03/02/2011 - 00:00

Endowment model a worthy strategy

03/02/2011 - 00:00

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The creation of wealth brings its own set of challenges, not least of which is determining the right investment strategy.

Endowment model a worthy strategy

WESTERN Australia’s wealth creation boom is seeding the establishment of new charitable entities, indigenous and not-for-profit community foundations, while also underwriting the expanding role of existing charitable endeavours.

These entities often struggle with the right investment strategy, designing the right decision making tools and balancing the right spending commitment to operational resources while maximising the funds available to their beneficiaries. However, there is an approach that addresses these concerns – and works.

The Future Fund is Australia’s largest single wealth investor with more than $69 billion at work, targeting returns of CPI plus 4.5 per cent a year.

The fund’s mandate is to achieve those returns over the long term without ‘excessive levels of risk’; to do that, it applies the endowment model of investing (EMI).

It is an approach which, by any measure, should sit comfortably with the growing number of charitable entities, indigenous foundations and public benefit organisations in WA, which control investments of up to $50 million – in some cases, more. And, as the resources boom continues to drive philanthropy and negotiated access, other organisations will also soon be controlling significant amounts of money.

How many, though, set their mission – desired outcomes, if you like – and rigorously monitor and benchmark performance?

What is the right investment strategy, the right decision-making tools and how do you balance the right spending commitment to operational resources while maximising the distribution of funds to beneficiaries?

This process is made even more complex – and, perhaps uncomfortable – because of the diverse and varying levels of financial skills of the part-time volunteers committed to the cause.

Successful people believe in best practices and this is even more in focus when managing money in a fiduciary role on behalf of needy beneficiaries. For WA’s most generous the investment strategy and generational equity considerations required of a not-for-profit undertaking demands a clearly defined and transparent approach.

Obligation – indeed, regulation – requires a change in thinking; no longer can it be said that these tools and processes are only available to the likes of the Future Fund and their ilk. The EMI is applicable to any organisation seeking to efficiently grow funding to support its worthy purposes.

Consistent with financial objectives, the key to an organisation’s decision-making is the establishment of its ‘return and risk’ target, and this necessitates a top-down approach – goals/objectives, processes, necessary resources.

EMI brings such rigour to major investing. Well established overseas among iconic institutions such as Harvard and Yale, it has generated long-term outperformance – even during the decimation of 2008.

Here in Australia, over the past decade, and including the GFC, an investment fund adopting the EMI would have more than doubled returns compared to domestic equities – 123 per cent return compared to 52 per cent.

It is that consistent performance which persuades the Future Fund to widen its investment opportunities to include allocations to non-traditional or skilled-based investment classes. Traditional fixed income and stock investments (beta) remain an important part of an endowment styled portfolio but non-traditional investments (alpha) comprise a meaningful allocation to achieve the desired outcomes.

“The likely heightened level of volatility in financial markets going forward attracts us to strategies with limited market exposure, and at the same time this volatility should suit the flexible and intense management style of many of these (non-traditional) managers,” the fund says.

The Future Fund’s alternatives allocation is textbook EMI, which provides for fixed income between 0-25 per cent; beta investments (equities) 0-50 per cent; and alpha investments (managerial skill) 20-60 per cent.

All three sources are required for EMI success.

The strategic asset allocation for the Harvard, Yale and Stanford University endowment funds in 2009 correlated to: 9 per cent fixed income; 29 per cent equities; and 62 per cent to alpha investments such as absolute return funds, private equity and real asset ownership.

Ironically, it is the active monitoring inherent in the EMI, which highlights the key weakness in WA’s growing endowment funds management. While they may not have the size to execute a Yale-style plan, they certainly can construct a form of the model to underwrite outperformance with proper checks and balances.

Alternatives in EMI are not solely based on absolute return funds – other non-traditional investments include commodities, foreign exchange, private equity, venture capital and real estate.

Integral to the model’s development in Australia is the growth in size, capability and reputation of the alternatives investment sector.

Austrade estimates the sector controls investment totalling $240 billion, with: Australian hedge funds being the biggest in Asia Pacific; Australian Real Estate Investment Trusts being the biggest in the world outside the US; and our infrastructure funds being among the biggest in the world.

But, in the context of the EMI, size does not necessarily matter. It is appropriate for smaller investment entities – and, depending on the investment fund size, its technical tools can be developed and retained in-house or outsourced to qualified people.

The tools are not simply essential to monitoring and measuring performance, but also to ensuring that investment remains aligned to an organisation’s goals and objectives. Beyond that, they also calculate impacts, which include distribution policy, targeted growth of the fund, and the inflation effect on a fund’s operating budget.

• Jon Horton is the managing partner of NWQ Capital Management, a Perth-based absolute return fund manager that manages the NWQ Diversified Fund.

 

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