College endowment funds: who is in charge?

College and university endowments have grown rapidly during the last 20 years. Today, the top 200 funds total more than $164.6 billion and are a significant funding source for many universities (Pulley, 2000). In fact, during the 1990s, college and university endowment funds grew at an unparalleled rate and their assets climbed to levels beyond the most optimistic forecasts. This phenomenon paralleled the record gains of the stock market over this period. Endowment investment committees and their advisors were held in high esteem and their actions appeared to be beyond reproach as the coffers grew rapidly during this period. Investment meetings often took on the appearance of love-fests with members congratulating each other for their shrewd investment expertise.

The status quo of the 1990s changed in March 2000. That point in time marked the start of the greatest stock market decline in the last 100 years. This decline, triggered by the collapse of the dot com companies, was further fueled by the economic collapse of energy giant Enron Corporation, and the public's concern over the role that the international accounting firm Arthur Andersen played in facilitating this collapse. Other recent high profile business failures such as Global Crossing, Inc., Halliburton, and WorldCom have only made matters worse. The market repercussions were in large part due to the scandals surrounding the dubious accounting and reporting practices that led to these failures, leading one investor to describe them as a "moral cancer and a governance cancer, which must be cut out if our economic health is to be restored" (Flanigan, 2002).

The present investing environment mandates that fiduciaries take a fresh look at how their funds are managed. Endowment committee members undoubtedly recognize that managing a portfolio requires expertise well beyond that needed in an ongoing bull market. They now face pressure to reverse the erosion in their funds' asset values that has taken place over the past few years. The big question that they (Endowment Committee members must answer is whether their investment committees have the knowledge, skills, and abilities to carry out the fiduciary responsibilities for which they are held accountable.

Our purpose for this study is twofold. First, we seek to better understand the policies, rules, and procedures of college endowment committees. In doing so, we will have a basis for assessing whether the inherent structure and practices of these committees facilitate effective discharge of their fiduciary responsibilities. Second, we seek to determine facts and circumstances that prompt investment committees to utilize outside money managers to assist in fund management and the extent to which these outside experts are employed. This should provide further insight into the decision making processes and the implications for the effectiveness of investment committees.

Method

In order to obtain information regarding the above-referenced activities of college investment fund committees, we mailed a portfolio questionnaire to the administrators of the top 200 US college endowment funds. Follow-up requests were mailed to non-respondents eight weeks after the initial mailing. Responses received within 12 weeks of the initial mailing were included in the study, by that time we received 112 (56 percent) usable responses. (1)

The questionnaire consisted of 39 items related to portfolio and investment committee characteristics, investment policy statements, and reasons for selecting professional managers. In each of these areas we solicited survey responses using objective questions with multiple response options and YES/NO questions. Over 73% (n=82) of the respondents indicated their endowment fund portfolios exceeded $100,000,000, 16% of respondents' portfolios were between $50,000,000 and $100,000,000, and nearly 11% reported portfolios with assets totaling less than under $50,0000,000.

Results

Committee Composition and Preparation

Typically, an endowment committee is established to oversee management of the fund's assets. Members of the endowment committee are charged with the fiduciary responsibility of carrying out the goals and objectives of the fund. To assess committee composition, the respondents were asked to identify the size and composition of their respective endowment committees. Sixty respondents (54%) reported that the investment committees consisted of more than seven members, 38 (34%) indicated that the size of its investment committee was between five and seven members, and 14 (12%) reported membership between three and five individuals.

Since endowment funds represent a significant resource for universities, it is important that qualified individuals serve on the committee that is charged with its oversight. In order to function effectively, investment committee members must have a clear understanding of the fund's investment philosophy, goals, and objectives. Quite often this is accomplished by providing new members with a formal orientation program. Accordingly, the survey asked whether the sponsoring organization had an investment orientation program for new committee members. Over 64% (n= 72) indicated that no formal program was offered to new members. As to whether a minimum level of investment expertise was used as a criterion for selection to the investment committee, 56% (n=63) reported having no such criteria, while 44% (n=49) indicated that investment and/or portfolio management expertise is required. Another strategy would be for investment committees to recruit individuals outside of the organization to fill this void. Seventy-two respondents (64%) indicated that their endowments utilize individuals outside of the organization to serve on the investment committee.

