The Endowment Model

large institutional investors like pension funds university endowments and sovereign wealth funds are looked to as thought leaders in portfolio management and asset allocation their asset allocation strategies often have a taste for alternative asset classes like hedge funds private equity and private real estate the fact that institutional investors allocate to these asset classes is in turn used as a sales tactic to convince high net worth individual investors that they should be doing the same this is a problem using what an authoritative figure like a large institutional investor does to support an argument is an appeal to authority a logical fallacy i'm ben felix portfolio manager at pwl capital in this episode of common sense investing i'm going to tell you what the evidence says about alternative investments complex institutional asset allocation strategies can't be discussed without mentioning yale's david swenson swenson's approach to managing yale's endowment documented in his book pioneering portfolio management involves diversifying across traditional asset classes like publicly traded stocks and bonds and alternative asset classes like absolute return hedge funds real estate private equity and venture capital yale uses a combination of mean variance analysis and market judgment to set the target asset class weights in the endowment portfolio and then they hire active managers to manage each allocation for the fiscal year 2021 yale has a target asset mix consisting of 23.5 percent absolute return hedge funds 23.5 venture capital 17.5 leveraged buyouts usually referred to as private equity 11.75 foreign equity 9.5 percent real estate 7.5 bonds in cash 4.5 natural resources and 2.25 in u.s equity this approach is broadly known as the endowment model since swenson began managing yale's endowment in 1985 their investment results have been exceptional it is likely that swenson's unique approach and excellent investment outcome are responsible for the popularity and positive perception of the endowment model but there are some problems while yale's long-term reported success has been enviable its results have not been easy for other institutions to replicate but not for a lack of trying this is observable through the increasing allocations to alternative asset classes in public pension funds and university endowments after the financial market decline in 2008 the amount of assets allocated to alternatives by institutions saw a sharp increase in a 2018 paper in the journal of investing titled the grand experiment the state and municipal pension fund diversification into alternative assets the authors document the shift they suggest that following the market decline in 2008 pension funds saw alternatives as having the magical combination of higher expected returns and lower volatility relative to public stocks and bonds this idea had the potential to dig them out of the hole created by the crash resulting in a near doubling of alternatives allocations in state pension fund portfolios consisting mostly of private equity hedge funds and private real estate unfortunately the experiment has not gone well the paper concludes that states and municipalities have obtained neither lower risk nor higher returns with more active management and a turn toward alternatives the grand experiment of diversification into alternatives has thus fallen short of its objectives a similar trend is visible in educational endowments though the allocation to alternatives is much higher at 58 for the largest endowments a 2020 paper in the journal of portfolio management titled institutional investment strategy and manager choice a critique examines the performance of both public pension funds and endowment funds from 2009 through 2018. we are going to dig into that data but i want to start with the punch line from the paper the diversification of public pension funds and educational endowments is explained by a few stock and bond indexes alone alternative investments ceased to be diversifiers in the 2000s and have become a significant drag on institutional fund performance public pension funds underperformed passive investment by one percent a year over a recent decade the annual shortfall of endowments is 1.6 a year interestingly this underperformance closely matches the level of fees that the author estimates the funds to be paying driven up by their allocations to alternative investments and active management this should not be a surprise based on the arithmetic of active management in aggregate active funds should underperform passive funds by the difference in their fees from july 1999 through june 2008 alternatives did have a powerful diversifying effect but in the decade that followed the returns of portfolios with heavy allocations to alternatives were fully explained by the returns of public stocks and bonds this finding discredits the typical pitch for adding alternatives to portfolios both from the perspective of expected excess returns and from the perspective of diversification what caused the failure of the endowment model in recent history a 2021 paper in the journal of portfolio management aptly titled failure of the endowment model offers some potential explanations the correlation between traditional assets like stocks and bonds and alternatives was very high over this period eliminating any diversification benefit that may have existed in the past increasing correlations could be explained by an increasing amount of assets piling into alternative asset classes which are tiny opportunity sets relative to the stock and bond markets alternatives also failed to deliver returns in excess of their riskiness which is something that they had delivered in prior periods compounding all of these issues the cost of a portfolio of alternatives is estimated by the paper's author at between two and four percent per year this effect is typical of any successful investing strategy strong past returns get the attention of investors increasing the assets in the strategy and potentially reducing its effectiveness further evidence of this issue is the increasing number of alternatives managers