UNIVERSITY OF ILLINOIS FOUNDATION CIO S ANNUAL ENDOWMENT REPORT Fiscal Year 2013 (July 1, 2012 June 30, 2013) Investment Office 1253 South Halsted Street Chicago, Illinois 60607 217-300-2483
ABOUT THE CIO The University of Illinois Foundation named seasoned investor Ellen J. Ellison as its new chief investment officer, effective January 15, 2013. Ellison has more than 30 years of experience in the financial sector and was the former executive director of investments at the University of Miami. While at the University of Miami, Ellison managed multi-class asset investment pools, including university endowment and pension funds that totaled $1.5 billion. In 2010, she was named one of the 10 Best University Endowment Managers by Business Insider. She has also served as the chief investment officer at J.I.K. Investment Services, Inc., a family office in Miami, Florida, and as a senior vice president at Fiduciary Trust Company International in both New York and Miami. Ellison also holds the Chartered Financial Analyst designation. As CIO, Ellison is tasked with building and leading a UIF investment team and providing guidance for the Foundation and the board on investment-related matters, including asset allocation decisions, portfolio management, and best practices. Ellison also monitors capital markets and economic forecasts as they relate to the global economic situation. FROM THE CIO It has been a year of significant changes as the Foundation s Board of Directors made a number of strategic decisions regarding how the pooled endowment is governed and managed. After a thorough, strategic review of the endowment office structure, and based on the recommendations of an external endowment industry consultant, the Foundation s Board of Directors voted unanimously to build an independent investment office. Since joining the team in early January, I have been focused on a number of important issues surrounding the creation of a new and independent investment office. In close consultation with senior Foundation administration and the Investment Policy Committee, we have decided to locate the investment team on the campus of the University of Illinois at Chicago (UIC) on South Halsted Street. We look forward to your visit in the coming year. We are enthusiastic about the opportunities that lie ahead as we build a world-class investment office in a world-class city. Supported by an extremely dynamic and experienced board, the University of Illinois Foundation is committed to doubling philanthropy and the size of the private endowment over the next seven to ten years. The Foundation board has recognized that a strong, well-organized, and professional investment office is central to this goal. As one of the premier public research universities in the country, the University of Illinois has recognized the increasing importance of private philanthropy. Recognizing the tremendous institutional opportunities that can be further enhanced by a strong investment program, we are committed to establishing a program of best practices in governance, investment management, and mission outreach to fund not only the current programs of the institution but also to reinvest sufficiently for future generations. It is a privilege to be a part of this endeavor. Sincerely, Ellen J. Ellison, CFA Chief Investment Officer 1
MARKET AND ECONOMIC REVIEW The 2013 fiscal year, ended June 30, saw strong returns across most asset classes and geographic regions. Equities performed well and were the primary beneficiaries of continued accommodative monetary policy. Developed markets produced gains in excess of the previous fiscal year with the MSCI World Index +18.6%. Despite back-to-back positive years, this index remains approximately 15% below its previous peak reached in October 2007. All developed regions of the world performed last year. Value outperformed growth by 4% for the first time since 2009 due to strength in European bank equities. Japan was the top performing developed stock market in local currency terms but the yen s 20% drop relative to the dollar brought the return down to 22.2% for unhedged U.S. dollar investors. The story was not so rosy for developing (emerging) market equities. After a strong 2012, they underperformed significantly in the final six months of the fiscal year, due primarily to concerns about a hard landing in China and its impact on the commodity supply chain. Frontier Markets equities outpaced both emerging and developed markets with an outstanding 23.4% for the fiscal year. For the fifth straight year in a row, U.S. stocks, as measured by the MSCI US Index, outperformed international stocks. The S&P 500 realized a total return of 20.6% for the fiscal year and surpassed