educational institutions participated in the fourth annual NACUBO-Commonfund Study of Endowments® (NCSE), for the 2012 fiscal year . • Institutions in the NCSE top decile reported an average one-year FY2012 return (net of fees) of 4.9 percent, a marked decline from last year’s 25.0 percent. By comparison, the entire Study population reported an average one-year return of -.3%. When viewed by type, the participating private institutions accounted for 63 percent of the Study universe and nearly 70 percent of institutions’ total endowment assets. • Against a backdrop of mixed economic news on the domestic front and challenges confronting major economies around the world, educational endowments avoided major gains and loss’ during 2012. • Assuming an average 4.5 percent policy spending rate, a notional estimate of 2–3 percent inflation and 1 percent expenses, institutions will need long-term returns of around 8 percent per year, on average, just to stay even.

3. Endowed Funds Performance & Spending Criteria • Returns & Investment Objectives: • Two investment themes dominated in FY2012. The first was that, with the exception of the large-cap U.S. stocks represented in the S&P 500 Index, equity markets globally had poor or negative returns. The second was that, partly because of the quantitative easing policies carried out by central banks as they sought to stimulate economic growth, active managers struggled to outperform in the face of market volatility and directional shifts. The highest returns for FY2012 came from bonds. • US Equities outperformed most developing and emerging market issues (including China) due to a combination of woes in Europe, a softening economy in China, et al. These issues were coupled with an investor flight to safety (i.e. the USA, in spite of its many problems). Other positive results from the U.S.: strengthening corporate earnings, a trend toward ‘reshoring’ of production and support related activities, and jobs.

4. Endowed Funds Performance & Spending Criteria • PERFORMANCE & RETURNS • The 831 endowments participating in the 2012 NCSE reported an average return of -0.3 percent (all current year and longer-term returns are reported net of fees), 1950 basis points behind last year’s 19.2 percent return. In the two previous Studies, participants reported an average return of 11.9 percent for FY2010 and -18.7 percent for FY2009. In the FY2011 Study, returns were positive for all asset classes and sub-asset classes, and double-digit gains were common. While most asset classes showed positive returns this year, there were some losses; and gains, in general, were much more muted. • ANALYSIS OF RETURNS • Three-, five- and 10-year returns were positive, both for Study participants as a whole and for each of the six size cohorts. The average annual three-year return for all institutions was 10.2 percent, a significant increase over last year’s 3.1 percent. Most of the improvement can be attributed to the dropping of FY2009’s -18.7 percent return from the computation of the trailing three year average.

5. Endowed Funds Performance & Spending Criteria

6. Endowed Funds Performance & Spending Criteria • Public-only institutions produced the highest annual return, 0.3 percent. Returns for all other cohorts were slightly negative; -0.4 percent among private institutions and IRFs and -0.7 percent among combined endowments/foundations • For 2012, the highest asset class return came from fixed income, a gain of 6.8 percent. The lowest return, -11.8 percent, came from international equities, a sharp reversal from last year’s 27.2 percent advance. Domestic equities, last year’s highest performer with a 30.1 percent return, generated a return of just 2.0 percent this year. Alternative strategies returned 0.5 percent versus 14.1 percent in FY2011, and short-term securities/cash/other returned 0.2 percent compared with last year’s 4.2 percent. • Long-term investment objectives for endowed funds were expressed by 66% of survey respondents. The average target is an annual return of 7.4 percent while the median return target is 8.0 percent. Highest average return target, 7.9 percent, was reported by institutions with assets between $501 mil and $1 billion, while the lowest, 6.9 percent, was reported by institutions with assets under $25 mil.

7. Endowed Funds Performance & Spending Criteria • Many institutions tie their long-term return objectives to the Consumer Price Index (CPI) or the Higher Education Price Index (HEPI). A typical response is CPI or HEPI plus an incremental percentage return, usually in the range of 4–5 percent. • UNC Asheville shadows investment manager ‘UNC Management’s’ long term real rate of return target of 5.5% (i.e. net of fees, above inflation, et al). • Investment principles espoused by NACUBO for institutions of all size for stronger long-term returns: • Portfolio should have have an equity bias. • Recognize the ‘time value of money.’ Longer-term capital commitment enhances rate of return. • Greater diversification reduces risk (e.g. inflation), and adds efficiency.