Investment Policy Statement

Sound portfolio management practice requires the existence of an investment policy statement. An endowment's investment policy statements should include its philosophy, goals, return objectives, risk tolerances, and constraints. Nearly 96% of respondents (n=107) reported having a written investment policy statement in place, all of whom confirmed that their documents included a section on investment philosophy, goals, and guidelines.

Typically, portfolio managers allocate funds between categories of financial assets to ensure that a portfolio is not too concentrated in any one sector or security. When asked whether their endowment placed a limit on such investments, 90% (n=101) responded that the investment policy statement specified a permissible asset allocation range, interestingly, only half of this group specified a maximum limit on the amount that can be invested in one security. While the maximum limit varied widely among respondents, 81% was the maximum percentage allowed to be invested in equities, 73% was the maximum percentage allowed to be invested in fixed income securities, and 44% was the maximum percentage allowed to be invested in cash and equivalents. Seventy-four respondents (72%) indicated that their investment policy statements explicitly contain a statement addressing risk tolerances.

Evaluation Practices

Endowment committees are periodically expected to review the performance of the investment fund as well as its managers. A section of the questionnaire explored how often investment performance is formally evaluated. Eighty-one respondents (72%) reported that they review endowment fund investment performance on a quarterly basis, 21(19%) reported reviewing performance on an annual basis, seven (6%) reported that they review performance semi-annually, and three (3%) reported monthly performance reviews. It is also good practice to review the investment policy statement periodically since the goals and/or objectives may change over time. Table 1 reports the answers to the question as to how often the investment policy statement is reviewed.

As Table 1 indicates, the majority of respondents (53.3%) reported that the policy statement is reviewed annually, 35.3% indicated that the statement is reviewed every one to three years, and 10.5% indicated that they reviewed the investment policy statement between three and five years. Only one respondent reported reviewing the statement every five to seven years.

Employment of Money Managers

Early in the life of an endowment fund a question arises as to whether the management should make investment decisions internally or seek the advice of professional money managers. The next series of questions were intended to shed light on this question. The survey asked whether the size of the portfolio was related to the decision to hire a professional money manager. Out of the 92 administrators who answered this question, 40 (44%) indicated that a minimum size did not apply. Of the 52 respondents who indicated that a minimum size is an issue, two (3.8%) indicated that the fund should be at least $100,000, eight (15.4%) indicated that the fund should be at least $1 million, 15 (28.8%) indicated that the fund should be at least $5 million, and 27 (52%) indicated that the fund should be at least $10 million.

The respondents were asked whether they used one or more outside managers. Table 2 reports the percentage of endowment firms using one or more outside fund managers.

As Table 2 indicates, 93 (83%) of the funds using outside professionals reported that they used four or more money managers. A follow-up examination looked at the relationship between the size of the portfolio and the number of management firms employed. The results are shown in Table 3.

The first column of Table 3 disaggregates the endowment funds into eight size categories and the second column indicates the percentage of respondents reported for each size category. The third set of columns cross-tabulates the number of funds in each size category by the number of outside management firms employed. For example, one of the portfolios (using outside fund managers) with under $500,000 in assets employs only one outside management firm, and one employs more than four outside firms. The other portfolio size categories can be interpreted in the same manner.

One would expect that as the size of the portfolio increases, more professional investment management firms would be employed. As Table 3 indicates, the results partially confirm this expectation. However, it is interesting to note that among portfolios in the $50-$100 million range, eight (44%) reported three or fewer firms employed.

Respondents who indicated that they employed multiple outside investment management firms were queried as to the reasons prompting this decision. The reasons given were: 1) managers were selected to ensure a greater range of styles (16.3%); 2) managers were selected to provide greater diversification (12.2%); 3) managers are selected for equities and fixed income securities (6.5%); and, 4) all of the above (61.0%).

Investment Manager Turnover and Selection Characteristics

Endowment funds, as is the case with many fund sponsors, are sometimes required to conduct money manager searches. The next series of questions assessed the frequency of these searches and the circumstances that led to the decision to conduct new searches.

Respondents were first asked a question regarding the length of service of their respective fund managers. Table 4 presents the responses to this question.

It is interesting to note that nearly 68% of the fund administrators reported that their fund managers had more than three years tenure. In fact, 39.1% reported that their fund managers have been employed for more than five years, and 28.7% indicated tenure periods between three and five years.

