Swedroe: Why Endowments Lag

February 15, 2019

Despite the publicity surrounding the long-term investment performance of endowments such as Yale and Harvard, until recently, little has been known about the overall performance of nonprofit endowments. This is an important topic, as collectively they manage about $0.7 trillion.

Recent Research

Sandeep Dahiya and David Yermack contribute to our understanding with their December 2018 study “Investment Returns and Distribution Policies of Non-Profit Endowment Funds.” Their database covered a comprehensive sample of more than 28,000 organizations drawn from Internal Revenue Service filings for the period 2009 through 2016. Following is a summary of their findings:

  • The typical endowment fund underperformed a 60/40 combination of the equity and Treasury bond market indexes by about 5.5 percentage points annually.
  • On a risk-adjusted basis, the Fama-French-Carhart four-factor (market beta, size, value and momentum) alpha was a statistically significant (at the 1percent confidence level) -1%.
  • Almost 60% of the alphas were negative.
  • Higher education institutions, whose endowments account for more than half of all assets in the sample despite representing just 6% of the observations, significantly underperform market benchmarks, with abnormal investment returns of -1.9% per year (statistically significant at the 1% confidence level). Nonhigher education endowment funds also earn negative alphas, with a statistically significant estimate of -0.9% per year.
  • The top 20 national universities as ranked by U.S. News and World Report produced relatively better results. However, there was no indication of superior performance—supporting the conclusion that the investment wisdom of top universities is largely a myth.
  • Smaller endowments have less negative alphas than larger endowments, but all size classes significantly underperform. This is somewhat of a puzzle, as larger endowments should be able to negotiate lower fees and have access to superior talent.

Dahiya and Yermack found that the performance of the typical endowment fund was so poor that it would have earned substantially higher returns if its trustees had followed a simplistic investment strategy of holding 100% Treasury bonds and taken no equity market risk whatsoever.

Because there was a bull market in stocks and bonds for most of the eight-year period, it appears the endowments sat on the sidelines and missed most of this run-up in stock and bond prices, implying that many funds may have held large amounts of cash and equivalents (the market beta estimate was just 0.5).

Among the authors’ interesting findings was that, for the largest funds in their sample, which comprised the vast majority of investment assets, they uncovered “a striking pattern: investment performance deteriorates if the fund is located closer to Wall Street or to another major financial center.” However, they also found that “the pattern was reversed for smaller endowments, which tend to perform better when they are located closer to expert financial advice.”

These findings are fairly consistent with those of Vanguard’s research team, which specifically examined the performance of university endowments.

Performance Of University Endowments

In its September 2014 study “Assessing Endowment Performance: The Enduring Role of Low-Cost Investing,” Vanguard noted that, over the preceding 25 years, there was a dramatic shift in the investment approach of many endowments. Previously, a balanced portfolio consisting of 60% stocks/40% bonds was the norm.

However, the performance of Yale’s endowment 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. The study’s authors noted that, as of June 30, 2013, the largest portfolios averaged about 60% alternatives. The question they wanted to answer was: Has the investment in riskier, less liquid investments paid off?

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



Even before adjusting for exposure to common factors (such as size and value) and the investments by endowments in riskier/less liquid investments, we don’t see any evidence of superior performance overall. And in the last 10 years, a period when the allocation to alternative investments has increased, we see evidence of underperformance—even before adjusting for risk.

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