Endowment & Similar Funds Investment Review September 2008 This cover page provides a summary overview of the Pennsylvania State University Endowment and Similar Funds for fiscal year 2008. The next page summarizes Endowment-related data that is discussed on the remaining pages, along with in depth Endowment performance analysis. Executive Overview Endowment Performance Annualized net investment returns for the Penn State University Endowment Pool (adjusted for the impact of gifts and spending, and after external investment management expenses) are shown below for periods ending June 30, 2008: Fiscal 08 3 Years 5 Years 10 Years -1.9% 10.6% 12.1% 7.5% Endowment & Similar Funds Market (pg 3) Penn State University s Endowment and Similar Funds were valued at $1.6 billion as of June 30, 2008, including the Long-Term Investment Pool s (LTIP) $1.5 billion in investment assets. Review of Investment Markets (pg 4) The graph below compares respective returns for 12- months ending June 30, 2007 and 2008 for the S&P 500, MSCI All Country World (ACW) ex-us, 91-day US Treasury Bills, Lehman Aggregate Bond, and publicly-traded Real Estate Investment Trusts (REITs) Indexes. As shown, public equity returns turned negative in 2008 and trailed year earlier results; however, bond and T-Bill returns remained positive. Domestic real estate (REITs) was also negative and trailed results from one year ago. Investment Diversification and Asset Mix (pg 5) At fiscal year-end, 50% of pool assets were invested in public equities (domestic and foreign), 23% in fixed income/cash, and 27% in private capital partnerships (venture capital, private buyouts, real estate, and natural resources). This was consistent with Penn State s current Policy Asset Allocation. Comparative Fund Performance (pg 6) Penn State s Long-Term Investment Pool returned -1.9% net for the year ending June 30, 2008 versus -1.4% for the passive policy portfolio. For longer periods, the Endowment s returns have compared favorably with benchmark returns for Penn State s Policy Portfolio. Asset Class/Manager Performance (pg 7) Fiscal 2008 performance of the Endowment s external investment managers, including both public and non-public (limited partnerships), is on page 7. Long-Term Investment Pool and Spending (pg 8) The Penn State Long-Term Investment Pool s average annual net returns of 7.5% and 9.7% over the last 10 and 20 years, respectively, have allowed the Endowment to maintain steady inflation-adjusted spending and achieve long-term intergenerational equity. 20.6% 30.1% Investment Market Returns Fiscal Years Ending June 30 5.4% 4.3% 6.1% 7.1% 12.6% 2007 2008-13.1% -6.2% -13.6% S&P 500 World ex-us T-Bills Bonds REITs -1-
5-Year Endowment Facts and Figures ---- - Annual Periods Ending June 30 ---- 2008 2007 2006 2005 2004 Investment Performance LTIP 1 (annualized net returns) -1.9% 21.2% 13.9% 13.1% 15.5% Market s ($ millions) Long-Term Investment Pool 1 1,487.9 1,538.7 1,279.6 1,128.6 1,007.3 Similar Funds 2 127.7 131.5 110.0 102.7 99.5 Total Endowment 1,615.5 1,670.2 1,389.6 1,231.3 1,106.8 Gifts & Other Additions ($ mils) 47.8 3 55.2 54.6 46.3 56.9 Current Spending ($ mils) 60.4 58.3 56.9 55.3 53.1 1) Long-Term Investment Pool (LTIP) Endowment assets over which Penn State s Office of Investment Management (OIM) has investment responsibility, as approved by the Penn State Investment Council (PSIC) 2) Similar Funds includes donor-restricted and deferred gifts, plus funds in transit to LTIP 3) Beginning in fiscal 2008, some endowed gifts are held in a special account for 90 days before being added to LTIP. Actual total endowed gifts received for the 12-month period ending June 30, 2008 were $70.2 million. Penn State Investment Council (PSIC) Meetings June 20, 2008 approved: Committing $5 million to US Venture Partners X and $10 million to Oaktree Real Estate Opportunities IV. Investing $25 million with Aetos Capital Distressed hedge fund (and subsequent approval of additional $10 million to Oaktree Opportunities hedge fund.) Liquidating Commonfund International Equity Fund and investing $40 million each to Marathon Asset Management and TT International, and $25 million to Victory Capital. February 20, 2008 approved: Committing $20 million each to LLR Equity Partners III and Advent International VI Committing $10 million each to Lubert-Adler