In 2003, Case Western Reserve University’s new president, Edward Hundert, introduced an ambitious three-year Vision Investment Plan that he hoped would transform the Cleveland-based institution into what he called “the most powerful learning environment in the world,” tapping into its cash reserves and leveraging the strength of its endowment fund. But by the next year annual losses became the order of the day when philanthropic support and research funding did not meet revenue expectations at Ohio’s largest private research university. By 2006, after receiving a vote of no-confidence from the arts and sciences faculty, Hundert resigned. In July of the following year, newly appointed president Barbara Snyder arrived on campus to take on the $20 million annual deficit. That October the board of trustees adopted a fiscal austerity plan designed to bring the school back into the black. With the help of tuition and enrollment increases and a few medical school grants, Snyder managed to balance the budget just in time for the close of the academic year on June 30, 2008. Then disaster struck.
In the summer of 2008, the financial markets began their nine months’ long downward spiral, punctuated by the September bankruptcy filing of investment bank Lehman Brothers Holdings and the government bailouts of mortgage giants Fannie Mae and Freddie Mac. Case Western Reserve’s endowment fund fell in tandem, losing 19 percent of its market value. The endowment, which provides 10 percent of the school’s operating budget, was seen as a key element of the fiscal recovery plan. With time running out for the red-ink-soaked medical, engineering and management school budgets, endowment CIO Sally Staley and her investment team were under pressure to turn those losses around. “It very nearly derailed our fiscal recovery at the university,” explains Staley, who oversees a $1.3 billion portfolio today, down from $1.8 billion at its height before the financial crisis. “We had to set aside the typical investment objective of the endowment model, which is to maximize return at any cost.”
Schools across the U.S. have been struggling to dig themselves out of the hole created when the markets crashed and there was nowhere to hide (save gold and Treasury bonds). The ten largest endowment funds alone lost a combined $36 billion before the sinking markets began to stabilize in March 2009. As every asset class correlation went to one — that is, they all produced similar returns, bad — the holy writ of portfolio management theories developed by financial gurus like Harry Markowitz and William Sharpe and disseminated for decades by U.S. business schools, investment consultants and leading investors like Yale University’s David Swensen went for naught. To access or backstop dwindling cash reserves, many of the most prominent schools resorted to floating long-term taxable bonds, obligating them to years of debt (see “College Bound,” page 38), and cut back on myriad programs, construction projects, staff and professors.
“Risk has changed significantly at endowments,” says Tanya Beder, founder and chairman of advisory firm SBCC Group in New York, where she heads the global strategy, risk, derivatives and asset management practices. “The aftermath has been so painful, there’s a sea change in how people are approaching risk management.”
As custodians of the largest pool of assets on campus, endowment officers are taking a new, hard look at risk. Recently hired and deployed risk officers have been taken out of the basement and given a seat next to the chief investment officer. At schools with the resources to hire specialized staff — and the inclination to do so — risk management techniques are front and center across all portfolios. It took a crisis to bring the truth into sharp focus: Risk exists in every division and department across campus. In response to this new holistic view, risk management is fast becoming the holy grail at educational institutions as school administrators — presidents, treasurers and finance officers — look to partner with their investment officers in an effort to avoid a repeat of the frightening 2008–’09 academic year.
At Case Western Reserve, Staley and her director of risk and strategy, Anjum Hussain, have implemented a new active investment strategy that can deliver both positive returns and downside protection, with small amounts of capital. Between June and August 2008, the investment office cut equity exposures by terminating long-only managers and, in some cases, put on short trades to hedge out the risk in long-biased, illiquid hedge funds. By November, Hussain began actively taking advantage of the very high market volatility and skew, or divergence from the normal distribution in the options markets, by selling volatility. Then he went even further. In the midst of the market’s mayhem, the risk director added a sophisticated option structure to the equity portfolio.
Until 2008 some of the smartest — and most dedicated — investment professionals managed school endowment pools believing that asset diversification and historical portfolio and markets data represented state-of-the-art risk management tools. As financial markets went into free fall, it began to appear that endowment officials had been walling themselves off in their ivory towers with a 100-year investment perspective rather than managing more-immediate, previously unforeseen challenges like institutionwide liquidity and counterparty risk. That realization has given rise to today’s new thinking: The most important risk of all is permanent loss of capital. The question of how to manage that risk is a work in progress as schools look at risk with fresh eyes.
