The Enduring Futility of the Endowment Model
Investors have no chance of adding alpha by pursuing an “endowment” model. New research shows that even the most sophisticated institutions do worse when they increase exposure to alternative asset classes, and that investors would be better served with a passive, 60/40 allocation.
At the end of fiscal 2019, the National Association of College and University Business Officers (NACUBO) compendium of annual endowment data showed that the 774 reporting endowments held more than $600 billion of assets. The average asset size was about $800 million, though the median asset size was only about $100 million.
The pressure on budgets, along with high equity valuations and historically low bond yields, led many endowments to try to improve returns by increasing their exposures to alternative investments such as private equity, private real estate and hedge funds. Unfortunately, the research from the 2013 study “Do (Some) University Endowments Earn Alpha?”, the 2018 study “Investment Returns and Distribution Policies of Non-Profit Endowment Funds,” the 2020 study “Institutional Investment Strategy and Manager Choice: A Critique,” and the 2020 study, “Endowment Performance,” show that factor models explain virtually all of the variation in performance of endowments, and that despite taking on more risks in the form of often opaque and illiquid investments (such as hedge funds, venture capital and private equity), there has been no evidence that the average endowment is able to deliver alpha relative to public stock/bond benchmarks. In fact, alternative asset classes have failed to deliver diversification benefits and have had an adverse effect on endowment performance.
Dennis Hammond contributes to the literature with his 2020 study “A Better Approach to Systematic Outperformance? 58 Years of Endowment Performance,” published in the August 2020 issue of The Journal of Investing. His study covers the 58-fiscal-year period ending June 2019. The data is from the NACUBO compendium of annual endowment data, which extends back to July 1961. His objectives were to determine whether endowments met various return goals over time and whether returns on average could be systematically improved. Because a disproportionate ownership of endowment assets (75%) is held by a relatively small percentage (14%) of large endowments, Hammond used the equal-weighted rather than the dollar-weighted mean of endowment returns to define the average return. (Dollar weighting would provide insight into the comparative performance of the average endowment dollar, but not the average endowment.)