sophisticated internal teams, averaging over 10 investment professionals. These teams tend to be well experienced and highly compensated, allowing them to manage some of the assets in-house as well as recommend investment managers. Whereas 79 % of the largest endowments employ a chief investment officer (CIO), less than 3 % of endowments with less than $100 million in assets employ someone whose full-time role is to oversee the endowment portfolio.
In addition to internal staff and an investment committee, many endowments employ external consultants. In 2011, NACUBO estimated that 79 % to 94 % of endowments with between $25 million and $1 billion in assets, and 68 % of the largest endowments, employed consultants. A non-discretionary investment consultant makes recommendations to the endowment on asset allocation, manager selection, and a wide variety of other issues, but leaves the ultimate decision to a vote of the investment committee. There is growing use of the outsourced CIO (OCIO) model, in which the endowment gives discretionary authority to an external consultant who may make and implement prespecified decisions, such as manager selection and asset allocation decisions, without taking those decisions to a vote. Endowments with smaller internal teams appear to find the outsourced CIO model attractive, as between 42 % and 62 % of endowments with assets below $100 million had hired OCIOs by 2011. The trend toward hiring OCIOs accelerated after the 2008 financial crisis, when investors realized that tighter risk controls and quicker rebalancing decisions were needed. Williamson (2013) reports that global OCIO assets under management had reached $1.066 trillion by 2013, including $619 billion in the United States, a growth rate of 59 % in just two years. In addition to small endowments and foundations, corporate pensions with liability-driven investing targets are increasingly likely to hire an OCIO.
The Commonfund Institute (2013) notes a number of benefits to hiring an OCIO, especially for endowments that are devoting ever-larger allocations to alternative investments. An OCIO firm will have a large staff and significant infrastructure resources that are shared across all its clients. This institutional-quality firm has resources that could not be afforded by smaller investors. There are economies of scale in manager research, as hedge fund and other alternative managers can visit the consultant or OCIO firm rather than visiting the dozens of underlying investors. The OCIO firm can be cost-effective when compared to attracting, training, and retaining investment professionals, who may be difficult to find and retain in a market where there is a growing demand for those who have experience managing foundation and endowment assets. For investors who do have staff, the OCIO may help train and educate that staff. Whereas 44 % of investment decisions take more than three months when an investment committee retains discretion, the OCIO model can make investment and rebalancing decisions on a far more frequent basis.
Lord (2014) studied the common factors shared by the largest and most successful endowments. Ideally, the investment committee would be staffed by investment professionals and others who have experience serving as corporate executives or board members. If those investors have experience in alternative investments and a wider variety of investment strategies, the resulting portfolio tends to be more diversified and experience higher risk-adjusted returns. Investment committees with significant representation from donors or employees of the universities tend to have lower allocations to alternative investments. Decision-making is improved when committee members have multiple perspectives and an ability and willingness to openly debate issues. When adding new members to the investment committee, endowments should seek members with knowledge and experience that differ from those of current committee members. Finally, top-performing endowments have a commitment to educating staff and committee members on new asset classes before allocations are made.
3.5 Risks of the Endowment Model
When applied by the largest investors, the endowment model has created impressive returns over the past 20 years. However, this style of portfolio management comes with a special set of risks. First, portfolio managers need to be concerned about the interactions among spending rates, inflation, and the long-term asset value of the endowment. Second, a portfolio with as much as 60 % invested in alternative assets raises concerns of liquidity risk and the ability to rebalance the portfolio when necessary. Finally, portfolios with high allocations to assets with equity-like characteristics and low allocations to fixed income require the portfolio manager to consider how to protect the portfolio from tail risk, which is a large drawdown in portfolio value during times of increased systemic risk.
3.5.1 Spending Rates and Inflation
There is an important tension between the spending rate of the endowment, the risk of the endowment portfolio, and the goal of allowing the endowment to serve as a permanent source of capital for the university. When the endowment fund generates high returns with a low spending rate, the size of the endowment fund increases. This may lead to concerns about intergenerational equity, as the spending on current beneficiaries could likely be increased without compromising the probability of the endowment continuing into perpetuity. Conversely, a conservative asset allocation with a high spending rate may favor the current generation yet imperil the real value of the endowment in the long run.
Kochard and Rittereiser (2008) present a history of endowment spending models. From the founding of the Harvard University endowment in 1649 until the 1950s, endowments were typically managed conservatively, with a focus on earning income from a fixed income–dominated portfolio. It was clear what the spending rate should be, as the entire portfolio yield was typically paid out to support the programs of the university. When bonds matured at face value, the notional value of the corpus was maintained. This sounds relatively straightforward, as the current beneficiaries received a strong income, and the requirement of maintaining the nominal value of gifts made to the foundation was easily achieved. Unfortunately, this conservative asset allocation earned little in the way of real returns, and the focus on minimizing drawdowns led to a low total return and stagnation of the nominal value of endowments.
Between the 1950s and 1970s, this conservatism began to fade. Rather than spending the income generated on the portfolio, endowment managers came to embrace the concept of total return. Consider a fixed-income portfolio with a 5 % current yield, which allowed a 5 % spending rate. Though the yield was high, the nominal return to the portfolio, net of spending, was zero. In this scenario, the spending needs were easily met, yet the value of the endowment declined in real terms, as the goal of maintaining the real, or inflation-adjusted, value of the corpus was not achieved. In seeking to maximize the portfolio's risk-adjusted return, a total return investor (i.e., an investor who considers both income and capital appreciation as components of return) may realize that a 5 % current yield is not needed in order for the endowment to have a spending rate of 5 %. Moving from a portfolio dominated by fixed income to one with a healthy mix of equity investments may reduce the yield to 3 % while increasing total return to 7.5 %. With a total return of 7.5 %, including income and capital appreciation, the endowment can afford a spending rate of 5 % while maintaining the real value of the portfolio, as the 2.5 % return in excess of the spending rate can be used to offset the impact of inflation. In order to generate 5 % spending, the entire income of 3 % is spent, and 2 % of the portfolio is sold each year to meet the spending rate.
The investing behavior of endowment managers began to change between 1969 and 1972. The 1969 Ford Foundation publication Managing Educational Endowments suggested that endowment portfolios had previously invested with overly conservative asset allocations. Endowment managers were chastised for building underperforming portfolios that were underweighted in equities, not celebrated for serving the university by reducing the risk of loss. The publication proposed that trustees might have imperiled the university by forgoing higher returns that could have increased both the income and the corpus of the endowment. The 1972 Uniform Management of Institutional Funds Act subsequently allowed endowment managers to consider total return when setting the spending rate. The act also allowed the use of external investment managers and encouraged trustees to balance the long-term and short-term needs of the university.
It was during the bull market in public and private equities, from 1982 to 2000, that endowment managers dramatically increased
