The Endowment
Note on Calendar 2009 Performance
There have been questions lately about the “endowment model” of investing and, given the losses by endowments in fiscal 2009, whether the approach of investing a significant amount of an endowment in illiquid (“alternative”) investments is flawed. There is, in fact, no single or universal “endowment model”. At Rochester, the “endowment model” is characterized by a highly diversified portfolio constructed over long time periods, on a manager-by-manager basis. Rochester’s investment managers, whether they fit into the alternative or traditional classification, follow a fundamental approach to managing their portfolios, without reliance on market timing or highly active trading (otherwise called “betting”).
A question remains, however, whether relatively large allocations to illiquid assets (private equity/venture capital/distressed and real assets) in an endowment portfolio, along with traditional buy-and-hold bonds and stocks, is appropriate over the long run. Positioning for the long run is the mandate for every endowment. Evidence suggests there is significant benefit in the strategy of including illiquid investments in an endowment, even after the disappointments of 2008. The benefit of this approach, in one recent example specific to Rochester, is found by comparing endowment performance to the S&P 500 Index. The S&P, if purchased ten years ago and held through June 30, 2009, would have lost approximately two percent per year. On the same basis Rochester’s endowment returned 5.7% per year, net of all fees. Rochester’s illiquid/alternative investments returned 10.5% per annum, net of fees for those ten years. So why not 100% alternatives? Rochester, like most endowments, allocates its portfolio to both traditional and alternative managers, in recognition of the tendency of returns from public securities to revert to their mean over time. Thus, continued exposure to domestic stocks is certainly appropriate in view of the poor return from the S&P over the past decade.
There are important considerations of liquidity with alternative investments. The current concern is that, in order to capture the superior returns offered by illiquid strategies, a few endowments have allocated too heavily to those investments, which caused them problems in the short run. Rochester avoided this because its illiquid allocations and commitments are not higher than the average large endowment. Rochester’s liquidity was sufficient in recent years, albeit a bit tighter than at any period in the past decade. In addition to questions on the “endowment model” and the resulting liquidity tightness, the recent recession also revealed that a few major endowments made substantial and prescient moves into U.S. Treasuries in 2008, which reduced their fiscal 2009 losses to approximately 16%, from the more typical 20% range. For market timing to work, it must be executed twice, lest a subsequent recovery be missed. As the current recession begins to recede, Rochester’s Investment Office, with campus leaders and the Investment Committee, will continue to take an objective look at the question of whether a portion of Rochester’s endowment should be “de-risked” after long periods of outperformance against the expected returns from a diversified portfolio (the current expectation is 8%). The endowments that timed the market in 2008 deserve credit for doing it well, but that isn't what managers of a permanent endowment ought to be doing. Most likely, as time passes, the "endowment model” strategies will be proven correct, at least for larger endowments with the ability to identify and execute them.
Rochester’s investment performance for the eight months ending August 31, 2009 was approximately 5.3%. This is significantly below the benchmark return of 17.1%. Since 80% of the benchmark consists of public stocks, and Rochester's portfolio contains 33% public stocks, Rochester’s performance will not keep pace during market rallies. Long-term holdings such as private equity and real assets have little or no correlation to the short term performance of public equity markets. If current conditions continue, it appears a return of above 8% will be achieved in calendar year 2009. The benchmark return (which is 80% weighted to public equity) may exceed this estimate.
Results from major asset classes for the eight month period are as follows:
• The domestic equity benchmark returned 16.7% for the period as measured by the Dow Jones Total Stock Market Index. Rochester’s domestic equities, representing a 16% allocation, outperformed for the period, returning 21.2%.
• The international equity benchmark returned 29.7% as measured by MSCI ACWI ex-US Index. Rochester's international equities, representing a 17% allocation, underperformed, returning 26.6%. This was a result of Rochester’s somewhat lower (but growing) allocation to emerging markets when compared to the benchmark.
• Fixed income (a 13% allocation, including cash) returned 7.2% versus 4.6% for the fixed income benchmark, thus Rochester outperformed here as well. Rochester’s credit-oriented allocation contributed to the out-performance.
• Rochester’s hedge fund investments, largely because of their ability to quickly seize upon market opportunities, returned approximately 15.6% for the eight months ending August, nearly equaling the return of the US equity benchmark. Hedge funds now represent an allocation of 22%, a decrease from 25% in June, 2009, resulting from rebalancing.
Despite the strong performance of hedge funds, Rochester’s alternative
investments, as a category, reflect a loss of 3.8% for the eight month period,resulting from changes in the values of partnerships invested in private equity and real assets. The revenues and earnings of the underlying holdings of these partnerships are not immune to the forces of a recession, and valuations can decline as a result. Rochester recorded, in the early months of calendar 2009, "mark-to-market" losses arising from the 2008 calendar year-end revaluations of its partnerships. These partnerships, even after recording the 2008 losses, have outperformed public equities over longer periods of time (5+ years) and are expected to continue to do so. These partnerships also tend to generate their best performances, and return substantial sums of capital, in the years following a recession, largely due to opportunities that arise in weak economic conditions.
