As you are probably well aware, the investment markets have been experiencing extremely difficult times in the last few months. In fact, the credit markets have been having problems since July, 2007. The stock market followed suit at the beginning of this year.

We are writing today because we expect that you may have questions regarding the performance of our endowment portfolio. Being aware of the severity of the market situation and the impact on the endowment will be necessary as you develop your plans over the next months and/or years. However, we believe that we have a good story to tell and that you should feel confident in our stewardship and the future performance of the endowment.

How bad have the markets been over the last year?

This particular downturn in the economic cycle began in July of 2007 when housing prices started to decline and subprime mortgages (mortgages made to the least creditworthy borrowers) began to lose their value for the financial institutions that held them. As this first domino fell, it became apparent that financial institutions of all types had too much debt and too little capital to support it. Therefore, banks needed to raise their capital reserves by selling other assets, which, in turn, put downward pressure on these asset prices. This negative cycle kept feeding itself — the need to raise more capital, the requirement to sell assets, the resulting fall in prices for everyone, the negative impact on balance sheets, the need to raise more capital and so on. By the end of 2007, confidence in financial institutions was severely impaired and the stock market began to decline in 2008.

The next domino to fall was the failure of Bear Stearns in March of 2008 due to too much debt and the inability to raise more capital. The federal government, knowing that a failure in Bear Stearns would be very negative for all financial institutions, stepped in and assisted JPMorgan Chase in buying the firm. The market reacted favorably for two months and then the wheels fell off in June. At that point, all major financial institutions were considered to be at risk of failure and stocks began to tumble. In September, the markets hit new lows as Fannie Mae and Freddie Mac were taken over by the federal government, Lehman Brothers announced its bankruptcy, Merrill Lynch was purchased by Bank of America, Goldman Sachs and Morgan Stanley converted to commercial banks, and the list goes on. Today, the news is dominated by government bailouts, rescues and guarantees in order to save the financial system from complete failure. As of this writing, the S&P 500 index has declined more than 35% and the international stock market indexes are down more than 40% (even after a +10% plus day on October 13). Many details have been left out, but hopefully you understand the basic theme: it has been a very difficult year for investments.

How has the endowment fared during this period of decline?

Before we describe our performance, it is important to know the UW Foundation’s philosophy for investing the endowment. The Foundation endowment has two objectives: to spend for current needs and to grow in real terms into perpetuity. Therefore, we recognize that the endowment has two conflicting goals, one being short-term and the other long-term. We reconcile these two differences by determining a long-term annual return and then use diversification strategies to reduce the risk and volatility in each year. The endowment annual return target is 10%, which is the sum of our spending plan, expected inflation and expenses. We realize that achieving 10% each and every year is not realistic, but we expect this return over a longer period of time.

In order to achieve a 10% return over time, the endowment emphasizes equity-related strategies. This by no means translates into a concentrated exposure to the stock market. In fact, the endowment has a wide variety of equity-related exposures, including stocks, real estate, oil and gas partnerships, venture capital companies, hedge funds and many others. We have found that this diversified approach provides a 10% or greater return over time, but also a relatively uncorrelated return profile to the U.S. stock market.

However, during this period of extreme volatility and indiscriminate selling of all risky assets, the endowment’s diversified portfolio has been affected in a meaningful way. Beginning in 2007, the UW Foundation investment staff recognized the imbalances in the credit and housing markets and began to gradually reduce risk from the endowment portfolio. Despite this more conservative posture, the endowment performed above target in 2007 with a net return of 11.6%. As the market performed considerably worse in 2008 and all asset prices fell, the endowment declined, but much less than the stock markets. As of September 30, 2008, the S&P 500 index was down nearly 20%, yet the endowment portfolio fell only 12%. In October, the markets (for lack of a better word) crashed and at one point the S&P 500 index fell more than 20% during the month.

Although our returns are still preliminary, we expect that the endowment captured roughly 50% of the decline in the stock markets. This would bring the endowment’s year-to-date return closer to -18% versus various stock markets being down 30 to 40%.

How will this affect the spending plan of the endowment?

Frankly, you should expect that the dollars available to be spent from an endowment fund will be less going forward. The current spending plan formula is 4.75% multiplied by the endowment’s market value average over 12 quarters. Like most endowments, the Foundation uses an averaging formula to increase the spending percentage in bad years and decrease it in good years. The spending plan also reduces abrupt variations in the endowment payout. Over the last five calendar years since 2003, the endowment has enjoyed excellent returns, averaging 15.1% per year. With the averaging formula, the actual spending rate has averaged 4.5% over that time. Going forward, the actual spending rate will most likely increase to more than 5.00% (perhaps as high as 5.50%) to maximize the actual dollars available to be spent for each endowment gift.

There are two issues to keep in mind. First, when actual spending rates increase during bad periods, the market value of the gift will fall more quickly. In other words, the endowment is spending a little more in bad times from the growth that was built in good times. Even though the spending rate is increasing, the market value of the endowment fund is decreasing at a faster pace and actual dollars available to be spent will decline. How much this amount falls per gift will depend on the performance of the endowment going forward. Second, some endowment gifts have discretion over the pace of spending regardless of our spending plan. The beneficiaries of endowment gifts may choose to reinvest some of the dollars available to be spent if there is a desire to preserve the fund for future students.

Is there any good news to take from this?

On an absolute basis, the news is grim. However, on a relative basis, the endowment’s performance has been meaningfully better that most equity portfolios. Prior to 2008, the endowment’s diversified equity strategies allowed us to participate in good markets and outperform in less profitable markets. In 2008, our focus has never been to completely eliminate risk from the endowment since we do not know when the markets will return to normal. We do believe we have been successful in reducing risk and minimizing losses during this most difficult period.

We also are keeping in mind that with any market decline, there are opportunities. Unlike most investors who have a finite life and are driven by emotions, the endowment can be a patient investor, buying assets as they become cheaper when sellers panic. We believe there are opportunities being created today in distressed credit and equity markets that will provide outsized returns in the future. Therefore, the UW Foundation investment staff and the investment committee of the Board of Directors are concentrating their efforts on gradually purchasing assets as they are being sold at “fire sale” prices. This strategy has not yet been rewarded as prices continue to decline. However, we believe that there is embedded value in the endowment, that we are invested with some of the best managers in the world and that this cycle will return to a positive position in the future. Patient investors will be rewarded.

It is unfortunate to have to report this news to you. We would prefer that equity markets increase indefinitely and losses never occur. Our economy moves in cycles and it is best to plan accordingly as we move along the cycle. We hope this letter will make you better aware of current events and allow you to adjust your plans as necessary.

As always, please feel free to contact us or anyone at the UW Foundation regarding the endowment or any related questions.

Sincerely,

David E. Erickson, Chief Investment Officer, University of Wisconsin Foundation
Andrew A. Wilcox, President, University of Wisconsin Foundation