Endowment Matters

Price Increases versus Inflation: The Reality

This weekend's issue of the Financial Times includes a column entitled "The Week in Numbers" at the end of the first section.

A key figure cited: 16%. The index of meat prices of the UN Food and Agriculture Organization is up 16% over the past year. What is more striking, for those who eat lamb somewhat regularly, is that lamb prices have reached a 37-year high.

Yet we are told that inflation is almost non-existent. My understanding of economics is that inflation is an increase in the money supply; that we have, to be sure. The meat figures cited above represent price increases, which are sometime referred to as inflation (I myself use that term loosely, sometimes).

So, we find ourselves in an environment in which, we're told, core inflation is near 0%, yet here we see that the meat index is up 16% in the past year. I have highlighted this issue before: the CPI number, we must remember, excludes food and energy prices.

There are two lessons here:

(1) commodities can be a valuable piece of the puzzle when it comes to an overall endowment strategy

(2) when independent schools set tuition rates based on CPI, boards of trustees might do well to take a broader look at the increase in prices of goods that are not included in the CPI number. If your school is raising tuition at CPI+2, you may be creating a deeper imbalance in families' pocketbooks by overlooking the fact that they're probably paying more for basic needs (food, for example) than ever before.

Question: how might this scenario affect your endowment strategy? Are you still willing to leave endowment growth on the back-burner?

Outlook on Endowments 2010 to 2014

The next several years will be incredibly difficult ones for endowments, in terms of generating substantial returns. With nothing but economic uncertainty in front of us, here are some suggestions as we muddle through:

• Expect volatility, sometimes severe. Geopolitics will play a role in your endowment portfolio like never before.
• Be sure that your endowment has a good portion of equities with a history of on-time payment (and/or increase) of dividends.
• Do not expect a significant increase in the prices of your assets, what is termed "price appreciation." If there is price appreciation, take it to the bank, but plan for little to none.
• For the fixed income portion of your endowment, screen out as many mortgage-backed securities as you can. This market is exceedingly volatile, and there could easily be further changes to the MBS (mortgage-backed securities) that would be deleterious to the MBS industry.
• Consider allocating some percentage of your fixed income portfolio to TIPS, treasurys that are inflation-indexed.
• Don't put great stock in the CPI numbers that are released, which will indicate low inflation. Some reports have identified inflation as being expected to average 1.6% (approx) over the next ten years. Don't forget that "core inflation" numbers do not reflect food and energy costs; these are expected to rise. Independent school families need food and energy, which means that these prices affect what they will be willing to pay for tuition more than the CPI figures, the prediction of which is questionable at this point. Read my white paper, "The Deleterious Effects of Inflation" for more information.
• Continue to maintain a portion of your endowment in cash. Your investment committee should determine what this allocation should be, but try to make it significant. Here is the reason: should your school need immediate access to cash, it's nice to have it on hand without having to worry about liquidation of equities at a loss. A basic guideline to use is to determine how many days in cash you would need to be in order to continue operations for three to six months. Then, look at your projected cash flow from normal tuition payments, discount it by 25% and use that 25% figure as the target for how much cash you should have. This projection would give you enough cash to continue operations should 1/4 of your tuition payments cease for a period of three months (or six, if you wish to be extra-conservative financially).
• Continue to funnel dollars into your endowment via a budget line item in your annual operating budget plus a minimum of 10% of your annual fund (25% would be better).
• If your endowment is small (<$2 million), don't plan for an endowment draw. There is no IRS rule (not yet, at least) which states that you must take a draw. If your endowment is >$2 million, convince your finance committee to take as small a draw as possible: perhaps 2%. Since these amounts are very small, it would be better to plan for them in terms of hard dollars (tuition revenue) rather than taking a draw from your endowment. Remember: you need to maintain the endowment for the long haul, and it's not going to grow if you continue to draw it down. Short-term pain = long-term gain.

Maintaining stability is the name of the game right now. Recent economic history (the last twenty years or so) shows us that we have a recession, on average, about every four to six years. That means that--potentially--we'll be due for another one sometime between 2011 and 2013. Take the time now to revisit your endowment strategy, and, if you haven't altered course, consider the implications of a possible recession in the short-term and how that might affect your operations. Then plan for it.

Portfolio Challenge

Just for the fun of it, I'm going to propose a fictitious endowment for a fictitious school, and we'll keep track of the school's endowment value on a quarterly basis of a typical fiscal year.

Some basic parameters of this endowment:

(1) gold = gold bullion, not shares in GLD or similar gold ETF

(2) no dividends or interest

(3) annual draw will be 4.5% of US Dollar value of corpus, taken on 6/30 of the first full fiscal year (in this case, 6/30/2010). X ounces of gold will be sold at spot on that date, corresponding to 4.5% of the value in US Dollars.

(4) school has an annual fund of $500,000, 15% of which will be directed to endowment as of 6/30 (end of fiscal). The 15% will buy x ounces of gold at spot.

(5) this portfolio challenge is not meant to be overly-technical, just fun, and perhaps we'll all learn something in the process (in regards to using gold as an endowment barometer).

Independent Academy

Endowment: 2,500 troy ounces of gold

Starting Dollar Value as of 6/30/2009: $2,321,250   (New York close of $928.50/oz.)

Dollar Value as of 9/30/2009: $2,515,000    (New York close of $1,006) +8.3% from 6/30

Dollar Value as of 12/31/2009: $2,741,250   (New York close of $1,096.50) +18.1% from 6/30

Dollar Value as of 3/31/2010: $2,781,500   (New York close of $1,112.60) +19.8% from 6/30

Planning for an Endowment Crisis

Niall Ferguson had a great article in today's Financial Times, addressing the sovereign debt crisis in Greece, which is affecting the European Union. He submits that it's only a matter of time until a similar crisis erupts in the US.

School leaders would do well to consider the potential implications, were such a crisis to occur in the US. The question is this: how can schools best hedge against this kind of crisis in terms of endowment management? If you haven't engaged your asset manager in a discussion of this sort, I would suggest that you do so sooner rather than later, as it may take time for him/her to 1) propose a new asset allocation and 2) execute the reallocation over a fixed period of time. As one example, George Washington University decided last year to reallocate their portfolio to allow 30% of funds to be invested in natural resources and commodities.

How active is your management?