In the Green, In the Green

When Scott Malpass headed to the University of Notre Dame from Erie, Pa., 24 years ago as a biology/pre-med major, he never suspected that he'd be doing major surgery at the university itself.

But, that's exactly what 41-year-old Malpass has done, even though he decided to forego medicine for a Master of Business Administration degree, after he became intrigued by his undergrad roommates' business assignments.

Following a three-year stint on Wall Street at Irving Trust Co., custodian bank for Notre Dame's endowment, Malpass was hired in 1988 as second-in-command of the fund. Nine months later, he became chief investment officer.

“By lengthening the investment time horizon, we changed the definition of risk and professionalized the office,” says Malpass. “With a perpetual time horizon, we can take advantage of illiquid, private investments that may not begin to approach earnings potential for five or 10 years. We can shift funds to more inefficient parts of the capital markets and take advantage of negative correlations. This change necessitated building a sophisticated team with specialized responsibilities.”

Today, Malpass' office employs 20 investment professionals — all Notre Dame graduates — who oversee $3.5 billion in 200 portfolios managed by 115 investment firms worldwide.

In 2000, with a return of 57.9 percent for 12 months ending June 30, The Wall Street Journal and U.S. News & World Report named the ND fund as the nation's top university fund performer for that period. Since Malpass has been CIO, the endowment has been among the top five university endowments in investment performance.

In early March, Malpass talked with Registered Rep.'s Contributing Editor Ann Therese Palmer about asset allocation, near-term investment strategies and criteria for selecting investment managers.

Registered Rep.: How do you determine asset allocation for an institution that needs to live off its investments?

Malpass: You have to balance intergenerational equity — balancing the needs of future generations of students and faculty with those of present students and faculty. You need to spread the benefit of endowment equally over time.

That means forcing yourself to put together a long-term investment plan which recognizes you must spend a piece of the endowment every year for expenses. But you can't spend all of it. You must save some money to invest and make money for the years when your investments don't yield enough money to pay expenses.

There's a creative tension. You want to be heavy in equities and equitylike investments for maximum long-term appreciation. But, you must achieve consistency in returns to meet annual spending requirements. So you can't put everything into one area. You must develop a risk-return profile that understands the dual nature of an endowment fund: long-term appreciation with annual spending. That's the impetus in establishing our asset allocation plan.

RR: One of the more significant changes you made at Notre Dame concerns risk. Before you were hired, more than one-quarter of its endowment was in bonds. The remainder was in blue-chips. In 1992, you convinced the trustees to increase investment in venture firms from 1 percent to 5 percent. In 2000, private equity (venture plus buyout funds) rose to 22 percent. Why did you lobby so hard for this change?

Malpass: There's a misconception about risk. Some people might characterize a portfolio that's plain vanilla — 75 percent equities and 25 percent bonds — as low risk. It's actually high risk. There's little diversification. I want more diversification because there are higher returns with less risk.

Incidentally, because venture cap is among the most inefficient investments, it's been fabulous for the long term and our best-performing asset class. From 1980 through December 2003, our composite venture capital returns were 30.6 percent. I'm expecting 15 percent to 20 percent in the near term.

RR: How has redefining risk influenced your asset allocation?

Malpass: We try to put together a blend of investments to make a reasonable rate of return at a modest risk. We invest for total return, not a certain amount of income.

We start by evaluating the major markets where we can invest, their expected returns, risk and correlation in and between those markets. With U.S. equities versus merger arbitrage, there's low correlation. There's a negative correlation between commodities and U.S. equities. Over the last five years, our U.S. equities were up 6.1 percent, but commodities were up 18.4 percent.

According to portfolio theory, if you combine a basket of assets, their expected returns are the weighted average of the basket. The expected risk is lower than the weighted average. You can have a nicely constructed quantitative model, but you've got to find firms that can execute the model and monitor it with frequent judgment calls based on rigorous fundamental analysis.

RR: Generally what do you invest in? Does being at a Catholic university influence your investments at all?

Malpass: We follow an investment policy that restricts investments in anything that might violate Catholic social teaching. This excludes, for example, investments in pharmaceutical companies that manufacture birth control products. We also restrict tobacco companies.

For long-term capital appreciation, we've increased our equity investments from 75 percent to 90 percent, but diversified investments within that category. We've reduced U.S. equity because our 10-year projections for U.S. equities are only around 8 percent — compare to midteen yields 10 years ago.

We've redeployed that money into hedge funds because of the inefficiency of those markets. We're hoping to get a consistent return of 10 percent to 15 percent, 4 percent to 5 percent above our U.S. equities prediction. Event-driven hedge funds — merger and convertible arbitrage and distressed debt — have one of the lowest correlations to U.S. equities. We get more downside protection.