“Continuous improvement in risk management is critical in what remains a very volatile environment,” says Jane Mendillo, president and CEO of Harvard Management Co., which oversees Harvard University’s $27.4 billion endowment. At Harvard — whose endowment dropped $10 billion in value for the fiscal year ended June 2009 — officials are working overtime to build a new, universitywide risk management operation. “We have a more robust risk management process than we had two or three years ago,” Mendillo explains. “Part of that is we’re looking at risk with a wider lens.” Risk is no longer defined solely through portfolio volatility or value-at-risk modeling, says Mendillo, who had been CIO of Wellesley College before taking the reins at Harvard from Mohamed El-Erian, now Pacific Investment Management Co.’s CEO and co-CIO, at the outset of the annus horribilis in July 2008. “We’re looking at what could happen to the market and what could happen to our particular portfolio.”
No one predicted the crash — with the possible exception of a few savvy hedge fund managers. Much of the problem was that getting risk management right is like trying to nail Jell-O to a tree. Good luck. First there was the folly of relying on risk systems and software. Quantitative approaches have been a mainstay of risk management since value at risk, or VaR, was created in the 1980s within the U.S. banking system to forecast how much a portfolio might lose, using historical data. The problem with forecasting future events based on history is that it works well only in the very near term. During the financial crisis these risk management programs failed miserably.
Then there is the sheer number of risks to tackle. Looming large is the risk of not having the liquidity to meet university or private equity capital commitments. There is the risk of investing in asset classes with greater volatility, but when investors try to reduce it by creating less-volatile portfolios they introduce a new risk — underperformance. There are also risks associated with markets, leverage, portfolio asset concentration, operations, credit and counterparties, and balance sheets. There is strategic risk — the potential impact to an organization’s long-term strategy and investment policy owing to fundamental shifts in external factors. There’s even gift risk as donations tend to diminish in tandem with a drop in the equity market.
Endowment officials can tackle risk in multiple ways. They can take a granular, bottom-up, security-level, multifactor approach, slicing and dicing portfolios along industry sectors or geographic regions. They can assess risk from the top down, coordinating with other school officials including the treasurer, comptroller and CFO. Lastly, they can address risk through active hedging within the portfolio, using derivatives to mitigate tail risk, or the risk that events considered statistically unlikely to occur actually take place.
Reinventing risk management means having to ask questions not previously in the lexicon. Schools are focusing in ways they weren’t in the past, observes Kathryn Crecelius, CIO at Johns Hopkins University in Baltimore since 2005. Achieving the highest performance had become the No. 1 goal of endowment offices, she says, drawing an analogy with college team sports. “Being No. 1 in sports and going to the finals is very different from managing endowments,” says Crecelius, whose school had the fourth-highest return — 15.6 percent — among large endowments for the year ended June 2010. “It’s not just about putting up top numbers if you can’t meet payout.”
The risk manager’s job is changing too. As Eric Upin, former CIO of Stanford Management Co. delicately phrases it, “In the past, you hired some highly educated quant geek and put him in the basement where he churned out different charts with Greek letters.” Upin, who left Stanford in April 2009 to become CIO at Makena Capital Management in Menlo Park, California, has seen the risk position elevated to the C-suite, as schools like Harvard, Stanford and the University of Michigan have hired chief risk officers during the past two years.
In July 2009, Mark Schmid was brought on to run the endowment at the University of Chicago, based in part on his experience building risk management programs complete with risk officers for the pension funds at Boeing Co. and DaimlerChrysler. In early 2010 Schmid hired that school’s first CRO as well as a chief strategy officer. “The philosophy and strategy is a total enterprise approach,” Schmid says. “It takes a page from asset-liability management and the corporate finance approach. I thought the endowment should be managed in the context of the total entity, not just from an investment perspective.”