A similar question asked respondents to state the average length of tenure of their fired managers when more than one portfolio was under professional management. The results showed that when more than one portfolio was under professional management, the longevity of the money managers was equally long with 97.8% of the respondents reporting an average tenure of more than three years. Moreover, 48.9% of the fund managers served between three and five years and 48.9% served more than five years.

When asked why the previous manager(s) was replaced, the majority of respondents (67) indicated "investment performance." The second most cited reason was a change in portfolio goals (23). Other responses (listed in order of importance) included firm size and management depth (7), lack of communication and accessibility (5), and fees and expenses (1).

Respondents were asked how they identified the pool of potential fund managers during their search process. A sizable majority (75) indicated that they retained the services of an outside consulting firm to conduct the search. Respondents also indicated that they relied on either referrals (16) or targeted Request For Proposals (14). "Other" responses accounted for the balance of the reasons given.

The last question of this section asked respondents to select the factors that led to the hiring of their current money manager. Figure 1 presents the results.

Factors In The Selection Of The Current Professional Manager. As Figure One indicates, the most frequent selection factor noted was "compatibility of management style with the portfolio's investment goals 75 (28.4%) followed by historical performance 64 (24.3%), firm size and depth 46 (17.4%), fees and expenses 37 (14%), and ease of communication and accessibility 18 (6.8%). It should be noted that respondents could list more than one factor, thus explaining how the tabulations exceed the number of respondents (112).

Transaction Costs and Related Expenses

The final section of the survey asked how outside consultants are compensated. This part of the survey produced some interesting results that are presented in Figure 2.

Eighty-six (76.7%) of respondents reported that they compensated outside consultants with hard dollars. Eighteen (15.9%) compensated them by means of a combination of hard and soft dollars, and eight (7.4%) indicated that they used commission and/or other means as compensation.

To be sure, the amount and type of fees charged can have an effect on investment performance. The next set of questions was designed to provide insight into the size of the fees currently being charged to endowments.

The first question was asked about the size of fees charged to endowment funds by outside professionals. Table 5 reports the distribution of responses to this question.

As Table 5 indicates, of those reporting, 56 (54.4%) paid between 50 and 75 basis points, while 30 (29.1%) paid between 25 and 50 basis points. Only 17 (16.5%) reported paying fees of 100 basis points or higher.

Table 6 examines the relationship between portfolio size and management fees. As over 82/112 (73%) of the respondents worked with funds with over $100 million in assets, this group has the greatest number of responses (76). It is intuitively appealing to expect that the larger the portfolio, the more negotiating power the fund would have in obtaining lower fees. However, if several managers oversee the portfolio, the fund's negotiating power might be mitigated. In fact, 64/76 (84%) of the funds reporting from this group pay fees of 75% basis points or less, in comparison to 86/103 (83.5%) of all firms as reported in Table 5, and 22/27 (81.5%) of the firms reporting from the other size categories in Table 6. Thus, there is little evidence that portfolio size has a significant impact on the size of the fees charged by outside managers.

Respondents were next queried as to the average price per share for an executed equity order. Of the 91 fund administrators that responded, 15 reported paying less than three cents, 45 reported paying between three and five cents, 20 reported paying between six and 10 cents, and 11 indicated paying between 11 and 20 cents.

The third question asked respondents about the extent of portfolio turnover. Ninety-six respondents replied to this question. The results are reported in Figure Three.

As Figure 3 indicates, 37 (38.5%) reported an annual turnover of between 26 and 50 percent, 33 (34.4%) reported an annual turnover of 10 to 25 percent, and 11 (11.5%) reported less than 10 percent annual turnover. Only 15 (15.6%) reported turnover levels of 51 percent or higher.

Committee members have a fiduciary responsibility to ensure that the money managers are not churning, i.e., selling securities needlessly to generate commissions in the endowment accounts. Thus, the level of turnover activity must be weighed against the policy statement itself.

Table 7 presents the reasons for the survey respondents selecting their current custodian.