For a long time we've invested 10 percent in hedge funds. Three years ago, we raised that to over 20 percent. We've reduced our U.S. and international equities from about 22 percent to around 18 percent.

RR: Where else are you investing?

Malpass: In the next 10 years, real, tangible assets are going to beat financial assets compared to the last 10 years, when financial assets killed real assets. We're investing in commodities futures, metals, energy, timber and real estate. This year we've started investing in funds that buy timber, primarily in the U.S., but some overseas. Thirteen percent of our endowment is in this real asset category.

For the last 10 years, we've been investing in private equity partnerships that own small, mostly domestic oil and gas exploration-and-production companies or pipeline companies. We're gradually increasing this 5 percent investment.

Real assets, such as various commoditylike businesses, have significant growth potential. These businesses haven't seen major investment in the last 20 years. No one saw any value in them. Commodity prices have been down. But now China, India and other emerging markets are importing massive quantities of industrial iron ore, copper, nickel and aluminum and importing a lot of crude oil to support its industrial expansion.

RR: What were your returns last year?

Malpass: Last year we had three themes: emerging markets, distressed debt and small-cap. Distressed debt — senior and subordinated debt of financially stressed companies like telecoms — was a home run, a 33 percent return. Emerging markets was a 53 percent return and small-cap 50 percent.

RR: How do you select outside investment managers? What role do alumni play? Where do you get your ideas?

Malpass: We interview about 300 firms annually. We're looking for the four Ps: people, process, philosophy and performance. Everything in life is about people. We've learned that from WorldCom, Adelphia and Enron.

You've got to be able to feel these people are your partners, that they're like-minded and they're going to do what they say they're going to do. Do I trust this person? What's my sense of this person after multiple meetings in different settings on different occasions?

Then I look at their organization. Have they developed an organization to allow them to execute what they say they will do? Quantitative analysis may show an investment manager has done some outstanding work, but the entire package has to be there.

The chief way that our alumni help is when I'm doing due diligence on a firm. There may not be N.D. alumni in that firm, but invariably some alumni have worked with the firm and know the firm. At most of the firms with whom we deal, there are alumni in junior and senior posts.

We get ideas from conducting intensive investing planning. Our internal staff meets off-site as a team to think about valuations. We try to be contrarian — what's really down and why? Maybe there's an opportunity where we should shift some funds at the margins. We determine asset allocation based on analysis of historical and forward looking appraisal of expected returns, risk and correlations among major asset categories combined with our long term horizon, which allows us a higher equity exposure in both public and private equity markets, both long and short.

RR: How do you measure success?

Malpass: We use an internal strategic policy portfolio that's the weighted average of the different asset classes in which we invest and benchmarks for each asset class. We pick managers who beat that benchmark, overweight a category that does well or underweight one that does poorly. Since 1989, we've beaten it by about 500 basis points annually, or by $1.3 billion.

RR: Do you use a “smoothing formula” to calculate spending as a percentage of the endowment's average value?

Malpass: Yes. We use a unitized pool that functions like a mutual fund. It's comprised of over 3,300 endowment funds, about 1,000 scholarship funds and endowed chairs plus unrestricted endowments whose earnings flow to the operating budget.

Everyone owns units in the pool. We spend a certain number of dollars per unit. The overriding goal of spending is 4.5 to 5 percent of a smoothed market value using a 12-month average. Over the last 10 years, the endowment increased about 15 percent annually. We spent about $673 million on our students and faculty.

RR: In 2000, when Notre Dame's endowment had a 57.9 percent return, the returns enabled Notre Dame to limit tuition increases to 5 percent. What's happened to tuition increases since, and what role has the endowment return played?

Malpass: Our tuition has been below our peers because our investment strategy has offset increased costs of educating students. Fifteen years ago, the University's budget was $211 million. Today it's almost $700 million. We've been able to keep tuition increases below 5 percent because of the markets, but with more modest markets, tuition increases have begun to creep slightly higher.

RR: What do you see in your crystal ball?

Malpass: Starting with the end of communism and greater economic cooperation and free trade, there has been an inner-connectivity of markets and economies that's accelerating, despite the Iraq war and dot-com bust. Two current examples are Chinese manufacturing and Indian software programming. This phenomenon will accelerate. America will benefit the most because we've got the most sophisticated economic and intellectual capacity and high-end technology.

University of Notre Dame Endowment Fund Comparative Returns as of 12/31/03

University of Notre Dame Asset Allocation vs TUCS* Universe of Trusts Greater Than $1 Billion (as of 12/31/03)