The entire history of risk management has been one of reaction to crisis and catastrophe. As previously unforeseen risks arrive, new methods are sought to deter them. But for all the advances in financial engineering, a dismal science that steals a page from Thomas Carlyle’s famous 19th century pronouncement on economics, most agree that quantitative forecasting tools didn’t work when the U.S. financial system nearly got plowed under.
Financial risk management first appeared on the scene in the 1980s, after financial theorists like Markowitz (efficient portfolios) and Sharpe (capital asset pricing) laid the groundwork. Barr Rosenberg, an economist and finance professor at the University of California’s Berkeley campus, applied these theories to build computer models that balanced risk-and-return trade-offs in pension fund portfolios at his firm, Barra. Not long after, in response to the development of complex new financial instruments called derivatives, J.P. Morgan & Co. developed a tool called value at risk, designed to forecast portfolio losses using historical data. Later, Barra and RiskMetrics, the firm spun out from J.P. Morgan’s VaR creators, were bought by the index company now known as MSCI Barra.
Risk system providers bemoan the lack of essential data needed to measure portfolio risk. “People with risk assessment systems only had about 80 percent coverage,” complains Dan DiBartolomeo, president of Boston-based Northfield Information Services. A major roadblock to devising a viable risk control program at endowments is that current prices on private investments — equity, venture capital and real estate — aren’t available to feed into a risk management program. “There has to be something in the chain to make sure for every asset we own, we have the data to describe and understand it,” DiBartolomeo says.
“Even today, coming up with a good system to model these [private investment] inputs and outputs is impossible,” agrees Johns Hopkins’s Crecelius, who served as director of marketable alternatives at the Massachusetts Institute of Technology under longtime CIO Allan Bufferd from 1998 to 2005. “That’s the challenge we face. The potential pitfall is you spend a lot of time on a model but quality isn’t there because the inputs are unknown.”
Investment officers have come to doubt the continued utility of risk management tools with a short-term perspective for endowments with long-term investment horizons. Deborah Kuenstner, for one, used quantitative models offered by Barra and Northfield during almost a decade managing long-only equity portfolios at the DuPont Pension Fund in the 1990s. “The models are only as good as their assumptions, and their assumptions are fairly squirrelly,” says Kuenstner, who took over Wellesley’s $1.5 billion endowment in 2009 as CIO after Mendillo departed for Harvard. “There’s so much risk that goes into your assumptions, and you get false comfort.”
The frustration with risk systems makes sense given that 52 percent of endowment funds are allocated to typically opaque private investments and alternatives, according to the 2010 survey of 850 U.S. institutions of higher education by the National Association of College and University Business Officers and Commonfund. The largest endowments hold 61 percent.
Endowment officers have historically thought of risk management in qualitative rather than quantitative terms. Yale CIO Swensen first developed the endowment model of investing in the mid-’80s by creating highly diversified portfolios of many asset classes invested with superior asset managers. The model has been blamed for the steep losses during the last crisis, but the finger pointers have got it wrong, because a diversified portfolio is only one piece of the puzzle. Getting it right means having access to top managers, generating new investment ideas and implementing long-term, consistent oversight on top of it all.
“The most important task is to select the best partners,” says Donna Dean, CIO at the Rockefeller Foundation in New York and a Swensen disciple, having managed the real estate portfolio at Yale from 1989 to 1995. “People thought they could duplicate the Yale model, but with partners who weren’t as strong. That’s where they ran into trouble.”
As portfolios became larger and more complex, schools sought better risk controls. Soon after the global stock markets suffered their worst one-day percentage drop on October 19, 1987, the University of Notre Dame hired alumni Scott Malpass in 1988 to take over its $425 million endowment portfolio. Malpass, who now oversees $6 billion, did not disappoint. From the outset he sought top managers in many asset classes. “It starts on the front lines with asset allocation,” he says, adding that access is essential in determining what kinds of risk each manager is taking, what environments they will do well or poorly in and what factors drive their returns.
Consistent oversight is another factor in risk management for Malpass’s investment team of 15 mostly Notre Dame alumni. In early 2008 Malpass tapped longtime investment staffer William James as full-time risk manager. James is responsible for monitoring exposures in the investment pool and portfolio-level hedging strategies. “Putting some fat-tail hedges on is appropriate selectively,” Malpass says. His team makes use of an extensive reporting structure to monitor key risk factors and does risk forecasts and scenario analysis.
