Swedroe: Endowment Returns Are Worsening

Despite the publicity surrounding the long-term investment performance of certain endowment funds, such as those belonging to Yale and Harvard, little has been known about the overall performance of university endowments until recently.

We are learning more these days, thanks to some solid research, including from Vanguard Group, and it's not terribly encouraging. Discouraging takeaways about investments at endowments may be growing familiar to readers of my blogs. I'll review a bit.

Earlier this week, we examined the results of a study that found that simple factor models explain almost all of the performance of endowments. We also learned that any apparent outperformance was explained by the strategic exposure to riskier (and generally illiquid) investments, not by any special skill in investment selection within an asset class.

The authors of that study, from 2013, concluded their results "suggest that manager selection and dynamic (or tactical) asset allocation do not generate alpha for top performing and elite institutions." And in examining the findings of another study, on the highly regarded Yale endowment, we saw that its authors came to the same conclusion.

Squeezing Water From Stone

The research team at Vanguard further contributed to our understanding of the performance of university endowments with its September 2014 paper, "Assessing Endowment Performance: The Enduring Role of Low-Cost Investing."

Vanguard noted that, over the past 25 years, there has been a dramatic shift in the investment approach of many endowments.

Previously, a balanced portfolio consisting of 60 percent stocks and 40 percent bonds was the norm. However, the recent performance of Yale's endowment fund has led to reduced allocations to public equities and increased holdings of alternative, less-liquid investments, such as hedge funds, private equity and private real assets.

Vanguard observed that as of June 30, 2013, the largest endowment fund portfolios averaged about 60 percent alternatives. The question is: Has the investment in riskier, less-liquid investments paid off?

The Evidence

Researchers at Vanguard found little evidence of outperformance even before adjusting for incremental risks, such as illiquidity. The table below shows the average annualized returns of endowments versus a 60 percent stock and 40 percent bond benchmark, as of June 30, 2013.

Even before adjusting for exposure to common factors—such as size and value and endowments' allocation to riskier and less-liquid investments—overall we don't see any evidence of superior performance.

And during the last 10 years, a period when endowments' allocation to alternative investments has increased, we see evidence of underperformance—even before adjusting for risk.

Vanguard also analyzed the relative performance of small endowments (under $100 million), medium endowments ($100 million to $1 billion) and large endowments (more than $1 billion). Small and medium endowments account for about 90 percent of the total population.

Small Endowment Underperformance

One important observation is that, with the exception of the most recent five-year period, small endowments (under $100 million in assets) tended to underperform larger ones.

Part of the explanation might lie in larger endowments' greater negotiating power for lower fees. Another explanation might be that the larger endowments have greater resources, allowing them to make superior choices. A third explanation might be that the larger endowments have access to superior managers unavailable to smaller endowments.

That latter possibility might be due to larger endowments' long-standing relationships with top managers who aren't accepting new assets. Or, it could be that the larger endowments have higher allocations to alternatives.

Problems With Increased Exposure To Alternatives

Vanguard found that during the decade through June 2013, large endowments had, on average, increased their alternatives allocation to 59 percent from 31 percent, medium endowments to 36 percent from 16 percent, and smaller endowments to 18 percent from 5 percent.

While these figures show that small and medium endowments have more modest allocations to alternatives, increasing allocations of that type hasn't helped performance relative to benchmarks, even before adjusting for factor exposures and liquidity risks.

We also know that over time, the markets have become more efficient, making it more difficult for alternative investment vehicles, such as hedge funds, to deliver alpha. The performance of hedge funds, for example, has deteriorated dramatically over the last 25 years. Unfortunately, as Vanguard noted, the smaller- and medium-sized endowments didn't benefit from the strong earlier performance of alternative investments.

Worsening Performance

Another important trend to note is the deterioration of the relative performance of the larger endowments. And while they did outperform the simple 60/40 benchmark over the long term, the evidence from the two studies we examined earlier this week indicates that much of the outperformance was before accounting for risks.

The superior results of some of the larger endowments generated great interest in the so-called Yale model, which included large allocations to alternatives. The reality for small and medium endowments is that, as their allocations to alternatives increased, performance has been disappointing.

For example, while the underperformance by small endowments versus the 60/40 benchmark was less than 1 percentage point over the past 20 and 25 years, as their allocations to alternatives increased, that relative underperformance rose to more than 1 percentage point over the past 10 years and to 2 percentage points over the past five years.

The trends are similar for medium and large endowments. As their allocations to alternatives increased, their relative performance deteriorated. And it's important to keep in mind that the evidence demonstrates that if we were looking at risk-adjusted returns, the relative performance of the endowments would look even worse.

Wanted: Greater Focus On Factors

The bottom line is that the evidence clearly indicates endowments in general would be better off focusing their efforts on deciding which factors and return sources they want to gain exposure, and in what amounts.

Once those decisions are made, they should use low-cost, publicly available investment vehicles with strategies that are based on evidence (not opinions), that are transparent and that are implemented in a systematic manner.

After all, the research clearly shows that that would be better than the alternative.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.