Real Estate VI and Franklin Park Venture Rebalancing non-us equity exposure to 80% developed and 20% emerging countries October 26, 2007 approved: Committing $20 million to WLR Recovery Fund IV, LP, a distressed buy-out fund September, 2007 approved: Withdrawing $10 million from Oaktree Capital Management Long/Short Emerging Market Equity, LP and committing $10 million to Oaktree Capital Management distressed-debt hedge fund. Committing $20 million to Natural Gas Partners IX, LP. Please note that commitments made to Limited Partnerships (LPs) are not immediately invested, and are called (paid) over several years until total commitment is satisfied, except as noted. -2-
Endowment and Similar Funds Market As of June 30, 2008, Penn State s Endowment and Similar Funds were valued at $1,615.5 million, which includes $1,487.9 million in Long-Term Investment Pool (LTIP) assets. Non-pooled assets charitable remainder trusts, charitable gift annuities, and other life income funds in addition to some donor restricted funds, as well as cash in transit to the Endowment accounted for an additional $127.7 million. The annual market values for the University s Endowment Pool and Similar Funds for the last five fiscal years are shown below: Endowment and Similar Funds Market Fiscal Years Ending June 30 ($ millions) 1,670 1,616 1,107 100 1,007 1,231 103 1,129 1,390 110 1,280 132 128 1,539 1,488 Similar Funds Long-Term Pool 2004 2005 2006 2007 2008 From the graph above: The Endowment and Similar Funds total value decreased by $54.7 million during fiscal 2008. As seen in the table on page 2, new gifts added to the Pool over the last 12 months totaled $47.8 million, while Endowment program support (spending) amounted to $60.4 million. The total Endowment s $509 million increase since 2004 reflects new gift contributions and reinvested investment earnings, after providing cumulative program support of $284.0 million. Inflows of new gifts, along with positive investment returns, have resulted in a cumulative 46.0% increase in the Endowment s value, net of spending, from June 30, 2004 to June 30, 2008. -3-
Review of Investment Markets in Fiscal 2008 Fixed income markets in fiscal 2008 handily outpaced worldwide equity returns, which suffered double-digit declines versus double-digit gains a year earlier. Non-US stocks continued to lead domestic issues. The performance of investment markets that directly impact Penn State University s Long-Term Investment Pool is discussed below. US Equities The S&P 500 returned -13.1% for the 12 months ending June 30, 2008, compared to 20.6% for fiscal 2007. The Dow Jones Industrial Index performed about the same, returning -13.3% and 23.0% in 2008 and 2007, respectively. Small-capitalization stocks, as measured by the Russell 2000 Index, returned -16.2% versus 16.5% last year. Reflecting strength in technology, the Nasdaq Index outperformed all domestic indexes in 2008, returning -11.9% versus 19.8% in fiscal 2007. Non-US Equities Equities outside the United States again outperformed those in the US. The Morgan Stanley All Country World (ACW) Index ex-us returned -6.2% for the 12- month period ending June 30, 2008, lagging its 30.1% return in fiscal 2007. Emerging market equities in less developed countries returned 4.9% over the last 12 months, far short of its market-leading 45.5% return in fiscal 2007. Fixed Income Domestic bonds outperformed equities worldwide, as the Lehman Aggregate Bond Index (various maturities of US Government and non-government domestic bonds) returned 7.1% in fiscal 2008 versus 6.1% in 2007. Long-Term US Treasuries returned 12.6% in fiscal 2008 versus 6.0% in 2007. Meanwhile, 91-day Treasury Bills returned 3.6% in fiscal 2008 versus 5.2% one year ago. Treasury Inflation Protected Securities (TIPS) led all fixed income categories, gaining 15.1% in fiscal 2008 compared to 4.0% in 2007. Real Estate Reflecting the downturn in housing in 2007, the publicly-traded Real Estate Investment Trusts (REITs) fell to -13.6% for the year ended June 2008 compared to 12.6% in 2007. Privately-held real estate investment partnerships, as measured by the commercial-property biased NCREIF Index, gained 13.6% in fiscal 2008 compared to 16.6% in 2007. Alternatives Private Equity Buyouts and Venture Capital rose, albeit more slowly, averaging returns of 