NACUBO: What Could Be Missing?

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00:00 - 00:21

The annual Nacubo study of endowments is out and we are excited to dig through it. But here's the thing it's narrowly focused on long horizon portfolios of college and university endowments, and it only actually covers 13% of the higher ed sector at that. So while there are plenty of lessons still to be learned, we really do need to ask the question what could be missing here?

00:30 - 01:09

Hi everyone. Welcome to Inspired Investing. I'm your host, Claire Golla, head of Foundation and Institutional Advisory at Bernstein. This podcast is where we strive to connect and share insights with listeners like you who are engaged in the nonprofit sector, philanthropy and or the broader social sector. Today, I've invited my colleague, Greg Young, senior investment strategist, to help me unpack the findings from this year's hotly anticipated Nacubo study. Frequent listeners may recall that Greg joined us last year to help break down the results and specifically as they applied to smaller organizations. So Greg, you did such a great job last year. Welcome back.

01:09 - 01:11

Yeah, thanks, Clare. Glad to be here.

01:11 - 01:26

All right. It's really good to have this conversation. We're having lots of conversations with organizations asking about Nacubo this year. So where to begin? Greg, how about giving us the top line on fiscal year 2021 investment performance? What did you see?

01:26 - 01:56

Yeah, happy to. You know, I think the big story and I'm glad you mentioned fiscal year, just remember that runs from July one to June 30 of the following year. Really the big story and looking at this recent survey is that it picked up the big post-COVID bounce in the markets. Right. So when it came to the equity market, it really was a rising tide phenomenon. Everything went up and institutions of all sizes benefited. So that's clearly good news, right?

01:56 - 02:27

But then the markets themselves, U.S. global, emerging, all of those stock returns were pretty tightly bonds somewhere between up 39 to 41% over a 12 month horizon. So it was really, really good. Within portfolios themselves, you know, style and factor returns and the like were similarly bunched. You didn't see a terribly big difference between, for instance, U.S. Large-cap value, which was up 45 and growth stocks, which are up 43. So really good news on the risk side.

02:27 - 03:13

Now, it was not that case, however, with bonds. And you have to remember that toward the back end of that fiscal year was when we started to see inflation come back from the debt and we started to see interest rates moved. So, for example, the yield on the ten year U.S. Treasury doubled. It was at 68 basis points at the beginning of that period and went up to 147 at the end. And that also led the yield curve to steep. And that's just a very strong headwind, unfortunately. So when it came to bond portfolios, it was a very clear difference, you know, depending upon duration, things like credit, risk and so on and so forth.

03:13 - 03:55

The other thing quickly to note, because of inflation, you know, the real asset category really surged as we saw rebounding consumption as the economy started to unlock. Combined with supply shortfalls, you know, that we've seen really fueling major increases across a lot of categories, crude oil. Just to take one example. West Texas Intermediate, which is the U.S. benchmark, was up an astounding 87% over that period of time. So pretty extraordinary. Pretty much anything that had a connection to inflation or protecting against inflation, private public real estate, commodities, you name it, tended to do well.

03:55 - 04:02

Got it. So so basically anything that doesn't tend to do well with the surge in inflation did not do well.

04:02 - 04:03

So like bond.

04:03 - 04:04

Yeah, like bonds.

04:04 - 04:14

So that's my next question. Right. So who was there a dispersion in type of institution or size of institution in terms of who's most invested in investment grade bonds?

04:15 - 04:53

Well, in across really not just bonds, but across the board. And that short answer is, yes, there was despite the fact that, for instance, equity markets were all up pretty uniformly, you know, strong. There was a noticeable difference at the organizational level, depending upon the size of the organization. So, for example, the average investment return net of fees among all respondents was 30.6%, and that's up sharply, sharply from the less than 2% average return that was reported the previous fiscal year. A pretty extraordinary turn of events.

04:53 - 05:34

But unlike that tighter bunching that we saw in the previous report, this time around, you look at the smallest cohort, the under 25 million. Now you those organizations on average are up 25%, while at the other end of the spectrum, the greater than 1 billion in assets rose approximately 36%. So over a ten percentage point delta. Now, you know, even at 25%. I mean, who wouldn't love to have that kind of return? But that's a pretty big dispersion between the smaller funds and their larger peers. And unfortunately. That tends to be a pattern. It tends to be a recurring theme that we see in these surveys.