its previous 2007 peak. Many U.S. investors concluded that it was less risky to stay home despite the compelling values in Europe and many emerging markets. The continued resilience of U.S. equity markets since their March 2009 trough has been a large determinant of endowment and foundation investment returns for the past one, three, and five years. Funds with larger than average allocations to U.S. equities have benefited. Many small endowments (defined as $500 million or less in assets under management) had more modest exposures by design or by default to the alternative investment universe than their larger endowment peers and, as a result, have benefitted. The U.S. bond market was flat for the year the Barclays Aggregate Bond Index lost 0.7% in value. However, underneath the surface, there was a broad disparity in returns between higher quality bonds, such as Investment Grade, and high yield or junk bonds. Investment Grade corporate bonds finished the year with a slim 1.4% total return, whereas high yield bonds returned 9.5%. Despite their strong performance, high yield bonds appear expensive at their current spread levels and therefore do not offer sufficient return for their underlying risk characteristics. Thanks to the nascent strength in the housing market (housing prices rose by 13.5% during the year), the mortgage market had a solid year. In particular, non-agency mortgage securities were the best performing segment of the fixed income market with a total return of close to 22%. The U.S. dollar traded higher against most other developed (+6.7%) and developing (+2.5%) market currencies. With the exception of the Japanese yen and Australian dollar, the currency markets were devoid of drama last year. Under Prime Minister Abe, Japan pursued Abenomics or a large quantitative easing program that sought to revive the Japanese economy after 30 years of decline and stagnation. This policy intentionally drove yen depreciation by 19.7%. The Aussie dollar was hit with fears of a significant decline in Chinese demand for Australian natural resources and, as a result, depreciated by 10.7% against the dollar. The U.S. economy experienced a tepid recovery last year led by an improving housing market. U.S. consumers loosened their wallets somewhat, but consumption remains sluggish in the face of some meaningful headwinds. Of particular concern are persistently high U.S. unemployment and stagnant median household income that is 7% below pre-crisis levels. A number of somewhat pessimistic observers have suggested that the economy, after five long years, may only be partially recovered since the financial crisis. However discouraging, this would suggest that the Federal Reserve s monetary support is likely to continue for the foreseeable future. Market participants know that the end game is not only inevitable but also desirable since it would signal that the economy is self-sustaining. 2
2013 FISCAL YEAR IN REVIEW Fiscal year 2013 was an excellent year for the University of Illinois, its Foundation, and the stewardship of endowment assets. The University of Illinois s endowment is composed of two major components that together reached $1.925 billion at the end of the fiscal year. Of that total, the University endowment totals $580 million and the Foundation endowment stands at $1.34 billion. This report focuses on the latter category the Foundation s $1.34 billion endowment assets and their management. The chart below summarizes the performance of the pooled endowment for one, three, five, and ten year periods ending June 30. For the year, the pool returned (net of all external and internal manager and advisory fees) 13.1% or 70 basis points in excess of the passive total portfolio benchmark. In addition, the 2013 return places the Foundation in the top quartile of all endowments within the Cambridge Associates Universe of 426 endowments. This chart also indicates top quartile performance for the trailing three year time period. Time Period Pool Returns Total Portfolio Benchmark Internal Benchmark Returns Relative +/- Top 25% of Peer Endowment Group Effective Total Spending Rate* 1 Year 13.1% 12.4 +0.7 > 12.5% 5.80 3 Year 11.5% 12.8-1.3 > 10.4% 5.80 5 Year 3.9% 5.4-1.5 > 4.5% 5.86 10 Year 6.9% 8.2-1.3 > 8.1% 5.71 *Includes Administrative Fee. Spending is pursuant to the Foundation s policy and in consultation with the University. The Foundation currently distributes 4% of a six-year moving average of the corpus of most endowment accounts to the University. It is reviewed annually by the Foundation s Board of Directors. For 2013, the 5.8% total spend consists of a 4.46% effective spending rate and a 1.32% effective administrative fee. PERFORMANCE ATTRIBUTION Asset allocation