Safer Bets

August 10, 2011

Over the past few weeks, the financial world has had everyone on edge. First there was the weeks-long debate about whether the federal government would increase the national debt ceiling or potentially default on its obligations. That was followed by Standard & Poor's announcement Friday that it would downgrade the U.S. sovereign debt rating. Thursday and Friday saw significant losses in stock market indexes, compounded by big losses in Europe and Asia.

So when the Dow Jones Industrial Average dropped 635 points on Monday, the sixth-biggest point drop in its history -- putting it close to a 10-month low -- many in higher education began to wonder whether financial markets, along with their colleges' and universities' endowments and employees' retirement funds, are about to free-fall like they did in 2008.

"If I were still a CFO, I'd be watching this on a daily basis," said Larry Goldstein, a longtime CFO who is now a financial consultant to colleges. "I wouldn’t be making decisions on a daily basis, but I'd be having conversations with my board on a periodic basis asking if we want to do anything differently."

Tuesday's market -- which started out rallying, took a big dive in the middle of the day, and rallied again before the market closed to show a 4 percent gain on the day -- showed that there is still significant uncertainty in the air when it comes to financial markets. But numerous observers say that even though university endowments still hold many of the risky assets that led to big losses in 2008, the current market losses are structurally different than in the last crisis, and university administrators, employees, and students have less to worry about.

"What we're seeing now seems to be more like a crisis of confidence than a crisis of the economic system," said John S. Griswold, executive director of the Commonfund Institute.

Most university endowment managers have policies that prohibit them from discussing specifics of current investments, and none of the colleges and universities contacted for this story would comment on how the recent losses might have affected their portfolios. But consultants who work with institutions and other investors said the past few days haven't given them too much reason to panic. Endowment management, they say, is a long-term game. The losses that happened over the first week of August will likely blow over, and universities that have a consistent approach to investing and risk management (and stick to it) will likely be fine, they say.

Several involved in endowment management did say that colleges learned some lessons from the last crisis that will help mitigate the effects of the current market losses. Scott Wise, president and chief investment officer of Covariance Capital Management, a subsidiary of TIAA-CREF that provides endowment management services to educational institutions and other nonprofits, said the 2008 crisis served as a wake-up call for many institutions to better manage risk, particularly liquidity, which should help them avoid problems this time around.

"Some of these institutions hadn’t paid appropriate attention to those items like liquidity management before 2008," he said. "You want to make sure you're not sort of addressing those issues on the fly."

Well before the last downturn, many institutions had begun investing in nontraditional assets, including hedge funds, real estate, and private equity, a strategy that led to big returns for many years, but also created big losses when the market collapsed in 2008. The NACUBO-Commonfund survey found that college endowment returns dropped by 22.5 percent in the first six months of the 2009 fiscal year.

One might think that universities would shy away from those riskier assets after the collapse, but the annual survey showed that the share of endowment assets in alternative investments actually rose from 46 percent in 2008 to 51 percent in 2009. "This indicates that a number of institutions were using the last major downturn as an opportunity to acquire assets at temporarily depressed prices," said Ken Redd, director of research and policy analysis for the National Association of College and University Business Officers, which conducts an annual survey of endowments.

Despite the risk, consultants said that investing in such alternative funds has become an essential part of most portfolios. "The returns are too great," Goldstein said. Smart institutions, consultants say, will see the current market losses as an opportunity to acquire even more of these assets at discount rates.

Some colleges have been more "conservative" with their investments over the past few years as a result of the 2008 downturn, Griswold said, noting that institutions are holding larger pools of cash.

Another reason the losses seen in the market over the past few weeks are less of an issue is that most states have made structural reforms to accounting laws that give universities some flexibility when it comes to spending endowment returns. The Uniform Prudent Management of Institutional Funds Act (UPMIFA), which has passed in most states, eliminates legal constraints that have historically limited colleges from spending from "underwater funds" -- investments for which the current market value has declined below the original value -- letting colleges spend based on total portfolio returns. Before the act, most institutions were severely restricted in their ability to use funds from underwater endowments.

The losses seen on Thursday, Friday, and Monday could also end up being short-term. "As grim as it seems, the economy isn't going to tank overnight," Griswold said, noting that companies are making profits and hiring. "There are still plenty of markets consuming."

Unlike in the 2008 crisis, the market losses haven't led to a freezing of credit, which was part of why the 2008 crisis was so widespread. Because the problems now are still mostly in the stock market, endowments are all that will likely be affected, and most institutions don't rely too heavily on returns as a substantial part of their budgets.

But because there is still uncertainty and volatility in the market, consultants and investors said, colleges should get a better sense of where the market is heading before making any significant changes in their strategy.

"My guess is that institutions generally are in a 'wait-and-see' mode and will wait until more information becomes available before making any substantial alterations in their investment plans," Redd said.

Goldstein said the current market volatility is also an opportunity for institutions to work on better communicating investing strategy to employees, something many business officers in a recent survey by Inside Higher Ed said they do poorly. A lot of people are probably wondering what's going to happen to their university's budget, he said. "This to me is the classic opportunity to have a conversation with folks in English -- in a way that the typical faculty member who isn’t trained in business could understand -- about the implications of this."

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