Mark Schimd, the chief investment officer at the University of Chicago, and Que Nguyen, managing director of strategy there, have written a wide-ranging paper that begins with the challenges at the University of Chicago’s fund and its commitments, but that has broad implications. Their paper is the result of an initiative begun in early 2010, known as Total Enterprise Asset Management (TEAM).
That acronym was chosen because the goal of the TEAM was to marry the operational side, the day-to-day liabilities, of the university with the endowment side. College endowments, like pensions, preserve a long-term outlook as to their portfolio, but as parts of a team they should also be aware of the volatility to which a university is subject in its day-to-day operations.
Restoring Risk Management
Traditionally, the endowment model has involved holding illiquid assets, and benefiting from the premiums that markets pay institutions with a tolerance for illiquidity. Further, this self-image of endowments as buy-and-hold institutions leads to a de-emphasis of risk management, in the expectation that near term zigs and zags will level out nicely if given enough time. Schmid and Nguyen break with this model. They say, “While we continue to pursue strong returns, we must do so without taking on excessive risk to the University.”
Their paper, published in the January 2012 issue of The NMS Exchange, declines to share their proprietary expected returns model, but it does indicate that the model is “designed to evaluate the underlying economic drivers of long-term returns for a variety of asset types.” Since the University has a successful history of investment “in private structures and hedge funds,” this model factors in the returns and alpha that can be captured in that way.
In considering an optimal portfolio, Schmid and Nguyen begin with the assumption of what they call “normal growth,” which is that the U.S. economy, and thus the assets whose value it determines, will return to a condition that was until roughly ten years ago the normal one: acceptably low debt vis-à-vis the GDP, and positive levels of inflation. In this situation, they are confident they can model a portfolio that will be able to “deliver returns and alpha as planned.”
Three Non-Normal Scenarios
But they realize they cannot take that scenario for granted. There are two axes to consider: the ratio of GDP growth to debt growth on the one hand, and the level of inflation/deflation on the other. Thus, there are four quadrants when these axes intersect.
If we presume that debt growth remains less than GDP growth, yet we move from an inflationary to a deflationary scenario, we arrive at what the authors call a period of Innovation. This sounds rosy, but it poses its own problems for endowments, which will create fierce competitive pressure for one another. Another university’s endowment could outperform your own significantly. The arithmetic is daunting: “Even a 2% annual performance increment causes a 22% wealth disparity in 10 years.”
Consider a third possibility: inflation on the one hand and abnormal debt growth on the other, i.e. Stagflation. Schmid and Nguyen view this without undue alarm. The risk to the real wealth of the University would be “moderate,” but fixed rates and long dated debt will immunize a University from higher interest rates, unless “more debt needs to be issued than planned.”
There is only one quadrant left. In a future with low or negative inflation and burdensome levels of debt, a “lost decade,” the real cost of debt will increase, endowment returns may prove significantly below planned levels, and difficult cuts will have to be made.
In sum, then, whatever turns out to be true about the ratio of debt growth to GDP growth, inflation will always be an environment preferable to deflation: “A stagflation environment may not be enjoyable, but by no means will it do as much harm to a university as a deflationary bout.” On the operational side of a college, the need for financial aid will rise, yet the ability of colleges to increase tuition will be constrained.
In managing for the whole range of possible risks, then, the TEAM risk-management approach prefers to overemphasize the more painful risks of the deflationary paths.