was a main driver of performance for the past fiscal year. In particular, the pooled endowment had 34.2% allocated to U.S. Equities versus a mean allocation of 18.2% (Cambridge Associates Universe of non-taxable portfolios over $1 billion). As mentioned earlier, this overweight proved quite positive for performance as U.S. markets outperformed non-u.s. markets (MSCI EAFE Index) by 2.6% last year and 39% cumulatively over the past five years. The Foundation ended the year with a smaller than average exposure to Emerging Market Equities (EME), 2.4% versus a mean allocation of 7%. This also helped performance since the group struggled for the second half of the fiscal year as concerns about a slowdown in China combined with the much-discussed end of the U.S. Federal Reserve s quantitative easing program hurt risky asset categories in general and EME in particular. The MSCI Emerging Markets Index closed the year with a 2.9% return for the 12 months ending June 30, 2013. Manager selection within the endowment s Fixed Income allocation added 2.1% over the Barclays Aggregate Bond Index as the PIMCO Total Return Fund and the Western Asset US Core strategy performed well on a relative basis in an otherwise ho-hum year for bonds. Other manager standouts included: Adage Capital, which generated 5.6% outperformance relative to the S&P 500 Index; Sanderson International Value Fund, with 2.2% in alpha versus MSCI EAFE Value Index; and Baillie Gifford, which outperformed its benchmark by 1.9%. 3
Marketable alternatives delivered a solid, nominal 12.2% return but fell short of the benchmark as both hedged equity and absolute return/credit managers underperformed the benchmark by approximately 3.2%, net of fees. Independent of the near-term performance shortfall, we are gradually moving from a fund-of-fund model to a direct allocation to marketable alternatives managers. Turning to the illiquid side of the portfolio, the past decade has been challenging for most Private Equity/Venture Capital investors who have grown impatient with lackluster returns. In exchange for the longer lock-up of capital associated with private equity, investors must be sufficiently compensated with returns that exceed public equity portfolios when investing in private equity. Referred to as the illiquidity premium, most private equity funds have failed to beat publicly-traded markets during the past decade. Nominal returns, however, have been strong. This was also the case for the Foundation s Private Equity allocation during the past 12 months strong absolute performance at 16.7%, but far below that of the public market benchmark at 24.2%. It is important to note that a 3% illiquidity premium over public equity returns has been historically applied to justify the risk of investing in private equity. This bogey will increase to +5% in the new fiscal year as it is important to maintain an especially ambitious benchmark for this part of the portfolio. On the other hand, it s very encouraging that Private Real Estate investments earned 12.3% last year and outperformed the NCREIF + 0.5% benchmark s return by 1.1%. THE POLICY PORTFOLIO The Policy Portfolio is reviewed and set annually by the Foundation s Investment Policy Committee based on input and recommendations from the Investment Team. It is the theoretical, long-term mix of asset classes that will best support inter-generational equity i.e. the fair balance between current spending and the future principal growth to support at least the same level of spending in perpetuity. The policy portfolio encompasses both expected returns and their associated risks. Finally, it provides the Investment Office and Investment Policy Committee a guide or baseline for the actual portfolio allocation at any given time, and also serves as a benchmark against which our active management decisions and resulting performance are assessed. The chart below details the current policy portfolio (as of June 2013) and changes from the previous fiscal year. UIF Pooled Endowment Policy Target Policy Portfolio FY 2012 FY 2013 Global Equity 60% 38% U.S. Equity 40% 18% Non-U.S. Equity Developed 17% 12% Non-U.S. Equity Emerging* 3% 8% Global Fixed Income 17% 10% Credit N/A 2% Inflation-Protected Bonds N/A 4% Sovereign Bonds N/A 4% Alternatives 23% 52% Marketable Strategies Credit/Absolute Return/Distressed 3% 15% Hedged Equity N/A 15% Private Assets Private Equity (1) 10% 10% Real Assets (2) 10% 12% Total 100% 100% *Includes up to 2.5% in dedicated Frontier Market Equity strategies. (1) Includes LBO, Mezzanine, M&A, Growth Equity, International PE, and Venture Capital. (2) Includes private real estate (non-campus), energy, and natural resources (oil and gas, timber, and agriculture). 4