The 1998 collapse of hedge fund Long-Term Capital Management, which lost more than $4 billion in the wake of the Russian debt crisis and had to be bailed out by a consortium of 14 banks, set off another scramble among universities to see whether they had the proper safeguards in place. The next year the University of Michigan established an investment office. Newly appointed CIO L. Erik Lundberg, who had worked at the Ameritech Corp. pension fund, set out to create a team and investment process to oversee the second-largest public university endowment (after the University of California system). Lundberg began working more closely with the school’s treasurer and CFO after the bursting of the dot-com bubble in 2000. Lundberg and his team of 13 investment professionals perform risk management without a computer-based system, although they rely heavily on internally generated reports to mitigate portfolio concentration risk. Last year he created a new role for compliance officer Rafael Castilla, a former Wall Street attorney who originally came on board to help the endowment with partnership agreements. With the help of an analyst, Castilla’s primary role is to make sure that Michigan’s portfolio managers look at all the risks in their portfolios.
“The best risk management tool is a properly constructed portfolio and how it fits together with the other parts,” says Lundberg, who saw the endowment drop from $7.5 billion to $6 billion during the 2008–’09 period. It was back up to $6.5 billion by December 2010 after putting up a 12.5 percent return over the year.
It would be difficult to find a school more actively involved in hedging its portfolio risk than Case Western Reserve. “We have created a hybrid investment model by not placing all our eggs with managers,” explains CIO Staley. “We might be at the beginning of a change in the endowment culture.”
Staley was a bit ahead of the crowd when, in 2006, she hired Hussain, the school’s first director of risk, who built a proprietary risk management system dubbed Carma — Case asset and risk
management access — capable of performing in-house asset allocation studies. As the markets began their descent in the summer of 2008, Hussain and Staley realized that report generation was not going to suffice as the sole risk management tool, because there were too many unknowns to feed into the system.
“This is a bigger thing than you think it is,” says Hussain, who had previously been an investment analyst at nearby Oberlin College. “Endowments see risk management as a backward-looking function, a reporting function to some extent. To us, risk is much more than that.”
Soon after building Carma, Hussain began to model spending and policy distribution from the endowment. In 2008, while looking at asset manager exposures, he saw benchmark risk and correlations increasing. “The volatility was punishing us,’” recalls Staley, who earlier in her career had been a senior consultant at PricewaterhouseCoopers and an investment director at the State of Wisconsin Investment Board. “We asked, Isn’t there a way we could learn to use it to our advantage?” That was the beginning of a new idea: active risk management that eliminates much of the external management across the domestic, international and emerging markets equity portfolios.
Staley and Hussain believe in managing exposures and risks so there is capital to deploy when it is most attractive to do so. As part of the process, Hussain lays out near- and longer-term tail risks that could impact the portfolio — inflation, deflation, hyperinflation, the European debt crisis, China slowdown, food inflation, dollar strength or weakness. Next he tries to quantify the existing hedges already held in the portfolio via manager positions and option holdings, and then identify what additional hedges would be required to mitigate the various risks. He creates key indicators such as forward rates, volatility, skew, swap rates and yield curves to track attractive entry points and executes with Staley’s final approval.
The notion of accessing a few top managers in an asset class and then filling in the rest of the portfolio with synthetic instruments is not new. However, Case Western Reserve’s strategy has a different twist. The approach combines funds and managers with option-based strategies transacted and managed in-house with the purpose of “controlling investment outcome” to meet the endowment’s liability to the university, Staley explains. Controlling outcome may mean watching for brief market dislocations that open the door for low- or zero-cost tail-risk hedges or assembling an option structure with an asymmetric return profile — that is, more upside potential than downside — or creating an exposure to the Russell 3000 index using a combination of active, sector-specialist managers plus options to plug any sector gaps and provide downside protection.