As Table 7 indicates, the most frequently cited factors were Cost and Quality of Service at 24.6% and 25.8%, respectively. These were followed by Expertise (19.5%) and Convenience (16.0%). Another question asked what are the costs of custodial services if investment managers provide such services. For those investment managers that provide custodial services, 15 (15.3%) charge from between 10-25 basis points. The respondents 83 (84.7%) indicated that their investment manager does not provide custodial services. The survey results also showed that 64 (61%) of the respondents indicated that their custodian does not charge fees for income distribution requirements, 17 (16.2%) indicated that their custodian does charge fees for income distribution requirements, and 24 (22.8%) of the respondents did not know.

A question was asked if performance results were reported using AIMR standards. The Association for Investment Management and Research (AIMR) is a non-profit international organization. Its membership has more than 50,000 investment educators and practitioners in over 100 countries. Of the 110 ten fund administrators who responded, 68 (61.8%) indicated "yes", two (1.8%) indicated "No", while a surprising 40 (36.4%) did not know. Investment managers who create performance presentations that provide fair representation and full disclosure should use AIMR's standards. These standards help investors directly compare performance results of a number of investment managers. All investment committee members should be familiar with these standards. They can be obtained by viewing the web site of the organization.

AIMR suggests that performance be reported on a net of fees basis. Those endowments that are being provided with performance reporting on a gross basis need to insist that the performance begin to be reported in a manner consistent with AIMR. In terms of investment performance reporting, 15 of the fund administrators reported performance gross of fees, 56 reported net of fees, and 39 reported both gross and net of fees.

Respondents were queried as to who provides performance evaluation and comparison data. Figure 4 presents the results.

Eighty-one respondents (60%) indicated that investment consultants provide this information, while 23 (17%) indicated that investment managers provide such information. Seven (5.2%) use an outside service and five (3.7%) use the investment committee as the provider. Nineteen (14.1%) indicated that this data was provided by other means. From the number of responses (multiple responses were allowed), it is obvious that some funds used more than one source for performance evaluation and comparison data.

Finally, the following question was asked: "Does your investment manager direct commissions in return for research and other services and products?" Of the 99 who responded to this question, an equal number (37) indicated 'yes' and 'no', respectively, while three indicated that the question was not applicable as they were not allowed direct commissions. Of concern is the fact that 22 of the respondents indicated that they did not know. This is indeed troublesome since directed commissions can increase the transaction costs to the endowment. Thus, the fact that these respondents were not even aware of the practice is unfortunate.

Summary and Conclusions

This study's results reveal that endowment fund characteristics and practices vary greatly. In most instances the policies and procedures conform to the best business practices performed today as defined by Association for Investment Management and Research (AIMR). However, one disturbing finding relates to the minimum level of expertise needed to serve on an investment committee. As the above-referenced results indicate, over 64% of the respondents indicated that no formal orientation program is offered for new investment committee members. This is particularly troublesome given that 56% reported that they require no minimum investment and/or portfolio management expertise in order to serve on an investment committee.

One would expect that investment committee members have the capacity to carry out their fiduciary responsibilities, and that a university managing an endowment would want qualified investment committee members. In volatile and complex financial markets, it would seem appropriate that if an investment committee was making investment decisions and not using the advice of professional managers in some or all of the investment decisions, then a minimum level of expertise and an orientation program for new members would seem to be prudent. The combination of expanding the membership of the investment committee to include a greater number of candidates from outside of the organization and developing a formal orientation program for new members would significantly strengthen their capabilities.

A second area of concern relates to the existence of an Investment Policy Statement. The existence of such a statement would appear to be a ubiquitous phenomenon, yet 4.5% of the fund administrators reported that their endowment fund investment committees did not have a formal policy statement.

A final area of concern is the large percentage of respondents that did not know whether their investment manager directs commissions in return for research and other services and products. This is indeed troublesome given that directed commissions can increase transaction costs to the endowment. Again, one would hope that investment committee members would be familiar with this issue.

