Bad Guess on Market Cost Getty Trust $400 Million
With gains of 25%, the stock market’s rally in 1995-96 was potent enough to gladden the hearts of investment managers all over the country.
But the news was not so cheering at the J. Paul Getty Trust, the $4.41-billion foundation whose landmark Getty Center museum and art research complex will open to the public Dec. 16.
The reason? In a little-noticed move, the trust had implemented a complicated strategy using stock index options to hedge its huge portfolio against a sharp drop in the stock market.
Unfortunately, the market did not cooperate. Instead of dropping precipitously as many market pundits expected, stocks soared relentlessly higher.
With every percentage point of the advance, the Getty’s hedge produced a corresponding loss. By June 30, 1996, when the trust closed its books for the fiscal year, the strategy had cost it a staggering $400 million.
By a wide margin, the 1995-96 hedge is the costliest single investment the Getty has ever made and remains a painful episode for the trust’s management.
“It’s the only time we varied from our standard [investment] policy,” said Getty Chief Executive Officer Harold M. Williams in an interview with The Times, “and I don’t think we’d do it again.”
An examination of the Getty’s flawed foray into stock market hedging opens a window into the investment philosophy of the trust, which is financing the Getty Center, the largest private construction project in the West.
Although the Getty Trust is widely regarded as one of the nation’s richest endowments, it faces economic pressures that are unusual among major foundations. Those pressures are what provoked its leaders to undertake an investment maneuver they thought was conservative, but turned out to be complex and unwieldy.
Perhaps even more important, the Getty’s stumble demonstrates the dangers facing investors who attempt to predict the direction of the financial markets.
The hedge was not widely disclosed at the time by the Getty Trust, and never publicly discussed until The Times reviewed investment records and queried Getty officials about the transactions earlier this month.
Disclosure Made in Biannual Report
The trust did disclose its substandard investment return in characteristically terse terms in its 1995-96 biannual report. The details of the transactions were made public in its annual filing to the Internal Revenue Service for the year ended June 30, 1996, the latest one available.
What The Times found was that the cost of the hedges--the equivalent to one-tenth of the trust’s entire investment fund--wiped out virtually all of the Getty’s stock market gains for that year. Thanks largely to other investments in corporate and U.S. Treasury debt, the endowment managed to eke out a 4.9% gain for the year, well below its stated investment goal and a fraction of that earned by other large tax-exempt endowments in the same period.
The transactions hardly impaired the financial health of the institution, which ranks second in asset size among U.S. charitable foundations. Getty officials say the endowment gained sharply in the most recent year, ended June 30, 1997, rising to slightly more than $4.4 billion on the strength of an investment return of 21.8%.
Trust officials note that because its annual spending is governed by a complex formula tied to investment earnings measured over decades, the hedge cost will not have a visible or material impact on programs.
But the Getty’s failure to capitalize on a major bull market move in the fiscal year from July 1, 1995, to June 30, 1996, while perhaps the only major blemish in a 14-year investment history, may be felt subtly in its overall growth rate for years to come.
The hedge, known technically as a “collar,” was initially proposed by a key board member, the retired investment banker and diplomat John C. Whitehead.
Whitehead, who retired from the Getty board in 1996, was chairman of its investment committee at the time. In an interview from his New York office, he said that the entire board was concerned that the endowment was vulnerable to a stock market downturn during a period in which it was spending heavily on construction of the Getty Center in Brentwood.
“We felt that caution and conservatism were the order of the day,” he said.
Because of his role as former co-chairman of Goldman Sachs & Co., an investment firm with broad experience in using options to manage investment risk, “I was more of an expert in financial techniques, particularly the collar, and I suggested that as an alternative” to other steps aimed at protecting the endowment from a stock downturn, he said.
“As things turned out,” he added, “that was the wrong thing to do.”
Remarked a rueful Williams, who will retire from the Getty on his 70th birthday Jan. 5 and is also a member of the board of the Times Mirror Corp., parent of The Times: “We don’t know how to predict the market. I think we proved that to ourselves.”
The root of the Getty’s attempt to protect what were already historic gains in its stock portfolio lies in the unusual nature of the trust as an investing institution and the poorly understood constraints on its spending.
Oilman’s Legacy Was $1.2-Billion Bequest
Virtually 100% of the Getty’s wealth derives from a single source: the bequest of J. Paul Getty, who died in 1976. When the oilman’s estate emerged from probate six years later, the legacy was worth $1.2 billion. One-third of that was in Getty Oil Co. stock and the rest in U.S. Treasury securities, much of which the trust quickly converted into a diversified portfolio of domestic and foreign stocks.
Two years later the trust profited further from the takeover of Getty Oil by Texaco, which sent the value of Getty stock soaring and the value of the endowment to $2.1 billion.