8. Endowed Funds Performance & Spending Criteria • Uniform Prudent Management of Institutional Funds Act (UPMIFA) • UPMIFA applies to funds held for charitable purposes by nonprofit, charitable institutions. • The three principal issues addressed are scope of coverage, investment obligations and expenditure of funds. • Appropriation for Expenditure of Funds: • Subject to the intent of a donor expressed in the gift instrument [and to subsection (d)], an institution may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes, and duration for which the endowment fund is established. Unless stated otherwise in the gift instrument, the assets in an endowment fund are donor-restricted assets until appropriated for expenditure by the institution. • Other Factors to consider: • 1. Duration & preservation of the endowment fund. • 2. Economic climate. 3. The investment policy of the institution. • Has helped to lessen scale of underwater funds in downturn.

9. Endowed Funds Performance & Spending Criteria

10. Endowed Funds Performance & Spending Criteria • 2012’s average rate spending declined to 4.2% from 4.6% in 2011. • The decline in the effective spending rate is largely a result of previous years’ asset value increases, but $ spending continued to rise. This extends from portfolio moving averages’ declining more slowly than the asset values coupled with reluctance to cut spending commensurate with portfolio losses. Conversely, when returns rose in FY2011 and FY2010, the effective spending rate declined. • Comments from a number of smaller institutions reveal caution regarding economic conditions and the budgetary realities imposed by lackluster investment returns, which caused many institutions to make special appropriations to support their operating budgets. Gift flows, in the meanwhile, remained finely balanced, with almost as many institutions seeing a decrease in gifts as experiencing an increase.

11. Endowed Funds Performance & Spending Criteria • 83 percent of NACUBO survey schools with assets between $51 and $100 million and between $25 and $50 million reported using the moving average formula, leading all other cohorts. The lowest incidence of use of this method was 56 percent of institutions with assets over $1 billion; this was up from 53 percent in 2011. • Costs: Items that educational endowments include in their costs, the vast majority—89 percent—include asset management fees and mutual fund expenses. After that, most count consulting fees/outsourcing, at 63 percent and Fifty-seven percent include direct expenses. • Note: UNC Asheville uses a 3 year moving average. In 2012 the spending rate was 5%, and effective spending rate was 4.2% (exclusive of management fees) ; rate coincides with 2012 survey national average. Pooled endowed resources totaled approximately $28 mil.

12. Endowed Funds Performance & Spending Criteria • Underwater Funds: • In the FY2009 Study, participants reported that 22.4 percent of the value of their endowment was in funds that were below their dollar value at the time of donation, or “under water.” The two subsequent years of strong endowment returns substantially lowered the proportion of assets that are under water. By 2011, that had fallen to 4.9 percent of assets. This year’s flat returns saw an increase in this rate, as it rose to 7.1 percent of assets on average. All six size cohorts reported having a higher share of assets under water in FY2012. In FY2011 & 2012, the smallest participating endowments had the lowest proportion of assets under water (6% in 2012 & 3.8% in 2011). • For UNCA, a small cohort school with approximately $28 mil pooled, 2.5% of UNCA’s were marginally ‘underwater’ for FY 2012.

13. Endowed Funds Performance & Spending Criteria • Investment Behavior & Current Trend(s): • From the New York Times (Oct 12, 2012): Endowment envy appears to have fueled the broad transition to the ‘Ivy League’ model. However, hedge funds have underperformed a simple 60/40 stock/bond mix every year for the past 10 years. • “Today, it’s hard to find a college or university that stuck with the older and far simpler allocation between stocks and bonds.” (Note the traditional 60/40 or 70/30 equities to fixed income split). Using the ‘Ivy League’ model, which includes heavy dependence on ‘alternative investments,’ Harvard Univ has generated 12.5% annual returns in the past 20 years. For 2012, Harvard reported a -.05% return while the S&P 500 index returned 5.5%. • Access to the top tier investment fund managers likely to remain restricted to largest endowments. Others using alternative methods likely to achieve mediocre results.