Introduction

Pooled assets managed for distribution come in many forms, such as endowments, foundations, and wealth funds.  The type of institution that safeguards these assets has similar objectives, which are to distribute funds to the institution’s cause and grow assets managed.  Furthermore, institutions that manage these funds provide for their beneficiaries by providing independence, stability, and opportunity for excellence.  Independence insures that funds are invested and distributed free from political restraints and onerous requirements.  Stability enables a reliable flow of resources to operating budgets, thus enhancing long-term planning. 

To successfully achieve their purpose, institutions must balance their conflicting objectives.  Distributing funds to operating budgets is most helpful when spending is stable.  However, a stable distribution can cause fund investments to miss out on high risk-high reward opportunities.  Furthermore, funds can sustain permanent damage if it must pay out more than it gains.  On the reverse side of the argument, funds are generally designed to persist indefinitely (with a time horizon of centuries), and preserving assets means the preservation of purchasing power relative to future designated expenses.  Thus, since spending stability directly conflicts with asset preservation, a sensible distribution policy needs to be cemented in place; most endowments target a 4-6% annual distribution.

Once the purpose and distribution target of the fund are established, investments within the fund can be considered.  Three considerations that have historically arisen in institutional investing are investment allocation construction, principal-agent issues, and active management.  Asset allocation addresses the needs of the institution, agency issues present a divergence of interests between the investor and recipient, and active management is exceedingly difficult in competitive, efficient markets layered with fees.

The Endowment Model

The endowment model is rooted in the idea that asset allocation predominantly drives investment returns.  This notion was popularized by David Swensen, who starting in 1985, generated abundant portfolio returns (16.1% annualized) for Yale’s endowment for over twenty-five years.  As success at Yale developed, other educational institutions mimicked the model, thereby standardizing the asset allocation theory for all types of pooled assets.  Today, the endowment model is also employed by Harvard, Princeton, Stanford, Texas, and many other smaller university institutions.

Focusing on asset allocation is logical.  Different asset classes exhibit various characteristics that serve universities’ multiple goals.  The functional attributes that shape asset class behaviors play a dominant role in forming the rationale for utilizing different asset classes in different environments.  Thus, diversifying a portfolio, by combining assets that respond differently to functional risks, across various situations, allows an endowment to reap returns generated by the assets while mitigating overall portfolio risk.  For example, equities, which rely on market generated returns, generally outperform bonds, which are higher in the capital structure and more beneficial in tumultuous or deflationary times.  By simultaneously holding both equities and bonds, an endowment is positioned to gain from market advances with equities during a hospitable environment and provide safety with bonds during a hostile environment.

Across all of the asset classes, an inverse relationship exists between the efficiency of asset pricing and degree of active management needed.  Since established markets have numerous participants, consistent outperformance proves to be an incredibly challenging task.  Furthermore, engaging in market timing presents further hindrances in the form of transaction costs, manager fees, and market impact.  Thus, actively managed stock funds, on average, fail to outperform their benchmark.  Less efficient markets, however, offer opportunity for manager outperformance since less liquid and less transparent markets are more likely to be priced inefficiently.  Asset classes exposed to illiquidity and value factors, such as private equity and absolute return, enable opportunity for outsized gains since assets in these categories are less frequently traded, held for long time horizons, and may be susceptible to traditional portfolio constraints.

Given an array of asset classes varying in efficiency, the next step involves evaluating the risk and rewards of each asset class.  A starting point to do this is to evaluate historical performance of asset classes.  The reward for each asset class is its annual performance, and the risk can be defined as how volatile its performance has been (measured by standard deviation).  However, a forward looking estimation of each asset class is necessary since asset classes are not stable and the covariance among assets is likewise unstable.  Thus, modified risk and return assumptions are necessary.  Based on this forecast, asset allocation targets are chosen and subsequent deviations from these targets are frequently rebalanced.  Within asset classes, passive management is used with efficient markets, such as equities and bonds; active management is employed in asset classes with inefficient markets, such as absolute return, private equity, and real assets.

Endowments in Action

In practice, the largest university endowments concentrate their allocations more towards assets in less efficient markets.  Whereas equity returns are predominantly market driven, which is depicted in finance by beta, outperformance in less efficient markets represents alpha generation.  In fact, each of the top five endowments (Yale, Harvard, Princeton, Stanford, and Texas) has at least two of the inefficient markets (absolute return, private equity, and real assets) as its top three holdings.  This historically contrasted to smaller endowments, which allocated funds toward the traditional asset classes of domestic equities, foreign equities, and bonds.  However, since 2006, smaller endowments have changed their tune and seem to be replicating the top five’s strategy.  Over the past four reported fiscal years, smaller endowments have, on average, doubled their allocation to absolute return, private equity, and real assets.  These three categories, which accounted for 20% of a smaller endowment in 2006, now represent 46.4% of their holdings.  This dramatic increase is too large to be solely the result of market circumstances.  Clearly, the endowment model is catching on.

 

Unfortunately for the smaller players, Yale et al will likely still outperform because of its experience in this field, and smaller players may lack the proper staff to manage these markets.  Having a history of building relationships with fund managers, and evaluating them, is meaningful since wisely choosing fund managers directly impacts endowment performance.  This plays well to the more established endowments because they have established longer relationships, at times, with emerging managers.  Funding managers during the initial years of their fund’s life ensures that the fund manager’s incentives are best aligned with the endowment.  Furthermore, managers who are just starting out are more willing to accept funds from a prestigious endowment and willing to negotiate looser terms.  These all bode well for the larger, established endowments.

Even though the endowment model has been successful in serving its institutions for over twenty-five years, it attracts some criticism.  First, managing a portfolio that is heavily dependent on alpha generation requires significant expertise.  Equally important is access to that expertise.  Not all endowments (or foundations and wealth funds) can access top managers, so perhaps replicating active management is imprudent.  Second, the endowment model relies on an ability to take illiquid positions for long time horizons.  Endowments trying to create intergenerational wealth must accept this risk, but illiquidity exposes the institution to an absence of funds during financial shocks, when funds may be needed.  Third, an asset allocation model may fail to fully account for all risk factors.  Risks evolve, assets exposed to risks may not always behave similarly to previous risk events, and future market environments may further shape current risks and introduce new, unaccounted risks and assets.  Focusing primarily on active management, alpha, instead of risk factor management, beta, managing exposure to risk factors might be underserved.

Given its strengths and critiques, the endowment model is the default methodology for managing endowments.  It will likely continue to hold this title even if it continues to experience turbulence, as evidenced by its survival through recent dramatic declines.  Until another methodology is proven and shown to be superior, the endowment model is likely to persist for some time.

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