Endowment Management – An Investment Adviser’s Perspective
The endowment fiduciary’s primary task, in my judgement, is the
I. Financial Policy ˛ – An endowment’s financial policy is essentially a set of internal imperatives (external imperatives, in the form of ‘legal lists’ or donative restrictions, for example, may impact as well). However a given endowment resolves the various issues discussed in this essay, it is imperative that the results be embodied in a formal, written record. This document is generally known as an investment policy statement’ and bears periodic revisit and occational revision for any endowment. While this essay does not address the legal context affecting endowments as they construct and implement overall financial policy, it should be noted that most states have enacted two so-called uniform acts (one for endowments organized as corporations and the other for those as trusts) that are directly applicable. Each contain a version of the ancient ‘prudent man rule,’ and both have fairly specific prescriptions and proscriptions about investment policy. Private foundations are also subject prescriptions and proscriptions about investment policy. Private foundations are also subject to certain provisions of the Internal Revenue Code that speak to these matters. Every endowment, large or small, should consult with councel to determine its precise legal context. Two are statistic in nature, in the sense that they do not require frequent review and modification. The first of these is the determination of what I would call an endowed institution’s terminal goal – its expected life. The range of choised runs from perpetuity to, I suppose, ‘as long as the money lasts.’ For most, the answer is self- evident – perpetuity is a demanding goal. Indeed, in my own experience, I have watched a large endowment lose more than three- quarters of its net asset value as a result of overspending during a period of poor performance in the capital markets, yet all the while it maintained an explicit policy of an ‘aspiration to perpetuity.’ The contradiction at least raises a presumption of imprudence, in my view. A second static issue is the creation of an appropriate structure for the management of an endowment. Fundamentally, this is a question of delegation (and accountability) – where will operational responsibility be lodged? A range of choises presents itself: the full board or a subcommittee may retain authority for the investment of the endowment, initiating or at least approving every transaction, or more likely it may delegate the perpetuity. Endowments must also consider other ways of achieving their asset allocation objectives, depending on their circumstances. Unlike pension plans, however, insurance-based approaches offer no promise because in general endowments have no long- term liabilities and therefore no actuarial reason to pay for this means of balancing (or form of intermediation between) asset and liability. For small endowments, mutual funds bring a very sensible way of achieving all of liquidity, diversification and professional management. There really is no better way to put ‘non-institutional’ money to work – the principal reason, I might add, that my own firms uses mutual funds as the sole means for managing clients assets. At the other end of the spectrum lies passive management or indexation. Large pension funds(which are many times the size of large endowments) have increasingly recognized that in various respects they are the market. Therefore, many have elected simply to ‘buy’ the market by allocating most if not all of their equity assets to index funds. Whether or not a large pension fund’s fiduciaries subscribe to the so- called Efficient Market Hypotesis and therefore no longer belive it possible to ‘beat the market,’ transaction costs, which go well beyond commissions, alone make this choice compelling if not imperative. Few endowments suffer from this compulsion, but some have elected to pursue indexation. The Efficient Market Hypothesis(the‘EMH’) states that assuming normally functioning markets, security prices at any given time reflect all known information and thus are, in colloquial terms, fair and accurate. It assumes or implies that investors are rational economic beings. Portfolio Theory in general and its corollary (or predicate), the EMH, in particular have become the prevailing orthodoxy over the last 30 years or so after successfully challenging more conventional, ‘practice’ – based thinking about the capital markets, but recently they have witnessed the arrival of a new heterodoxy called behavioural finance. If Portfolio Theory sprang from the academic field of statistics, behavioural finance comes from the school of social psychology. To explore behavioural finance in this essay would take us too far afield, but suffice it to say that its theorists and practioners say that security prices simply are and never represent some pure standard of accuracy or fairness. To them value is in the eye of the beholder, and since that beholder is generally human and therefore fundamentally irrational, security prices will only coincidentally and occationally represent ‘fair value.’ They point to all of the manias of the last 300 years – from tulips to tech stocks – and say simply, QED. Today, many larger endowments implicity embrace behavioural finance especially in their use of private equity and hedge funds since both presume that securities are systematically misprized. To our network for individual pension plan assets, please have a analysis for you. Further information below.
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