Endowment chiefs have to find ways to manage risk that fit their schools’ cultures, their staffs’ abilities and their own comfort levels. Crecelius, who was hired from MIT to set up Johns Hopkins’s first investment office in October 2005, manages portfolio risk without a risk officer or computerized system. Instead, she thinks a lot about contingency planning and works closely with the school’s treasurer and CFO. At the height of the crisis, Johns Hopkins issued taxable debt. “We did it because the world was very uncertain,” says Crecelius, who holds a Ph.D. in French from Yale University, and taught the language at MIT before entering the financial world in the late 1980s. Hopkins’s bank lines of credit were ending in a year, and there was concern that the borrowing window would close. Crecelius saw at the time that the appetite for university paper was stronger than for U.S. corporations. “It was a vote of confidence for us but a measure of how leery people were of everything else,” she adds.
Crecelius views risk from the top down. She looks at the total university to gauge its financial strengths, including sources of income; number of applicants who can pay full tuition; dependence on government financing and risk of losing it; the school’s debt burden, taxable and nontaxable; and what is needed to preserve its bond rating. “It’s devilishly complicated,” she observes. “‘Know what you own’ has always been important, but it is even more important now, particularly when you think about allocations.”
During the financial crisis Crecelius called all her private investment managers and made a list of all those who would be going out over the next 24 months for new funds, and how much could be budgeted for these investments. Another risk-mitigating factor at Hopkins’s endowment is operational due diligence: Crecelius built the investment office with the notion that the operations team would be as important as the investment staff.
While schools like Johns Hopkins, Harvard, Notre Dame and the University of Michigan have billion-dollar risks to wrangle, small endowments have to contend with a somewhat different set of problems. Many have spent years trying to achieve the performance of the big guys. “People get so complicated in what they do and want to mirror bigger funds,” Notre Dame’s Malpass worries. “But they don’t have the proper oversight and management.” Malpass is particularly critical of investment vehicles like funds of funds that charge high fees, which eat up most of the performance.
Small schools have historically been unable to match the returns of their larger brethren. Endowments with $100 million to $500 million in assets lost 4.4 percent a year, on average, for the three years ended June 30, 2010, while schools with more than $1 billion in assets fell 3.5 percent. In a January 2011 report on the financial prospects for U.S. higher education, Moody’s Investor Services announced it is maintaining a “negative outlook ... for the large majority of rated universities.” The report raises fundamental questions about the long-term economic viability of many colleges, especially smaller ones. It found that except for the market-leading colleges and universities, less-diversified schools continue to be more directly challenged by tuition pricing, weak fundraising and state-funding threats.
As the largest schools continue to beef up their risk management with new hires and new approaches, small schools are taking another route. The smallest endowments, with under $100 million in assets, have often depended on local banks to manage their assets. The lack of coordination among the banks and a school’s administration often meant that portfolio diversification was not possible. Over time schools have chosen to outsource their portfolios to one specialist manager that can oversee their portfolio risk.
For years the endowment at Central Connecticut State University wasn’t much more than a “letterhead foundation,” says Nicholas Pettinico Jr., the senior vice president for advancement. Although it was founded in 1971, the now–$25 million fund remained in the hands of the same managers until Pettinico was assigned to rationalize it in 2008. Following a request for proposal, the CCSU Foundation selected Oaks, Pennsylvania–based SEI as manager. Central Connecticut has already seen a payoff: Its endowment put up a 15.2 percent return for fiscal year 2010, well above the 11 percent average for funds of its size.
Experiences like Central Connecticut’s are giving Tom Heck, CIO at the Ball State University Foundation, food for thought. The last two years have been difficult for the Muncie, Indiana–based endowment, as the once–$200 million fund lost a full quarter of its value, now standing at about $150 million. The portfolio earned 6.9 percent in 2010, well below the 11.9 percent Nacubo average for schools its size. A good part of the problem, says Heck, was his inability to move quickly when changes were needed. The CIO, who saw the fund grow from $30 million over 19 years, aspires to the endowment model of 50 percent in alternative investments and is now considering outsourcing. Heck does not want to relinquish total control of the assets and is looking to become an active partner with the outsourced firm, participating in investment strategy discussions, with the ability to monitor and track managers. “We still believe in the endowment model,” Heck says. “It’s the execution that we need to examine.”
