DATELINE: June 23, 2009, Chicago
College, university, and other endowments certainly have taken a hit during the last year. We all know the numbers—25% to 40% declines in value. We all know the consequences—insufficient cash flows, inability to access principal due to lock-ups, possible UBIT as a result of borrowings, and shortfalls in program funding.
But what should really be bothering investment committees is the fact that...
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the hedge funds, portfolio insurance, and active management didn’t result in endowments outperforming the market. For those lousy results, institutions paid high fees and incurred large monitoring costs.
According to an article in yesterday’s Wall Street Journal, some institutional investors have taken notice and are now responding. Craig Karmin, Active Managers Get the Cold Shoulder (June 22, 2009). According to a Karmin, both institutional and individual investors are taking a skeptical view when it comes to active portfolio management. People are abandoning investment managers, replacing them with index funds, which could include exchange-traded funds (ETFs). The strategy makes sense. Active managers can charge up to 10 times the amount in fees that index funds do. Study after study shows that most asset managers don’t outperform the markets over the long term. There also are studies that prove that past performance is not a predicator of future returns. Those studies show that those managers who are in the top quintile during the previous measurement period are unlikely to be there during the next measurement period.
While most professionals and academics agree that the efficiency of the markets has been overplayed, they also agree that it is difficult to consistently capture returns derived from the inefficiencies that can exist in new investment vehicles and markets, as well as inefficiencies identified by behavioral economics. Given those realities, investment committees should at least consider indexing as a strategy.
Indexing doesn’t eliminate allocation decisions entirely. The investment committee must still decide to how to allocate endowment assets among various asset classes represented by index vehicles. The committee must also establish rebalancing procedures and protcols. This can still require outside advice, but investment committees may be able to avoid tiers of investment managers and their fees. The committees also must examine indexing vehicles carefully. ETFs, for example, traditionally have been viewed as indexing vehicles. Many are, but there are a growing number that have elements of active management.
Karmin’s article focuses on pension funds. It doesn’t specifically mention endowments, but the implications for endowments are plain as day. If this trend does take hold, it could result in a massive realignment for Wall Street and money managers across the country. Karmin notes that public pensions are a $2.3 trillion industry—we assume he is referring to assets under management. The smart investment professionals are recognizing what may be about to happen. Karmin notes that the acquisition by BlackRock of Barclays PLC’s Barclays Global Investors is recognition by BlackRock that indexing will become more important as institutional investors attempt to cut fees.
To date the trend has been inspired by what Karmin refers to as “long-only” accounts. These are accounts that invest in stocks and bonds. The implication being that the trend has not hit hedge funds yet.
Bottom line: Investment committees should be taking a serious look at indexing vehicles. To facilitate that review, the committees should examine metrics that reveal the impact of fees paid to investment managers and monitoring costs on past portfolio returns.
| THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NONPROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL.
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