Meanwhile, the stock market had embarked on a historic rally. “We’ve been blessed by a very positive market,” Williams acknowledged. Indeed, from August 1982 through last week, the Dow Jones industrial average rose from about 900 to more than 8,000, a total gain of about 790%, or an average of 13.5% a year.
For most of that period the Getty managed to keep pace. Although its investment returns did not match the stock market over the long haul, they were not expected to. The Getty generally followed the investment approach of most tax-exempt foundations, seeking long-term asset growth while controlling risk by keeping 40% to 50% of its assets in risk-free but low-yielding investments such as U.S. Treasury securities and the rest in stocks.
That strategy placed the Getty firmly within the growth range of comparable foundations.
Assets Grew by 89% in 10-Year Period
Between 1985 and 1995, the trust’s assets grew 89.3%, according to a survey by the New York-based Foundation Center. That placed it fifth in asset growth among the 10 largest U.S. foundations as ranked in 1985--behind such institutions as the Robert Wood Johnson Foundation and the Lilly Endowment, which experienced triple-digit percentage gains thanks to the strong performance of, respectively, Johnson & Johnson and Eli Lilly stock, but ahead of the MacArthur, Kresge, and Rockefeller foundations.
Over the 10-year period, in which it grew to $6.5 billion in assets (including its financial portfolio, real estate, and its museum collection), the Getty retained its position as the second-largest U.S. foundation, behind only the Ford Foundation.
Contributing to that stability was the exceptionally patient investment regime imposed by Williams, who placed the Getty’s endowment in the hands of 11 carefully chosen outside managers and encouraged them to think for the long term.
“I have a photograph of all of our outside managers on the [Brentwood] site taken 14 years ago, and almost all of them are still with us,” said Joseph J. Kearns, the trust’s vice president and treasurer and its chief investment officer since 1982, who will also retire next month.
In some ways, however, the Getty’s reputation of being wealthy beyond any worldly concerns was an illusion.
Among other things, it lacked both the spending flexibility of grant-making foundations, which in tough times can always cut back their grant programs, and the revenue flexibility of universities and other fund-raising institutions.
Universities “can always raise tuition. . . .” Kearns said. “We can’t.”
For those reasons, the Getty’s investment approach tended to be more conservative than other tax-exempt bodies. In 1988, for instance, only 41% of the endowment was invested in stocks, which traditionally harbor the most potential for long-range growth--but 28% was in cash, which throws off a low, if safe, return.
But the Getty’s rising expenses demanded a more aggressive investment policy. Operating a large system of art research institutions and building a billion-dollar hilltop complex would eventually drive its operating and capital budgets to more than $500 million in 1996 from $158 million in 1987.
Moreover, as a legally desig nated “private operating foundation,” it was required by U.S. tax regulations to spend annually at least 4.25% of its total assets on programs. Many necessary expenses, including investment expenses and public grants, could not count toward that minimum.
In sum, the Getty felt it had to earn at least 5% over inflation--or as much as 8% to 10% a year on its investments--to avoid having its endowment dwindle away over time.
The trust accordingly raised its stock ratio over the years, if slowly. As a portion of total investments, equities reached 55% in mid-1994, when investment professionals were advising other foundations to raise their stock allocations to the 60% to 70% range. Only in the last year has the Getty’s stock allocation settled around 65%, including domestic and foreign equities.
“As has been true of most endowments, the tendency has been to increase asset allocation more toward equities,” said Getty board Chairman Robert F. Erburu, the retired chairman and chief executive officer of Times Mirror, “because it’s very clear over the long term that the return on equities will exceed other assets.” Erburu also remains a member of the Times Mirror board.
Pundits’ Bearish Mood Fueled Concern
Toward the end of 1994 and into 1995, however, concern was growing about whether the Getty was overexposed to the stock market. Among stock market pundits the mood had turned distinctly bearish. Many noted that the Federal Reserve Board was aggressively raising short-term interest rates, a trend that almost always has presaged a stock market slump. (The Fed ultimately raised rates six times in 1994.)
“No one really could argue against wanting to be cautious,” said Erburu, “particularly because we were in the midst of building the center and the budget was coming in ahead of what we expected.” Construction of the Getty Center, originally budgeted at $360 million, had been re-estimated at $773 in 1993. (It now appears to be close to $1 billion).
Sometime in 1994, Whitehead, then the chairman of the trust’s investment committee, proposed that the Getty hedge its bets through a stock index option strategy.
How much debate the proposal engendered is unclear. Getty Trust executives and board members say there were repeated and intense discussions, some of which revolved around the idea that the hedge represented an unprecedented change in the Getty’s tradition of long-term value investing.
