Swedroe: Questioning Value Of Endowments

Educational institutions hold billions of dollars in endowment funds. As of June 2013, the most recent data available, the five largest educational endowments (Harvard University, Yale University, The University of Texas system, Stanford University and Princeton University) collectively managed nearly $110.5 billion. All educational endowments managed in excess of $448 billion.

While they are often critical to funding educational institutions, we actually know very little about the performance of endowments. The poor performance of many of these funds, however, has led to questions about whether the “endowment model” actually delivers superior results.

Under The Microscope

Brad Barber and Guojun Wang—authors of the 2013 paper, “Do (Some) University Endowments Earn Alpha?”—set out to examine the following three questions:

1. Does the average endowment earn an abnormal return (alpha) relative to standard benchmarks?
2. Do elite institutions earn alpha?
3. Is there evidence of performance persistence in endowment returns?

To find the answers, the study’s authors analyzed the performance of a large set of institutions for the 21-year period ending June 2011.

Initial Verdict

The following is a summary of their findings:

• A simple factor model (which did not include the size and value factors) that shows a 59 percent exposure to stocks (the S&P 500 Index for U.S. stocks and the Morgan Stanley Capital Index ex-U.S. for international stocks) and a 41 percent exposure to bonds (Barclays Capital Aggregate Bond Index) explains virtually all (99 percent) of endowment returns.
• Even before adjusting for exposure to small and value stocks, endowments’ small positive alpha of 0.4 percent per year wasn’t statistically different from zero. And, given that in the U.S., the size premium was about 2.6 percentage points a year and the value premium was about 4.5 percentage points a year over the period studied, it seems likely that if returns were adjusted to account for exposure to small and value stocks, the alpha earned by endowments would have been zero or negative.
• Despite taking on more risks in the form of opaque investments (such as hedge funds), lack of liquidity (hedge funds and private equity) and other incremental risks (such as with venture capital), there was no evidence that the average endowment is able to deliver alpha relative to public stock and bond benchmarks.
• Using both the two- or three-factor models, there is strong evidence of persistence in performance. The endowments in the top-performing decile earned returns that were roughly 4 percentage points a year higher than the endowments in the bottom decile.

Statistical Significance

That difference was statistically significant. Furthermore, the top Ivy League schools appeared to have outperformed other institutions.

However, once the benchmark was expanded to include other factors that more accurately reflect the way endowments actually invest—36 percent in U.S. stocks, 31 percent in U.S. bonds, 13 percent in non-U.S. stocks, 11 percent hedge fund index (Hedge Fund Research Fund-Weighted Composite Index) and 8 percent private equity index (Cambridge Associates U.S. Private Equity Index)—the average fund underperformed by 0.7 percentage points per year.

Moreover, the alphas of the Ivy League endowment funds disappeared. In other words, any apparent outperformance was explained by the strategic exposure to riskier investments, not any special skill in investment selection within an asset class.

It’s important to note that the authors reached this conclusion despite recognizing that the data may contain a bias arising from the voluntary nature of self-reporting.

Dirty Data?

Regarding the shortcomings of self-reporting, they wrote: “If institutions are reluctant to publicize poor performance, they may refrain from reporting in below-par years and the reported returns would overestimate the performance of endowments.”

Another finding was that, using the broader five-factor model, large endowments performed no better than small endowments, in fact, producing a negative alpha of about 0.5 percent. That’s unreliably different from zero.

In short, any fund outperformance was explained by exposure to the types of investment, not the particular choice of investment managers.

The authors reached this conclusion: “These results suggest that manager selection and dynamic (or tactical) asset allocation do not generate alpha for top performing and elite institutions.”

Different Ivy, Similar Conclusions

It’s worthwhile to compare the findings from this paper with the findings from a previous study examining the accepted role model for endowment management, The Yale Endowment.

The authors of that study, “Yale’s Endowment Returns: Manager Skill or Risk Exposure?” reached the following conclusions:

• For public equity holdings, the endowment’s returns are fully explained by exposure to risk factors, not manager skill. The excess returns over the chosen benchmark, the Wilshire 5000, were achieved by the endowment fund’s exposure to small-cap and value stocks. A similar result was found internationally. While the endowment did beat its benchmark, the MSCI EAFE Index, the outperformance was explained by exposure to emerging market stocks and the same Fama-French risk factors. Put another way, the benchmarks were wrong.
• The private equity managers that the endowment hired did add value. Note that private equity is the one asset class or investment category in which there is some evidence of persistence in performance. This is not true for hedge funds.

The implication is that the Yale Endowment’s exposure to private equity—and venture capital in particular—has been the unique source of its excess return.

The authors concluded that while the conventional wisdom has attributed Yale’s success to its ability to hire the top active investment managers, their returns can better be explained by consistent exposure to diversified, risk-tilted, equity-oriented assets and the extraordinary outperformance in private equity, venture capital in particular.

Outside of private equity, Yale’s endowment appeared to underperform risk-adjusted benchmarks.

Just Index, Smarty-Pants

The authors concluded that any disciplined investor with a high risk tolerance could replicate Yale’s results using publicly available index funds and some degree of leverage. They did, however, see value in Yale’s broad diversification across asset classes with relatively low correlation.

The takeaway for us is striking. If Yale, with all of its resources, cannot identify the future generators of alpha, then what are the odds that any individual money manager or investment advisor can do so?

That is why I believe active management is the triumph of hype, hope and marketing over wisdom and experience.

Later this week, we’ll take a look at the results of a September 2014 study by Vanguard’s research team on the performance of university endowments.

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