ENDOWMENT OFFICERS learned an important lesson in the 2008–’09 academic year: Their mission is critical to supporting their institutions. They’ve also learned to integrate their operations with the rest of the school. “The crisis inspired a conversation that extended from boards of trustees to administrations to the endowments that I haven’t seen in 25 years,” observes John Walda, Nacubo president and CEO.
It’s very important to have cross-disciplinary committees to manage the overall risk of institutions, says Verne Sedlacek, CEO of Commonfund, a Wilton, Connecticut–based firm that manages over $25 billion for more than 1,500 schools and foundations. He believes that endowments should take a page from the pension investors’ playbook and manage their assets and liabilities.
In the past the annual distribution from most endowments was flexibly structured based on the pool of assets; as values increased at a substantially greater rate than inflation, some schools with larger endowments received close to 50 percent of their operating budget from the endowment, although most institutions receive about 10 percent. Now that endowment distributions have become a very volatile revenue stream — correlated to market movements, as well as to the amount of distributions, tuition and scholarships — Sedlacek believes schools should detach them from the value of their assets. Distributions should instead grow with the rate of inflation, or the cost value of providing an education. That would result in a far less volatile — and risky — revenue stream than the current system. He suggests a distribution based 80 percent on the inflation rate and 20 percent on asset value.
Schools that had not formally integrated their financial offices before the crisis with their endowments began to do so in the wake of the crisis. Prior to 2009, Cornell University CFO Joanne DeStefano attended investment committee meetings, but then-CIO James Walsh did not return the favor. After the endowment lost 26 percent of its value in the 2008–’09 academic year, things changed. Walsh began attending DeStefano’s meetings before returning to the United Kingdom at the end of the 2010 academic year to start his own hedge fund. Another Brit, Michael Abbott, former head of the investment committee at fund-of-hedge-funds firm Robeco-Sage, arrived last November to replace Walsh.
Cornell has instituted other changes. First, because of Moody’s new requirement for schools to report how much of their investments can be liquidated within a month, Cornell has developed an internal report that is more of a management tool. The university also now looks not just at its variable rate debt risk and swaps contracts, but at all financial components holistically. The third and perhaps most important change, says DeStefano, is that Cornell created a new trustee advisory committee to focus on finance, particularly treasury, debt strategies and swaps. The committee includes the chairs of the finance and investment committees, an emeritus trustee, DeStefano, the CIO and treasurer. “We all come from different perspectives trying to solve problems,” she explains.
Similarly, at Harvard, president Drew Faust in 2009 created a financial management committee to integrate risk and financial management across Harvard Management Co. and the university. Members include HMC head Mendillo, treasurer James Rothenberg, chief risk officer Neil Mason, senior administrative officer Katherine Lapp, CFO Daniel Shore and several faculty members and alumni with financial expertise. The committee meets monthly to discuss the university’s spending policy, the interaction of the risks held by the endowment portfolio and the rest of Harvard’s financial resources, and the right level of emergency cash that the school should collectively have on hand.
“The risk tolerance of the university is a key component in our portfolio construction,” says Mendillo. Harvard depends on its endowment to cover 35 percent of its operating budget. More than 60 percent of its undergraduates receive need-based scholarships totaling $158 million, a sum expected to increase about 7 percent in fiscal 2011.
Soon after Mendillo arrived at HMC, she began to revamp risk management. She hired Mason, who has a background in both trading and external manager oversight, as chief risk officer in March 2010 and assigned two staff members to work with him. Mason is one of five members of the HMC management committee that meets every Monday afternoon to discuss strategy, risks, opportunities and long-term plans for the portfolio and the organization. He also runs a Tuesday morning risk review meeting. Mason interacts with HMC’s internal portfolio managers on a daily basis to evaluate changes in the risks in their holdings and reports any significant findings to Mendillo in real time. He regularly spends time assessing risk at each of HMC’s four internal trading desks. When a new strategy is adopted, the risk team studies how it could affect other positions and strategies in the portfolio.
Mason, Mendillo and other members of the investment team regularly meet with external managers to evaluate the strength of their risk management systems and to flag any weaknesses or concerns. Harvard has beefed up its ongoing due diligence with external managers’ operations, risk management and legal departments, looking at things like how a manager is handling due diligence with its own counterparties.