05:34 - 05:50

Yeah, so that's an interesting point. It is a massive spread, right? And everyone's doing well and that's great. But that's a that's a pretty wide dispersion. And so in addition to potentially smaller institutions having more exposure to investment grade bonds. Was there anything else that you might attribute the dispersion to?

05:50 - 06:50

Yeah, that really is a critical question. And you're right, it came down to allocation choices, but not just that. We could also see differences in manager results. But let's talk about allocation first. So as you note, the largest endowments, not surprisingly, were rewarded for typically having substantial exposure to think private equity, venture capital or the alternatives, both of which were standouts, even in an overall bullish year as well. These larger size organizations tended to have greater exposure to the inflation sensitive, real asset category. Likewise, the relative underperformance among the smaller organizations tends to be due to their lower exposure to private equity, venture capital and real assets. And a substantially you said it substantially higher exposure to traditional bonds. So those are the top level takeaways at the allocation level.

06:50 - 07:15

But you dig into it a little bit more. We think there's also manager differences that drive does because not only did the larger institutions reap the benefits of greater exposure to the high performing, you know, private and alternative asset classes, it's their access to, I think we can presume better managers was demonstrated by the higher average returns within these categories.

07:15 - 08:05

So for example, the average return and a very high performing private venture capital category, the average return for the big funds, the greater than a billion, the average was 50% compared to the very smallest funds. Their average return in the same category was less than a percent. In fact, it was only 40 basis points. That's just a wild amount of dispersion. And that's a little exaggerated given, you know, it's an esoteric category, I'll grant you that. But still, you see the same sort of pattern play out in other private categories. And unfortunately, there tends to be this linear pattern. As the as the assets decreased in the size of the endowment, the returns tended to go down in lockstep.

08:05 - 08:25

Now, I guess, fortunately, this same sort of delta wasn't wasn't nearly as pronounced in some of the other categories, but yet it still is a stark difference. And I think, you know, we see this from time to time. And I think the question that we ask ourselves as well, what sort of conclusions can we draw from this?

08:25 - 09:19

So I would tell you that Ed Bernstein, we're firmly in the camp that one of the principal means for organizations, big and small, of overcoming what we all think are going to be lower expected returns for, let's call it the traditional stock and bond markets is going to be for foundations and nonprofits again, of all sizes. You've got to seriously consider potentially adding private or alternative investments. I can't really emphasize that enough. But these results also here's my concluding point. That really does also hammer home the point that upping the exposure isn't enough. Right. Given that difference that we just talked about with venture cap, the choice of who you partner with, particularly in these categories, is going to be equally important.

09:19 - 09:32

Yeah, I couldn't agree more. So that's a lot to digest. But the theme is really around smaller institutions being the least prepared for what we expect ahead in many ways. And I actually saw this.

09:32 - 10:20

I'd be curious to get your thoughts on this, Greg. In the chapter, there's an entire chapter devoted to climate change, which in and of itself it's not surprising, right? Colleges and universities have been leaders in the responsible investing movement, particularly around divestment from fossil fuels. But here again, right, we saw that 70% of the largest in only 30% of the smallest institutions reported that ESG considerations, which is really typically around, you know, actively managed strategies, are a part of their investment decisions. So we know that there are strong, responsible investing strategies available out there in the marketplace, even for fiduciaries that are really measuring to traditional financial benchmarks. You don't have to sacrifice return. What do you think is going on here?

10:20 - 11:12

Yeah, look. To a certain extent, this interest in ESG related investing, there's no question it continues to gain market share among. Colleges and universities. And that really shouldn't be surprising. And, you know, in many respects, this movement really sort of originated in academia. So what we're seeing, investors are embracing ESG. And no surprise, managers are clearly responding. They'll be foolish not to know. I will say, if you'll pardon me, I would say in Bernstein's case, we've been committed to responsible investing, really going all the way back to being one of the original signatories to the United Nations, what's called the principles of Responsible Investing, where back over a decade ago, in 2011 and that sort of from that humble origin, that commitment has evolved in numerous ways.