12.4% and 11.5%, respectively, for the 12 months ending March 31, 2008 (private capital markets are reported on a 3- month delay). In the previous 12-month period, Private Equity Buyouts gained 28.3%, while Venture Capital returned 15.2%. By comparison, the Russell 2000 Index of small-capitalization stocks returned -13.0% for the 12 months ending March 31, 2008 and 5.9% for the year ending March 31, 2007. Economic and Market Outlook Global equity markets turned dramatically negative during the 12 months ending June 30, 2008, partially offsetting gains made during the 12 months ending June 2007. As has been the case for the last couple of years, non-us equities continued to lead domestic stocks. Fixed income markets provided a second consecutive year of positive returns, as the Federal Reserve cut short-term rates to alleviate credit market troubles brought on by the decline in housing prices. Looking ahead, domestic corporate profits will likely lag year-earlier levels, as the US and World economies slow in the face of continuing credit concerns. Penn State s well-diversified endowment portfolio consisting of public equities, private partnerships, bonds, and hedge funds in addition to inflation-sensitive real assets continues to be the most appropriate investment approach for long-term growth and sustainable spending. -4-
Investment Diversification and Asset Mix Asset allocation is a primary determinant of investment performance and risk control. The strategic policy asset mix targets a combination of three very broad asset categories to maximize potential returns, while tempering volatility. Reflecting a desire to support generous spending and the need to preserve purchasing power in light of changing market conditions, the Penn State Investment Council (PSIC) regularly reviews the Endowment s strategic policy. Shown below are the Endowment s actual asset mixes for June 2007 (far left) and June 2008 (middle). The allocation on the far right represents the Endowment s prospective, long-term goal, which is expected to be realized over the next five to seven years. Endowment Asset Allocation 100% 0% 53 50 47 25 27 33 22 23 20 Jun-07 Jun-08 Long-term Goal Public Equities Private Capital Fixed Income To take advantage of superior growth and purchasing power protection offered by equity-type investments, the above illustrates the Endowment s significant exposure to both public equities (US and non-us common stocks) and private capital partnerships (real estate, venture capital, buyouts, and energy.) As illustrated in the left and middle columns above, between June 2007 and June 2008 the allocation to public equities decreased from 53% to 50%. At the same time, private capital partnerships increased from 25% to 27%, while fixed income increased from 22% to 23%, during fiscal 2008. Over approximately the next five to seven years, it is anticipated that publicly-traded equities split between US and non-us stocks would represent 47% of the investment pool, including equity-oriented hedge funds. Another 33% would eventually be allocated to private partnerships, including private equity buyouts and venture capital, as well as real assets (public/private real estate and natural resources). The remaining 20% of the Endowment would be allocated to fixed income (primarily government bonds plus some credit-oriented hedge funds) in order to manage risk and to provide current income. Penn State s commitment to equities continues to be substantial because of expectations that ownership of assets will provide superior purchasing power protection and asset growth in the long run. -5-
Long-Term Strategy and Endowment Performance Compared The Endowment s Long-Term Investment Pool (LTIP) is guided by its hypothetical Strategic Policy Portfolio, whose prescribed mix of broad asset categories serves as a passive composite benchmark against which the performance of the actual, actively-managed Endowment is monitored. In the table and graph below, the respective weightings of five major asset categories as of one year ago are associated with corresponding market benchmarks to generate Strategic Policy Portfolio returns over 1-, 3-, and 5-year horizons: 6/30/2007 -- Annualized Returns -- Asset Class Benchmark Weighting 1 Year 3 Years 5 Years U.S. Equities S&P 500 Index 36% -13.1% 4.4% 7.6% Non-U.S. Equities