Well-centered investment philosophies drive the success of large foundations and endowments.
Among institutional investors, large foundations and endowments generally are regarded as the investment pioneers, constantly seeking new opportunities for superior returns. Although it can be difficult to stay ahead of other investors, their efforts generally have proven worthwhile.
Foundations and endowments with more than $1 billion in assets posted a median return of 10.28% for the five years ended December 2006, according to Wilshire Associates’ Trust Universe Comparison Service (TUCS). That compares with a 9.06% median return for large public pension funds; 9% for large corporate funds; and 8.31% for the entire TUCS database of more than 1,450 institutional investors.
“Foundations and endowments have tended to be the first to enter into new, more interesting investment strategies,” says Kendall Kay, director of institutional client services at Northern Trust. “They exercise a high degree of professional diligence, skill and prudence with regard to the assets under their direction.”
“You have to be willing to sit in a conference room and listen to a lot of (idea) pitches. We turn over a lot of rocks,” says Mike Patrick, chief investment officer of the approximately $1 billion Meadows Foundation, a Dallas, Texas-based organization that assists local people and institutions with improving the quality and circumstances of life for themselves and future generations.
In the mid-1990s, the Meadows portfolio was 100% allocated to U.S. stocks and bonds, but now up to 40% of the assets are invested in alternative investments, including hedge funds, private equity and inflation-hedging or real assets. “We try to add some spice to our portfolio, but we don’t want to take on an undue amount of risk with the spice,” Patrick says.
One reason foundations and endowments pursue innovative strategies and alternative assets is the return goals they set to fulfill their missions. “Foundations typically attempt to balance short-term grant making obligations with the goal of providing grants into perpetuity,” Kay says. “Many establish a flexible grant-making policy, stated as a percentage of the portfolio value, rather than set an absolute dollar amount year to year.” That flexibility allows investment in more aggressive portfolios and the capacity to endure periods of underperformance.
One reason foundations and endowments pursue innovative strategies and alternative assets is the return goals they set to fulfill their missions.
The Yale University Endowment Fund, considered one of the elite institutional investors in the nation, has actively pursued innovative strategies and alternative assets for decades. Its real assets portfolio, which represents 27.8% of the fund and includes investments in oil and gas, real estate and timberland, has averaged a 17.4% return per year since its inception in 1978. Yale also was the first institutional investor to pursue absolute return strategies as a distinct asset class, starting with a 15% allocation in July 1990.
Other institutions share Yale’s investment philosophy. Harvard University’s endowment allocates about one-third of its assets to real assets, including commodities, real estate and inflation-indexed bonds. Another 18% is in absolute return strategies.
Given their past successes, it’s not surprising that several studies have found that foundations and endowments are expected to remain significant players in the alternative investment universe.
The Commonfund Benchmarks Study 2007 Foundations Report, for example, cites a general interest in increasing allocations to international equity and alternatives among the 279 institutions it surveyed.
“Foundations and endowments have tended to be the first to enter into new, more interesting investment strategies.”
— Kendall Kay
Director of Institutional Client Services, Northern Trust
Raj Gupta, research director at The Center for International Securities and Derivatives Markets at the University of Massachusetts, says he expects two vehicles to attract more institutional attention. The first is special purpose acquisition corporations (SPACs), which raise money through initial public offerings and acquire target companies in a specific sector, industry or geographic location. The other approach is business development companies (BDCs), closed-end funds that take private equity positions in small- and middle-market companies.
Patrick at the Meadows Foundation says he still sees opportunities for hedge funds, particularly those with a disciplined approach to investing. He also says the foundation will continue to explore small- and medium-sized private equity deals, as well as opportunities involving distressed companies.
“Our history has been very selective,” Patrick says. “We like uniqueness of strategy, but that strategy has to be readily understandable.”
Although it remains uncertain as to which strategies and asset classes will provide the best returns in the future, one thing is for sure: large foundations and endowments likely will lead the way.