11:12 - 12:04

I think a good example would be more recently in 2017. Bernstein We initiated a dialogue with Columbia University's Earth Institute. Why? In order to improve our ability to assess investment, risk and opportunities arising from climate change. And in the course of that, it eventually led to what I think is a groundbreaking initiative where we rotate within Bernstein all of our investment professionals, we put them through this sort of curated curriculum, if you will, that's led by Columbia professors on the intersection of climate science and portfolio risk and simultaneously the platform.

12:04 - 12:53

While this has been going on, the platform of services that we can offer our clients in the space has grown too. So clearly Bernstein has not only been leading in this space, but we've also been building out our capabilities. And the latest example would be we partnered with a very well-regarded team on a new private equity venture capital, let's call it an impact strategy that focuses on environmental sustainability along with economic opportunity and health equity. So enough of a commercial. This is really an exciting space for clients of all sizes, for managers and for Bernstein. If I had to guess, I'd say this interest really among investors is almost certainly just going to continue to grow.

12:53 - 13:13

Yeah, so let me turn the tables, Claire. I feel like I've been sort of in the spotlight here. Let's sort of sort of shift focus, and I'd love to hear from your perspective as you look through the survey, what struck or what stood out to you about this year's report?

13:13 - 14:01

It's a great question, Greg, and this report. Well, I think the first things that people look at or the performance in the allocation data, there are so many other really interesting and useful parts of this report that struck me. So we just talked about the climate change piece a little bit. In addition to the allocation and performance stuff, I was struck by certain aspects of both the gifting section and there's some good news there as well as the spending section, maybe some not as good news potentially there. And it begs the question, I think those sections beg the question of are we actually capturing in this report enough data to extrapolate more broadly into the nonprofit and sort of institutional world? Because we're just seeing some trends across philanthropy that may not be captured in this report.

14:02 - 14:07

Well, you've got my attention now, so give give us an example of what you're referring to there.

14:07 - 15:00

Sure. So so I'll start with some of the good news piece. Right. And maybe a little bit touch on my question around relevance of this report. So on the gifting section, look, there's some striking news here, particularly for smaller institutions. So in fiscal year 2021, the level of new gifting into endowments in the study increased by 15% overall versus fiscal year 2020. That's great overall. But what's interesting is in the $1 billion plus group, the biggest organizations, the increase was 8.8%, while with the average gift size increasing close to 10% in the under 25 million group, there was a 58.5% increase. Right. With the average gift size increasing 64%, you know, if you're starting from a much lower baseline. So the percentages will creep up a little faster. But this is enormous. This is an enormous difference regardless.

15:00 - 15:58

And so getting to the relevance piece, like what this doesn't even include is all of the transformational seven figure eight figure gifts that we've been seeing over the past couple of years, particularly to smaller institutions that weren't directed to endowments per se. Right, but that were more broadly to general operating or other programs. And so we've talked about Mackenzie Scott and other donors on this podcast who aren't endowment givers necessarily. Right. They're leaving the choice in the hands of the institutions out at. How to best manage or deploy those assets granted. And so we're just seeing these larger sums being given to organizations that support constituencies that maybe have been marginalized in our society and in different ways. So I know, Greg, you focus and I focus a lot of our time on that $25 million cohort, that $50 million cohort. And we're having just as many, if not more conversations today on other parts of their investable assets.

15:58 - 16:46

Right. So you know how to think about excess cash reserves, thinking about moving, you know, strategically bucketing assets and moving, you know, investments into intermediate time horizon types of funds with different liquidity needs. And those strategic conversations are where those are really the challenges and the solutions for so many of the organizations or institutions in this, what I would call sort of the small end of the middle market of the institutional sector. Right. These aren't the endowments, right? It's not conversations about the restricted funds. So it's just, you know, I wonder I think there are tons of great takeaways every year from this report, but it really doesn't address some of these much more critical issues that we're dealing with. So, I don't know, maybe there's opportunity for an additional research report here somewhere.