MSCI ACW ex US 14-6.2 16.2 19.4 Marketable Alternatives Custom Index 7 3.5 12.2 NA Non-Marketable Alt s Custom Index 24 9.4 16.2 16.4 Fixed Income/Cash Lehman Total Bonds 19 7.1 4.1 3.9 Policy Portfolio (net) 100% -1.4% 9.9% 11.0% (Note that the above composite returns for periods greater than one year are biased towards recent Strategic Policy Portfolio returns relative to the investment pool, whose actual mix can vary from year to year, as discussed on the previous page. Also, because the Endowment s hedge allocation 5 years ago was minimal, the current 7% hedge fund allocation was distributed among the other 4 asset categories for those years.) Penn State Endowment (LTIP) vs Policy Portfolio 9.9% 10.6% 11.0% 12.1% Policy Portfolio PSU LTIP -1.4% -1.9% 1 Year 3 Year 5 Year As shown above, Penn State s Long-Term Investment Pool returned -1.9% net for fiscal 2008 versus -1.4% for the Policy Portfolio. The Endowment s 0.5-point slippage was largely due to underperformance of some of the Endowment s investment managers who failed to keep pace with benchmarks, as discussed on the next page. For the trailing 3- and 5-years, the Policy Portfolio would have realized annualized returns of 9.9% and 11.0%, respectively. By comparison, the Endowment returned 10.6% net and 12.1% net, respectively, as LTIP s non-marketable investments (representing nearly one-fourth of LTIP s assets) returned 28.7% and 28.3%, respectively, over the same periods. The Strategic Policy Portfolio provides a guidepost to help achieve long-term results that are consistent with the twin objectives of purchasing-power preservation, along with stable endowment spending. The Endowment s performance varies from the static Policy Portfolio as a consequence of several factors, including but not limited to the following:timing of cash-flows into and out of the Endowment, tactical shifts in asset mix, and investment manager performance. -6-
Asset Class/Manager Performance The Endowment utilizes external investment managers whose 12-month performance ending June 30, 2008 is compared below to broad asset class returns, which do not necessarily correspond to benchmarks used to assess individual manager performance. Traditional public portfolios are on the left, non-public on the right. Public Stocks (Domestic Equity) As of June 30, 2008, 22% of the Endowment was pegged to the S& P 500 Index. Four Domestic Equity portfolios that are designed to outperform the S&P 500 Index over longer term market cycles represent 10% of Endowment assets. Performance of these four is shown below relative to the S&P 500 Index s -13.1% return for fiscal 2008. Domestic Equity Large Cap (Institutional Capital) - 14.9% - 1.8 Large Cap Growth (Sands Capital) -1.2% + 11.9 Small Cap Growth (Chartwell Partners) -11.1% + 2.0 Small Cap (Indexed) -21.8% - 8.7 Public Stocks (Foreign Equity) The three non-us Equity managers below represent about 11% of Endowment assets in developed, emerging, and small-cap mandates, respectively. Their fiscal 2008 performance relative to the -6.2% return for MSCI s All Country World ex-us Index is shown. Foreign Equity EAFE (Commonfund Internat l Equity) -10.2% - 4.0 Emerging Mkt Eq (Commonfund EME) -1.5% + 4.7 Int l Small Cap (Dimensional Advisors) -17.5% Public Bonds (Domestic Fixed Income) - 11.3 Performance of the three below portfolios, which were invested in a variety of bonds, is shown relative to the Lehman Aggregate Bond Index s 7.1% return for fiscal 2008. They represented approximately 15% of the Endowment, while another 6% was invested passively and/or short-term. Fixed Income Intermediate Bonds (Standish- Mellon) 6.1% - 1.1 Multi-Strategy Bond (Commonfund) 6.2% - 0.9 Inflation-Protected (Indexed) Bonds/TIPS 13.6% + 6.5 Marketable Alternatives (Hedge Funds) Hedge funds, representing about 6% of Endowment assets, include private limited investment partnerships that employ strategies not limited to long-only positions and are designed to provide uncorrelated returns, irrespective of capital market trends. Shown below is the fiscal 2008 performance for the Endowment s current hedge funds relative to their unique benchmarks which reflect their individual strategies MSCI Emerging Market Equity Index for Oaktree Capital, MSCI All World Index for Federal Street Partners, a combination of the S&P 500 and Russell 2000 