“Foundation & Endowment Investing”by Lawrence E. Kochard and Catheleen M. Rittereiser

Background

This book is based on a series of interviews with Chief Investment Officers (CIOs) of a dozen of foundations and endowments.  The purpose of this blog is to summarize some lessons that individuals may be able to learn from these CIOs.

“Foundations and endowments have become investment powerhouses, managed by sophisticated investors using advanced investment techniques. Despite a smaller asset base than pension funds, they have become increasingly influential institutional investors because their long-term perspective gives them the latitude to take more investment risk and the impetus to adopt new asset classes and strategies before other investors.”

The primary difference between foundations and endowments is that the foundations are established with a pot of money and no further funds are added to it, whereas endowments can fundraise on an ongoing basis. Foundations are usually established for charitable purposes by an individual or a family, whereas endowments are public charities (i.e. many donors) for example for purpose of education. Time horizon is usually perpetuity for both, though foundations it could be finite. Foundations are required to spend a minimum of 5% of assets annually in order to protect their tax-free status, and but both may have to spend even more depending on the needs of the beneficiary.

It’s an interesting and informative book, as you learn about the character of the various CIOs and their investment approaches.

Lessons for individual investors:

-retired individuals have a lot of similarities with foundations: (1) no asset refills, (2) must make the annual payout to cover expenses, and (3) have some spending flexibility; foundations have been able to live with the (minimum) 5% withdrawal restriction and survive for generations while preserving principal and payout to beneficiaries (the expected real value of foundation assets and payout will decrease/increase by the percent that 5% is greater/smaller than the real return of the portfolio-which is a function of the asset allocation)

-Asset Classes: (1) U.S. public equity, for long-term hedge against inflation  (though poor short-term performance when unexpected flare-up of inflation) and equity risk premium, (2) Non-U.S. (international) public equity for performance and currency diversification, (3) Fixed income (intermediate and long-term) -investment grade for deflation protection , (4) Fixed income –non-investment grade for enhanced return (5) Cash as source of low risk for cash-flow needs, (6) Real assets as hedge against inflation (real estate, real return bonds, commodities, timber/farmland), (7) Private equity for  higher return than public equity (430 bp liquidity premium over public) and (8) Absolute returns   for (hopefully) lower volatility (arbitrage, long-short, distressed, event-driven, etc). Emerging asset classes: intellectual property, litigation finance, frontier emerging markets

-Asset classes: “the traditional asset buckets don’t make as much sense today…it is harder to understand correlations among buckets” and “borders of asset classes are melting away”

-Asset class- attractiveness: three ways to make money: (1) yield, (2) earnings growth and (3) multiple expansion

-Benchmarks- In addition to the usual index weighted policy allocation (1) for alternatives a spread (e.g. 350-600 bp) over 3 month T-bills, (2) spend rate (e.g.  5%) plus inflation, or (3) 30/70 or 60/40 passive benchmark, and of course (4) peer comparisons

-Asset allocation- The best asset allocations (in decreasing order of merit) on a risk-adjusted return basis (Sharpe ratio, SR, measure) are those which are “highly diversified with most specific exposure to alternative investments”: 85/15, 70/30 and 60/40 having SRs or 0.51, 0.49 and 0.48 respectively. The 15, 30 and 40% represent U.S. fixed income, with the balance split between 35-42% U.S. an international equity, and absolute return, hedge funds, VC/PE, REITs, real estate and commodities. (Fig. 1.1 compiled by Cambridge Partners)

-Rebalancing is critical- it helps you sell appreciated asset classes and buy ‘on sale’ ones

-Return sources: leverage, beta (market-passive), alpha (active)…

-One of the few things that you can control in investing is price (mistake is getting into investments at the wrong point in their life-cycle)…one of the most difficult thing in investing is getting the timing right

-Core-satellite works well- core could be low cost index/passive, while satellite can be concentrated portfolios (make sure you pick the “right” managers- more important than the right asset class); individuals unlike institutional investors,  have greater difficulty with selecting top managers of for alternative asset classes, where the dispersion of returns is even greater than for classical asset classes

-Evaluate: return generators, inflation hedges, deflation hedges

-Market is not efficient

-When there is a SALE (market swoon), everyone runs away

-Business Week and Economist are great contrarian indicators

-Contrarian thinking- finding places where there is more opportunity than capital

-Theme rather than asset based:

-40-50% market exposure (beta)

-15-25% risk reducers (hedge funds, fixed income)

-15-25% returns enhancers (private equity, emerging markets)

-15-25% inflation hedge (TIPS, real assets, infrastructure, commodities)

-Themes- long-term:

-energy + natural resources

-wealth shift from developed to developing world

-growth of Asian consumer

-Japan/Germany reflating economy

-heath care

-Defense! When “measure of risk is flashing warning” get hedged & move to absolute returns

-Lessons-other:

-tactical asset allocation with overlays

-search for (new) ideas? Next asset class

-strong asset allocation, and diversified portfolio of uncorrelated assets

Quotable quotes:

-“Selling is transferring your enthusiasm to other people”

-“The turtle does not move forward if it doesn’t stick its neck out of the shell”

-“Hedge funds are not an asset class, but a compensation scheme”

-“You’ll find it harder to find heroes as you get older”