“In a sense,” Williams told The Times, “if you adopt a policy for the long term you should stick to it for the short term, [even though] sometimes you don’t sleep well at night.”
Whitehead and Erburu said that the board and staff eventually reached a consensus to implement the hedge.
“We certainly discussed the pros and cons,” recalled Erburu, “particularly because it represented a departure and we all knew that market timing can be dangerous. In the end, it was a decision for the board and the investment committee and there was agreement we should go in that direction.”
The board chose three firms to execute the collar: Morgan Stanley & Co., Bankers Trust Co. and Goldman Sachs. Although the latter was Whitehead’s old firm, Getty spokesmen say the contracts were awarded on the basis of competitive bidding.
The collar is a well-understood financial technique that involves buying put options and selling call options on the Standard & Poor’s 500 stock index.
Puts, which represent the right but not the obligation to sell the underlying investments at a set price, rise in value as the underlying investment--in this case a representative group of 500 stocks--falls, and lose money if its rises. Calls represent the right but not the obligation to buy something at a set price. They fall in value as the underlying commodity falls, but since the Getty was selling calls, not buying, its position would gain money if stocks fell and lose money if the market rose.
The earliest transactions appear to have been done in April 1994, with the program continuing at least through mid-1995. Options experts who reviewed the transactions for The Times said they seem to have been properly designed to accomplish their purpose, in that they would indeed make money if the stock market fell.
That sets them apart from some well-publicized financial disasters involving options and other risky securities in the ‘90s, including Orange County’s $1.8-billion investment scandal and a $195-million options loss by Procter & Gamble Co. In those cases the transactions were so complex that they failed to function as anticipated; in the Getty’s case the transactions worked as anticipated, but the underlying market confounded expectations.
But there lay one of the two major flaws in the trust’s strategy, professionals say. The Getty was taking such an insistent position that stocks were doomed to fall that it was left unprotected when they continued their unbroken advance.
The second flaw is that, ironically, the Getty was not invested enough in stocks to warrant the hedge. Anticipating a market downturn, the trust had already cut back significantly on its stock holdings before it ever placed the hedge.
Tipped Too Far Into Pessimism
The result was that its maneuvering tipped it too far over into pessimism. The combination of a relatively low stock allocation and an aggressive hedge turned into a double whammy, depriving the trust of any significant upside gains from stocks, while the options sheared it relentlessly on the downside.
“We all realized after the fact that we had downside protection by our relatively conservative asset allocation,” said Erburu, “and that’s a better strategy.”
As stocks rose, Getty officials could only watch as their plan unraveled. For every dollar their stock portfolio earned in late 1995 and early 1996, the hedge took a dollar away.
At one point, at least, the trust considered unwinding its costly hedge, but a professional analysis demonstrated that ending it early would be even more expensive than letting it run out. By the end of June 1996, the last option contract finally expired. The hedge had cost $397.2 million.
Whitehead said he still believes the hedge was a defensible maneuver at the time. “I liken it to an insurance policy,” he said. “If you buy life insurance and don’t die in the first year, you don’t say, ‘Wasn’t I stupid.’ ”
But the experience reinforced the trust management’s conviction that its long-range outlook was the right one after all. Kearns, asked whether the stock market’s currently high valuation might lead it to consider trying such a hedge again, replied without hesitation: “Not in my lifetime.”
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The Getty and Other Foundations
The J. Paul Getty Trust’s foray into stock market hedging cut its investment return in relation to other comparable tax-exempt foundations in 1995-96. A sample:
*--*
Endowment Invest. at end of period return FOUNDATION (billions) (%) Getty $4.41 4.9% Ford Foundation* $8.04 15.7% Harvard Univ. $8.6 26.0% Rockefeller $2.46 11.7% Foundation**
*--*
* Fiscal year ending Sept. 30, 1996
** Fiscal year ending Dec. 31, 1996
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Growth of Getty Trust
With the exception of fiscal 1996, the investment performance of the Getty Trust endowment has closely tracked a target index reflecting a 60/40 mix of stocks and bonds. In that time the endowment, founded in 1982 with 1.2 billion from the estate of J. Paul Getty, has grown to $4.41 billion.
Year-to-year percent change, fiscal years ending June 30
Getty Trust
1996: 4.9%
Target index
60% stock
40 % bonds
Note: Target index is a 60/40 meld of the Standard & Poor’s 500 stock index and the Salomon Bros. Broad investment Grade bond index.
****
Growth of Getty Trust endowment, in billions of dollars, fiscal years ending June 30
1987: $3.10 billion
1997: $4.41 billion
Source: J. Paul Getty Trust; Standard & Poor’s
Compiled by MICHAEL HILTZIK / Los Angeles Times