Indexes for Cumberland Associates, and 90-day T-Bills for Aetos Capital, respectively. Marketable Alternatives Index Oaktree Cap Mgmt EME L/S 4.9% 0.4% - 4.5 Federal Street Ptnrs Global Eq -8.8% -6.4% + 2.4 Cumberland Domestic Eq L/S -14.7% -18.5% - 3.8 Aetos Capital Absolute Return 4.3% 1.3% - 3.0 Non-Marketable Alternatives (Private Capital) Non-marketable investments accounted for about 27% of the Endowment and are invested in more than 70 private partnerships. These term-limited investments represent broad strategies, three of whose 1-year composite performances are compared below to representative index returns not available for Energy and Distressed Debt for the 12 months ending March 31, 2008. (Note: the timeweighted returns below represent March 31, 2008 net asset values and include cash flows through June 30, 2008.) Non-Marketable Alternatives Index Venture Capital 11.5% Private Equity 12.4% 11.9% 14.8% + 0.4 + 2.4 Private Real Estate 13.6% 13.3% - 0.3 Energy (Oil & Gas) Distressed/Subordinated Debt NA 23.2% -- NA 7.9% -- -7-
Long-Term Endowment Growth and Spending In the chart below, the top line represents the cumulative net investment return of the Penn State Endowment over the last 20 years. The layers illustrate investment return apportioned to program support (spending) and inflation (as measured by the Higher Education Price Index [HEPI]), with the remaining residual representing net, real (inflationadjusted) growth. Endowment Investment Return (9.7% per yr) Program Support Inflation (HEPI) Real Growth Cumulative 20-year Returns The Endowment s primary investment goal is to earn a long-term rate of return sufficient to support current spending and to preserve future purchasing power. This two-pronged objective is illustrated by apportioning total nominal (i.e., before adjusting for inflation) investment return (top line above) into layers, representing program support and inflation. A residual layer, which oscillates around the horizontal break-even line, corresponds to net real growth. The variability in real growth is attributable to plotting investment returns that periodically fluctuate (illustrated by the jagged lines above) alongside implicitly stable spending and inflation. Over the full horizon, the Endowment has balanced generous current spending while preserving future purchasing power, known as intergenerational equity. Two Very Different Decades of Market Performance The variable nature of investment returns is characterized in the below table which bifurcates the last 20 years into two consecutive 10-year periods, whose respective investment returns differed widely. The 10 years ending June 1998 (second row) benefitted from a long-term equity bull market, while the 10 years ending June 2008 (first row) suffered two large sell-offs in equities, as shown by the S&P 500 s significant return disparities (last row) below: 10-Year Periods ----------- Annual Nominal Returns ----------- ------ Annual Real Returns ------ Ending June 30 S&P 500 Bond Index Endowment HEPI S&P Bonds Endowment 1998 to 2008 2.9% 5.7% 7.5% 3.9% -1.0% 1.8% 3.6% 1988 to 1998 18.6 9.1 12.1 3.8 14.8 5.3 8.3 Diff (percentage points) -15.7%p -3.4%p -4.6%p 0.1%p -15.8%p -3.5%p -4.7%p As shown by the negative differentials in the last row above, investment returns for the most recent 10 years lagged those for the previous 10 years in every instance. Owing to the severity of two bear markets, the S&P 500 s 2.9% annualized nominal return for the 10-year period ending June 2008 trailed its 18.6% pace for the 10-year period ending June 1998 by a remarkable 15.7%p (percentage points). Over the same two periods, the respective return difference for bonds (Lehman Aggregate Bond Index) was -3.4%p and for the Endowment was -4.6%p, net of fees. On an inflation-adjusted basis relative to HEPI (boxed column in above table), the Endowment s net real return difference was -4.7%p, compared to real differences of -15.8%p for stocks and -3.5%p for bonds (last row of the right three columns above). Over the past decade, decreased public equity exposure along with increased alternative investments has enabled the Endowment to outperform both stocks and bonds (nominal as well as real) in the most recent 10-year period, when overall investment returns were substantially lower than the prior 10-year period. -8-