“We’re being more granular with our external managers and internal platforms and how those changes in risk would overlap with or interact with other risks in the portfolio,” Mendillo explains.
Mendillo and Mason look at how risk is changing in the portfolio and how they might want to adjust it. They continually review and revise the analytic functions HMC uses to measure and control risks. HMC’s scenario analysis, for example, now includes larger downdrafts that go further out on the time spectrum — modeling how HMC’s portfolio would react to severe corrections that continue for several years — and higher correlations between asset classes, a newer area for Harvard and other schools, Mendillo says.
HMC has also developed contingency plans for problems that could arise and the degrees of freedom it has to deal with them: where to go for liquidity or extra market exposure or reduced market exposure, how to verify that the risks identified are what they appear to be and that the portfolio has the appropriate amount of risk, and how to identify if the risk implied in the policy portfolio — the asset allocation agreed to by the investment committee and HMC executives — is being well managed.
Geopolitical risk is very much on the minds of the brain trust at HMC, which has allocated 11 percent of the endowment to emerging markets. Harvard looks at total exposure to India, Brazil and China across all asset classes, weighing that against what’s going on in various regions of the world to create the right balance in the portfolio. “Everyone here understands the stakes are quite real and that this can’t become routine,” Mendillo says.
When the opportunity to hire a risk management expert to head its endowment arose in 2009, the University of Chicago grabbed it. After former CIO Peter Stein left to join Irvine, California–based Pacific Alternative Asset Management Co., University of Chicago president Robert Zimmer and the investment committee selected Mark Schmid, a veteran corporate pension plan executive, to oversee the now–$6 billion portfolio.
Schmid arrived at the endowment office in July 2009, bringing a new perspective on risk management built over two decades at the helm of the defined-benefit plans at Chrysler Corp. (later DaimlerChrysler) and Boeing, both of which had chief risk officers. In April 2010 he hired Michael Edleson, the former head of risk for all equity divisions at Morgan Stanley in New York, to be the university’s first chief risk officer. Schmid then established a risk committee, headed by Edleson, a West Point graduate who has a Ph.D. in economics and finance from MIT, and Joanna Rupp, the chief operating officer, who joined the endowment in 2001 as manager of public equities.
“The minority of organizations spend the resources on a dedicated CRO role,” Schmid observes. “I think that’s a huge mistake. The role is as important as my role, and the talent is hard to find.”
Edleson is building a risk management framework from the top down, beginning with governance procedures, the risk committee and initiatives like building an extensive factor model to manage the risk in the portfolio. Edleson defines total equity risk exposure across the entire endowment. With input from Que Nguyen, whom Schmid hired to fill a new position as chief strategy officer, he built a framework for determining the amount of global equity in the endowment on both a qualitative and quantitative basis, and reduced the allocation by 10 percentage points, from 85 to 75 percent. (The excess assets went into credit investments temporarily.) By June, Schmid expects to have a new liquidity budget in place, totting up how much liquidity the endowment fund should have across the total portfolio. He then plans to move on to the asset class level, identifying how much of the returns of its private equity, hedge fund and real asset investments comes from the market, or beta, as opposed to from manager outperformance, or alpha.
Schmid is at the vanguard of a new movement to match assets and liabilities much the way pension funds and corporate finance offices do: “I think the endowment should be managed in the context of the total entity, not just from an investment perspective.”
Schmid spent a lot of time defining the need-based liabilities of the university as well as the university’s medical center and pension fund, whose roughly $700 million in assets he also oversees. Since the financial crisis, the school holds biweekly financial coordination meetings with the CFO, treasurer and the endowment COO, to talk about functions like debt raising, audits and upcoming financial planning with the board. Schmid also attends a financial strategy meeting chaired by the university provost at least once a month.
The work being done by Schmid and others is encouraging. The depth of the last financial crisis and the time it will take to build back lost assets seem to ensure that schools will actually stick to their new resolve to oversee their assets with a fresh perspective on risk management. They will have to if the U.S. higher education system is to retain its ranking as the best in the world.
