Karl Scheer joined the University of Cincinnati’s investment office as chief investment officer in 2011, and set about improving the efficiency of the school’s investments. The total endowment exceeds $1 billion. After recent changes, the fund’s large-cap U.S. allocation is heavily indexed, with the portfolio divided between standard market-cap-weighted and fundamentally weighted index funds. In all, about 23 percent of the endowment assets in the main pool track an index.
JOI: Would you give us an overview of the endowment?
Scheer: The endowment is approximately $1.1 billion. It comprises 1,800 individual endowments that have been created by private donors for specific, discrete purposes. We pool these funds together, commingle and unitize them, so it’s managed as a single fund.
JOI: What is the fund’s target growth rate?
Scheer: As at virtually all endowments, the goals are to grow the buying power over time. That sounds simple, but it’s hard to achieve. In order to grow the buying power of each of our 1,800 endowments, investment returns need to exceed outflows plus inflation. Outflows include spending policy distributions to the university of 4.5 percent, plus a 2 percent fee to the UC Foundation—the university’s fundraising arm—plus somewhere in the range of 20 basis points of expenses for managing the internal components investment program.
The outflows sum to approximately 6.7 percent. If you add today’s inflation, you’re talking about 9 percent investment returns to just maintain the buying power of the endowments. If we get back up to the historical average of 3 percent inflation, then our investments need to generate double-digit returns over time. That’s a real challenge.
At UC, we’ve been trying to attack this challenge on all fronts. The board of trustees, with internal leadership from the president, administrative leaders and academic leaders, reduced the spending policy over the past two years by about 1 percentage point, and a similar discussion is underway regarding the UC Foundation’s draw on the endowment. I think we’re headed toward a sustainable spending policy that the endowment investment pool can outperform over time.
JOI: Do you have an investment philosophy that drives your approach?
Scheer: Absolutely. Some of our key principles are around risk. No. 1: An endowment investment program cannot avoid or extinguish risk; rather, it must choose among risks. If we avoid market risk, then the odds we will fulfill the permanent missions of the endowments drop to zero. With negative or zero real returns, spending and inflation reduce an endowment’s buying power with frightening speed. If we have 9 percent spending plus inflation and we invest in T-bills, it only takes about eight years to cut the endowment’s buying power in half.
On the flip side, if we take excessive market risk, the odds grow unacceptably large that the endowment will suffer a permanent diminution of capital—a big realized loss that can also decrease the endowment’s ability to support its missions. Therefore, one critical role of the UC Investment Committee and investment office is to balance the mission risk and market risk from a top-down perspective.
The other big misconception in the marketplace relates to risk from a bottom-up perspective. Our job is not to avoid risk, but to assume the right risks, the most profitable risks. We don’t generate returns; all we can do is choose which risks to take, and it is the market that rewards intelligent risk-taking with returns.
Continuing with the topic of risk, we’re extremely sensitive to permanent loss of capital. Experiencing losses and then not having capital in position to recover is very corrosive to long-term returns. But there are only a few discrete ways that can occur: leverage; excess concentration; fraud; and foolish behavior.
Leverage can lead to margin calls in which your capital is seized at the bottom. Similarly, an excessively concentrated portfolio can lead to excessive losses from defaults—again, leading to crystallized losses and no opportunity for recovery. Fraud typically leads to capital that is impaired and frozen, which is particularly damaging if the investment was not sized appropriately.