16:46 - 17:05

Right. And that that research and that advice, I think you alluded to this. It's probably goes without saying, it would matter so much more. It does matter more to the smaller institutions, just, frankly, because of resources and maybe their experience investing hasn't been, you know, as as long lasting. So all great points.

17:05 - 17:09

Now, what about spending since you mentioned outflows earlier.

17:09 - 17:50

Yeah. So that this big spending conundrum. Right, always a conundrum. So look fiscal year 2021 posted great absolute returns as you mentioned overall. So spending wasn't really an issue for for most institutions in especially because most of them are doing a look back right bill spend a percent the average of the last 20 quarter and asset values or 12 quarter and asset values. Right. So essentially in an in a rising market environment or a positive market return environment, that 4% that an institution spends may actually be a little less than 4% of today's portfolio value, if that makes sense. So so it wasn't really a big deal.

17:50 - 18:15

But here's the thing. The average spending rate, I guess, reported was 4.54%. And most institutions surveyed plan to maintain their current spending rate over the next few years. None of the smaller institutions right surveyed plan to decrease their spending rate. So it's all great organizations. Institutions, especially on the smaller end, have been receiving more new gifts, larger gifts to their portfolios.

18:15 - 18:44

But like, here's a thing. Number one, we're forecasting muted returns and higher volatility, as you've mentioned, Greg, as well as inflation. And so that's that's a concern. And then the second piece is like the smallest institutions surveyed, as you mentioned, they're potentially they're more highly allocated to publicly traded stocks to, you know, investment grade bonds. And so they're the most exposed to this potentially lower return and higher volatility environment. And they're the ones that are saying, no, we're not going to spend less.

18:44 - 19:16

So what I take from this is that in a much more challenging investment environment ahead, smaller organizations in particular are really going to need to look at not just their asset allocation, the mix of assets, but also reevaluate their spending rate as well as take advantage of that, capitalize on that momentum that they've got in terms of fundraising in order to successfully grow that endowment over time. It's not going to just be about, you know, asset allocation. You're you have to really think about these different areas as well.

19:16 - 19:22

Yeah, all great points. So look, we've only got a minute or two left. Any final thoughts you want to share with us?

19:22 - 19:54

Yeah, of course. So it's a lot to digest this report. I think one thing is it's a report on past outcomes and past is not necessarily prologue. So we always have to keep that in mind. And the second piece that I take away from this year's report is that we can extrapolate quite a bit, but only up to a certain point for the overall social sector and nonprofit sector. Right. And so take what we can from it. But then, Mike, make sure that we're thinking more broadly about the needs of institutions of different sizes. And I'll ask you the same.

19:54 - 19:55

Greg, final thoughts?

19:55 - 20:33

Sure. Look, I'd go right back to the heart of the matter. For years, endowments have sort of big and small, frankly, have had a standard target return or a bogey in the parlance of this world of call it seven and a half percent. And with that seven and a half, diamonds had to cover all their spending requirements, cover inflation fees and expenses. And the good news is, is that over the last ten years, so looking back over the last decade, the average endowment return drumroll. He was eight and a half percent. So they covered their bogey. That's great.

20:33 - 21:08

But stop me if you heard this before, we think the next ten years are not going to be as beneficial. Seven and a half will be very tough to hit going forward and look as funds take on, you know, as they all sort of react in different ways. What we're probably likely to see is a common denominator of organizations taking different types of risk in order to hit that return target. And that's almost certainly going to lead to probably even a greater dispersion of returns going forward.

21:08 - 21:29

I was struck. My final thought I was struck by something that the authors of the Nacubo survey. I thought they said it very appropriately when they, looking back over the last very good ten years, is that attempting to replicate these types of returns over the next decade to hit the return target should be an increasingly daunting proposition. I couldn't have said it better myself.

21:29 - 21:43

Thanks, Greg. Absolutely. So, look, that's all we have time for. But thank you so much for joining me today. For more for our audience here. Check out the link to our balancing structure and flexibility White Paper. Thanks for being here, Greg.

21:43 - 21:44

Thanks for having me.

21:45 - 22:15

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