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Allocating assets, part 3 – Alternative investments grow

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[Editor’s note: This is the third of six articles examining endowment strategies by charitable organizations.]

By Todd Cohen

To help cushion the ups and downs of the economy, charities are tinkering with their investment strategies.

Endowments tracked by Commonfund Institute in Wilton, Conn., for example, have shifted from traditional stocks and bonds to alternative investments, including private direct investments such as venture capital, private equity and hedge funds, says John Griswold, the research group’s executive director.

“The shift into alternatives is to provide higher return, more diversification, which means lower risk for the total portfolio, and hopefully more consistent return over periods of time,” he says.

More than one-fourth of the $182 billion in endowment assets of 617 institutions surveyed for the 2002 Commonfund Benchmarks Study, for example, are invested in alternatives, up roughly 10 percent from three years ago, he says.

Endowments, whether at colleges and universities or at foundations, he says, can have a tough job meeting minimum payouts that typically total 5 percent a year, based either on legal requirements or board policies, and derived from a three-year moving average of market values.

Endowments generally invest 60 percent to 70 percent of their assets in stocks and, respectively, 40 percent to 30 percent in bonds, he says.

While stocks typically generate higher rates of return – 10 percent to 11 percent over the long term – they are more volatile than bonds, which generate returns of 5 percent to 6 percent over the long term, Griswold says.

“Bonds have cushioned the fall in equities,” he says, although the slumping economy has dimmed prospects for bond returns.

“There’s a likelihood rates will not decline further but instead will rise from this point forward,” he says, noting that bond prices – on which total returns are based – move in the opposite direction from interest rates.

“It’s very difficult to buy a bond that will guarantee you five to six percent, without taking some risk,” he says. “The challenge is to provide a mix of assets that will provide that 6 percent.”

Foundations also are shuffling their investments.

The Duke Endowment in Charlotte, N.C., three years ago adopted a more diversified investment strategy to reduce dependence on U.S. equities, and has been increasing the share of its portfolio in alternative investments such as hedge funds that seek to generate returns independent of the stock market.

“We like to make changes at the margins,” says Stephanie Lynch, chief investment officer. “We tend to move slowly and move in a conservative way.”

The foundation’s investment in private equity peaked at about one-fourth of its portfolio in June 1999, when assets reached an all-time high of $2.8 billion.

As the technology bubble burst, the foundation’s investments in private equity returned to more normal values, Lynch says, bringing its private-equity portfolio closer to the foundation’s policy target of 15 percent of holdings.

The foundation has not changed its overall investment strategy, which includes 70 percent equity, 20 percent long-term bonds and 10 percent in real assets such as real estate, timber, and oil and gas partnerships.

The long-term strategy has paid off, Lynch says. For the three years ended Sept. 30, the foundation’s annualized rate of return totaled 4.3 percent, compared to an average annual loss of 8 percent the foundation could have expected based on market benchmarks, she says.

“If you really look at the long-term perspective on when stocks do well and poorly, you’ve got to do a lot of things right to earn 5 percent year after year,” she says. “It’s just not something the average bear can pull off.”

The struggle to earn 5 percent, she says, provides a solid reason to avoid the impulse many foundations may have to shift too drastically from stock to bonds.

“If bonds are not going to earn enough over time to meet your 5 percent payout plus the natural rate of inflation,” she says, “then in my opinion it’s just as risky to have too much in bonds and eat away your corpus.”

NEXT: Community foundations shift gears.

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