After the Flood: Endowment Investing for the Next 100 Years

1. After the Flood:Endowment Investing for the Next 100 Years UJC Investment Institute February 4, 2009 David R. Brief, CFA Chief Investment Officer Jewish Federation of Metropolitan Chicago

2. Floods: Foresight and Hindsight • And G-d looked upon the earth, and, behold, it was corrupt … - Genesis 6:12 Cartoon created for CoolRisk.com by Michael Mittag

3. 60-Year Flood

4. Key Issues Economy Risk Allocation Implementation Outsourcing

5. Economics 101 • Predictions • Crisis unfolded in July 2007 • March, June, September 2008 … what inning is it? • Mean reversion • What reverts and what does not • Supply and demand • Price vs. quantity

6. Long-Term Trend

7. Growth Rate Comparison Annualized CPI Increase = 4.0%

8. Mean Reversion and Corporate Profits Data obtained from U.S. Department of Commerce Bureau of Economic Analysis: http://www.bea.gov/

9. Mean Reversion and Valuations

10. Return to Long-Term Equity Ownership ~8% - 10% 6% (3+3) 3% 0% (?) Growth (Real Growth + Inflation) Income (Dividend Yield) Valuation Change (P/E) Total Return

11. Bond Market Expectations

12. Price of Credit vs. Price of Stuff

13. Corporate Risk Premium Mean and standard deviation data calculated from February 1976 through December 2007

14. Price vs. Quantity(e.g., U.S. Debt, U.S. Dollars, etc.)

15. Return to Bond Ownership 2% 2%± -?% +?% Price Change (Inverse of Yield Change) Income (Coupon) Valuation Change (Spread) Total Return

16. The only risk that matters:Enterprise Mission … to boldly go where no one has gone before

17. Endowment Objectives • Generate income to augment organizational resources in perpetuity • Spending policy and investment policy are key mechanisms • Balance natural tension between long-term and short-term objectives • Compounding wealth is a long-term process • Managing budgetary needs is a short-term process • Defining tradeoff between return and risk • Maximize long-term resources … • … subject to limiting short-term cutbacks (frequency and magnitude) • Feasibility serves as overriding constraint • Effective spending policies are complex • Liquidity requirements may present challenges • Size can limit investment opportunities • Incomplete understanding can inhibit prudent risk taking/return seeking

18. Want vs. Need:Risk Management Priorities • “Explain the change, the difference between what you want and what you need, there’s the key” - R.E.M., “I Believe,” Lifes Rich Pageant, IRS Records, 1986 • “You can’t always get what you want, but if you try sometimes you just might find you get what you need” - Rolling Stones, “You Can’t Always Get What You Want,” Let It Bleed, Decca Records, 1969“ • Distribution policy – represents the “front line” • Investment policy – should not be driven by volatility measures (e.g., standard deviation)

19. Joseph in Egypt revisited: Fat years and lean years

20. What we wanted vs. what we needed Modestly larger distribution + MUCH larger endowment (3x!)

21. Risk/Return TradeoffUpside Participation + Downside Protection

22. Asset Allocation and MPT:Mostly Poor Theory • Top Ten Critical Assumptions of MPT: • Returns on all assets follow stationary lognormal distributions … always • Risk equals volatility (standard deviation) … nothing more, nothing less • Zero transaction costs (brokerage or bid/ask spreads) or taxes of any kind -> indifference between income, realized gains, and unrealized gains • No market impact of trading and infinite liquidity • Complete awareness at all times by all investors of all risk entailed in every investment • Single universal time horizon for all investors • Risk management = diversification (via stable correlations). Period. • Ability to buy and sell all assets at all times • Unlimited ability to (a) sell short any asset, (b) borrow, and (c) lend at the risk-free rate • Zero impact on markets resulting from politics and/or investor psychology Adapted from essay by Travis Morien

23. Lognormal vs. Abby Normal?

24. Asset Allocation + Liquidity Allocation

25. A New Allocation Matrix

26. Implementation Implications

27. Alternative Investments vs. Alternative Rock • “The term "alternative" was coined in the 1980s to describe punk rock-inspired bands on independent record labels that did not fit into the mainstream genres of the time.”– Helen Popkin, MSNBC.com • Selected “Best Alternative Rock Album” Grammy nominees: • U2 (170 million albums sold) • Paul McCartney (100+ gold and platinum records) • R.E.M (3 multi-platinum albums) • David Bowie (1st gold record in 1974) • “Alternative” = Mainstream 27

28. Caveat Emptor • Lake Wobegon: • Fictional place, imagined by Garrison Keillor, where "all the women are strong, all the men are good looking, and all the children are above average." • New Jersey: • Real place in which 68% of drivers (74% of men) rate themselves as “above average” and only 1% as “below average.” –Fairleigh Dickinson University's PublicMind Institute, June 2007 Survey • “Alternative” Investment World: • Semi-real place in which all the managers are top quartile.

29. Caveat Corollary • “I sent the club a wire stating, "PLEASE ACCEPT MY RESIGNATION. I DON'T WANT TO BELONG TO ANY CLUB THAT WILL ACCEPT ME AS A MEMBER". –Groucho Marx • Want vs. need vs. achievable … • “If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.” – Unknown • Better to not play than to be the patsy.

30. Manager Diversification:102 Separate Investments

31. Transparency:Too Much Information? INFORMATION

32. Outsourcing:The Role of Committees • “A committee is a cul-de-sac down which ideas are lured and then quietly strangled." – Barnett Cocks • “A camel is a horse designed by a committee.” – Sir Alec Issigonis • “An investment committee should have an odd number of members, and three is too many.” – Warren Buffett

33. iPod by Committee?

34. Prudent Man Rule: "All that is required of a trustee to invest is that he shall conduct himself faithfully and exercise sound discretion. He is to observe how men of prudence, discretion and intelligencemanage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." – 1830 by a Massachusetts Court decision (Harvard College v. Amory) Prudent Expert Rule: The section directs directors or others responsible for managing and investing the funds of an institution to act as a prudent investorwould, using a portfolio approach in making investments and considering the risk and return objectives of the fund. – UNIFORM PRUDENT MANAGEMENT OF INSTITUTIONAL FUNDS ACT drafted by the NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS July 7-14, 2006 Prudence

35. Decision Hierarchies and Outsourcing • Security Selection • Manager Selection • Manager of Managers Selection • Strategy Selection • Asset Allocation • Where does the comparative advantage begin (and/or end)?

36. Ends Justifying Means?

37. Skill vs. Luck • “It's better to be lucky than smart, but it's easier to be smart twice than lucky twice.” - Unknown • “The man who said "I'd rather be lucky than good" saw deeply into life. People are afraid to face how great a part of life is dependent on luck. It's scary to think so much is out of one's control.” – Woody Allen, “Match Point”

38. The optimal 3-legged stool Advisors Workgroups COMMITTEE Staff Can a stool stand on one or two legs?

39. Food for thought • “Don’t put all of your eggs in one basket” – Unknown • “Put all your eggs in the one basket and --- WATCH THAT BASKET.” – Mark Twain • How does one define the “basket”?

40. Top Ten Take Home Lessons • Endowment investing must serve the enterprise mission • Investing is not a casual exercise • Driving via the rear-view mirror is dangerous • Superficial emulation of others’ success is likely to fail • Conventional distribution policies run too hot or too cold • Modern Portfolio Theory can do more harm than good • Diversification remains a free lunch • Asset class diversification is not enough • Risk does not equal standard deviation • The question is not whether to outsource, but to what degree