being employed by institutions in 1994 large university endowments had an average of 18 managers while they had 108 on average in 2019 as more skilled managers enter the alternatives arena the competition for excess returns becomes increasingly difficult and outcomes are dominated by luck failure of the endowment model concludes the vast majority of institutional investors would be better off managing their funds passively at next to no cost in the configuration that best accords with their risk tolerance and other preferences there's another big headwind that alternative asset classes face the expected returns of illiquid asset classes may be decreasing this concept was addressed in a 2020 paper in the journal of alternative investments titled demystifying illiquid assets expected returns for private equity one of the most important observations from the paper is that due to the absence of mark to market accounting reported private equity returns will have understated volatility and a low equity beta overstating their on paper benefit in portfolios in other words a portfolio with a high allocation to illiquid assets may look like it is earning higher returns while taking less risk when in reality it is earning higher returns by taking more risk one of the theories about illiquid assets like private equity is that they have higher expected returns due to a liquidity premium the authors assess this assertion finding that while there theoretically should be a higher expected return associated with a lack of liquidity in reality investors may actually be willing to pay more for illiquid assets due to the previously mentioned smoothing effect that they have on reported returns if a portfolio manager can invest in a risky asset with an associated higher expected return that looks less risky on paper it will make their risk-adjusted performance look better they may be willing to pay more for that asset driving up its price and decreasing its expected return one of the places that this shows up is in private equity valuations private equity investments have gotten significantly more expensive in terms of the price that investors pay for private companies over the last few decades this is important when we consider the historical performance of endowments like yale investing in illiquid asset classes like private equity and venture capital historically offered substantially higher expected returns due to low valuations in private markets but that advantage has largely gone away today with private equity expected returns being very close to public equity expected returns there we have it the evidence suggests that while there may have been a time when institutional investors could access asset classes with attractive return profiles and meaningful diversification benefits those days seem to have passed i know the evidence that i've presented so far was intended to dismantle an appeal to authority argument but i'm also going to fight fire with fire the single largest institutional manager is not conforming to the traditional models norway's sovereign wealth fund government pension fund global the largest sovereign wealth fund in the world at over 1 trillion u.s dollars in assets has forged its own approach to managing a large pool of assets the norway model is characterized by a primary focus on public stocks and bonds with a majority being passively managed in a manner similar to low-cost index investing while there is some allowance for active management the fund is mandated to stay within tight tracking error limits relative to its benchmark index there is a small allowance for unlisted real estate with a maximum allocation of seven percent and an even smaller allowance for up to two percent in unlisted renewable energy infrastructure the equity and fixed income allocations within the portfolio are designed to seek higher expected returns through exposure to theoretically sound and empirically robust systematic risk factors like those associated with smaller companies cheaper companies and higher quality companies the fund's investment strategy is underpinned by a set of core beliefs a belief that markets are largely efficient a commitment to diversification a focus on earning risk premiums a clearly articulated benchmark careful selection and monitoring of asset managers especially for less liquid assets and a commitment to responsible investing the fund's total management costs are a miniscule 0.08 percent per year and it has generated modest excess returns of 0.17 percent after costs largely due to exposure to systematic risk factors not that considering that most pension funds are trailing a risk appropriate benchmark by more than a percent per year high net worth individual investors are often pitched exotic investments like hedge funds private equity and private real estate based on their supposed ability to generate excess returns and provide diversification benefits and supported by the fact that large institutional investors employ these asset classes in their portfolios the excess return and diversification arguments fail to stand up to scrutiny possibly due to an increasing amount of capital absorbing any excess return benefits that skilled alternatives managers could otherwise generate and possibly due to the increasing prices of private assets the fact that large institutions use alternative investments is a non-argument a logical fallacy but if you want to fight fire with fire the world's largest institutional investor follows a largely passive investment strategy with some evidence-based tilts towards assets with academically sound higher expected returns thanks for watching my name is ben felix and this is common sense investing if you enjoyed this video please share it with someone who you think could benefit from the information don't forget if you've run out of common sense investing videos to watch you can tune in to weekly episodes of the rational reminder podcast wherever you get your podcasts [Music]

Channel: Ben Felix

Views: 61,141

Keywords: benjamin felix, common sense investing, ben felix

Id: pMxYYYZ04nc

Length: 12min 29sec (749 seconds)

Published: Sat Mar 13 2021