Carnegie Reporter, Vol. 3, No. 4 | Serving the Legacy of Andrew Carnegie: Investing for the Long Term, page 2

Allocating assets is as much art as science, and Shuman describes the various computer modeling she and her colleagues perform as helpful but limited intellectual exercises. “If you unconstrain the model,” Shuman observes, “we end up with a portfolio dominated by emerging markets, venture capital and real estate with no global equities,” a course that would be far too risky even if, in the long run, it is likely to outperform other portfolio allocations. Similarly, while the Corporation has a greater emphasis on asset classes such as emerging markets and real estate than many of its peers, a portfolio wildly out of kilter with comparable foundations might create institutional discomfort, especially if things went sour.

That said, the Corporation team has had a tendency to go its own way compared with other large foundations. One of Shuman’s main initiatives at Carnegie Corporation has been to broaden the range of asset classes included in the portfolio and to make the Corporation’s investments more global in nature. Bonds have been declining as a proportion of the Corporation’s investments for years, and Shuman has continued this move away from fixed income securities, positioning the portfolio more heavily in real estate, absolute return strategies² and private equity vehicles—investments that are at once less liquid but, traditionally at least, significantly more remunerative. These nontraditional investments, or “alternatives” as they are known in asset management circles, accounted for 45 percent of the Corporation’s portfolio as of September 30, 2005. See Chart 2.

In making these changes, Shuman has built on her experience at the Yale University Investments Office, where she served as Director of Investments for the university’s real estate investments, and where she worked with the legendary David Swensen as part of a team that produced stellar results year after year. Swensen emphasized the rewards of nontraditional—and relatively illiquid—investments for institutions like Yale or Carnegie Corporation. “Rewarding investments,” he has observed, “tend to reside in dark corners, not in the glare of floodlights.” A big advantage for the Corporation is the manageable size of its endowment: $2.2 billion is big enough to support a nucleus of investment professionals and get the attention of outside money managers, but not too large to deploy effectively into attractive strategies that exploit often fleeting market opportunities.

The Corporation’s investment and spending policies are designed to work together, dampening fluctuations in spending so that funding for grants is reasonably steady, even during periods of market volatility. Investment policy which supports the diversification within the portfolio, particularly into alternative assets, has lowered overall volatility because the behavior of these asset classes have low correlations with each other and with the broad public market. In addition, using a 12-quarter average market value to determine spending smoothes results. Thus, during the 2001 and 2002 fiscal years when the bursting of the tech bubble, the aftermath of 9/11, and the Enron and WorldCom scandals devastated many institutional portfolios, the Corporation’s total spending remained essentially flat. Diversification and strong manager performance protected the portfolio on the investment side while the spending formula created additional smoothing of the payout.

Ironically, as a 1999 Council on Foundations study demonstrated, the more a foundation spends as a percentage of its endowment, the less in total grants it can distribute over long periods of time. Higher spending erodes underlying endowment value, given those dollars go out the door instead of being reinvested and therefore compounded. Shuman and her team recently ran a similar exercise, analyzing the Corporation’s actual spending (which fluctuated, but averaged out to 5.0%) and market values from 1950 through 2005 and comparing them to what would have happened if the Corporation had spent an average of 4%, 5% and 6% each year. As Chart 3 illustrates, their simulation confirmed the conclusions of the Council’s study—namely, the counterintuitive, but very real, inverse relationship between rates of spending and actual total spending and endowment value.

The results are striking. Had the Corporation spent 6% of its assets versus its actual average of 5%, the nominal amount of grants made from 1950-2005 would have dropped by over $400 million over this period, from $1.55 billion to $1.12 billion (a 28% reduction), and the ending 2005 value of the endowment would have dramatically fallen by roughly $1 billion from $2.24 billion to $1.25 billion (a whopping 44% reduction), reflecting a serious impairment of the Corporation’s purchasing power and future grantmaking. The bottom line is that by striking the right balance between spending for today and spending for tomorrow, an institution can end up spending many more total dollars over its lifetime, generating a greater benefit to its grantees.

Under all these circumstances, doing good in perpetuity and giving away 5 percent annually may seem mutually incompatible aims, and the miracle of compounding by itself won’t do the job. There simply are no riskless investments that will generate the returns necessary to meet the 5 percent rule, cover expenses and make up for the inflation that eats away at the seed corn every year. “Most of us would say today that 5% is not an easy number,” says Richard Flannery, chief executive of The Investment Fund for Foundations (TIFF), which provides investment services to smaller nonprofits.

Next page: Still, Carnegie Corporation has some decided advantages in its quest for the investment returns it needs.

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² “Absolute return” investing seeks to achieve returns that are not correlated with wider market moves. Hedge funds are a common absolute return vehicle, and despite their reputation, they often dampen volatility in the context of the overall investment portfolio.