In conclusion, it is clear that policies and procedures need to be adopted and/or modified to ensure that the fiduciary responsibilities of those overseeing the fund's management are being carried out. It is also important that endowment committee members have a better understanding of their roles and responsibilities in managing the money managers. Table 1 Investment Policy Statement Review Frequency of Review Number of Funds Reporting Percent Annual 60 53.3% 1-3 Years 40 35.3% 3-5 Years 11 10.5% 5-7 Years 1 0.9% Total 112 100.0% Table 2 Number of Professional Investment Management Firms Employed Number of Professional

Management Firms Number of Endowment Percent of Endowment

Employed Funds Reporting Funds Reporting

One 6 5.4%

Two 1 0.9%

Three 8 7.1%

Four 4 3.6%

More Than Four 93 83.0%

Total 112 100.0% Table 3 Size of Portfolio and the Number of Investment Management Firms Employed

Number of Outside Firms

Employed

Number (%) of Size of Portfolio Respondents 1 2 3 4 Over 4 Less than $500,000 2 (1.8%) 1 1 $500,000 - $1 million 2 (1.8%) 2 $1 - $5 million 4 (3.6%) 4 $5 - $10 million 0 (0.0%) $10 - $20 million 1 (0.9%) 1 $20 - $50 million 2 (1.8%) 1 1 $50 - $100 million 18 (16.1%) 3 1 4 2 8 Over $100 million 83 (73.2%) 4 2 77 Total 112 100.0% 6 1 8 4 93 Table 4 Length of Tenure of Current Portfolio Manager

Number of Percent of

Tenure of Endowment Endowment

Portfolio Manager Funds Reporting Funds Reporting Less Than One Year 14 12.7% Between One and Three Years 22 19.5% Between Three and Five Years 32 28.7% More Than Five Years 44 39.1% Total 112 100.0% Table 5 Management Fees Charged by Professional Managers

Number of Endowment Fees(Basis Points) Funds Reporting 25-50 30 50-75 56 100-125 11 125-150 2 Over 150 4 Total 103 Table 6 Relationship of Size of Portfolio and Management Fees

Number of Respondents Reporting (Basis

Points Charged)

Portfolio Size 25-50 50-75 100-125 125-150 150+ Less that $500,000 2 $500,000 - $1 Million 2 $1 - $5 Million 2 1 1 $20 - $50 Million 1 1 $50 - $100 Million 8 5 4 Over $100M 15 49 6 2 4 Total 30 56 11 2 4 Table 7 Reasons Cited for Custodian Selection

Number (Percentage) of Factor Endowment Funds Reporting (1) Cost 63 24.6% Convenience 41 16.0% Expertise 50 19.5% Quality of Service 66 25.8% Range of Custodian Products 24 9.4% Other 12 4.7% Total 256 100.0% (1) Multiple responses were allowed for this question. Figure 1 Factors in The Selection of The Current Professional Manager Historic Performance 24.3% Firm Size and Depth 17.4% Fees and Expenses 14% Compatibility of Management 28.4% Ease of Communication 6.8% Note: Table made from pie chart. Figure 2 Compensation of Outside Consultants Hard Dollars 76.7% Hard & Soft Dollars 15.9% Soft Dollars & Other 7.4% Note: Table made from pie chart. Figure 3 Portfolio Turnover Greater than 100% 1.0% Less than 10% 11.5% Between 76 & 100% 34.4% Between 26 & 50% 38.5% Between 51 & 75% 10.5% Between 10 & 25% 4.2% Note: Table made from pie chart. Figure 4 Provider of Performance Evaluation and Comparison Data Investment Managers 17.0% Investment Consultants 60% An Outside Service 5.2% The Investment Committee 3.7% Others 14.1% Note: Table made from pie chart.

Flanigan, James: 2002, 'Others bolder than president about reforms', Los Angeles Times (July 10).

Oppenheim, A. 1966. Questionnaire Design and Attitude Measurement. New York: Basic Books, Inc.

Pulley, John: 2000, 'Endowments Earned 11% in 1999 Down From 18% in the Prior Year', Chronicle of Higher Education (February 18).

(1) We conducted tests for non-response bias using the early-late hypothesis (Oppenheim 1966, 34). We conducted separate t-tests and Chi-Square tests to assess the significance of mean score differences between the first 25 respondents and last 25 respondents on key demographic questions and questionnaire items. The results indicated no reason to suspect a significant non-response bias associated with the study.

G. Timothy Haight is Dean of the college of Business and Economics and a professor of Finance in the Department of Finance and Law at California State University, Los Angeles.

George Engler is a Professor of Finance in the Department of Finance and Law at California State University, Los Angeles.

Kenneth J, Smith is the Trice, Geary and Myers Professor of Accounting at the Franklin P. Perdue School of Business at Salisbury University.