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.

Vanguard also analyzed the performance of small endowments (under $100 million), medium endowments ($100 million to $1 billion) and large endowments (more than $1 billion), with small and medium endowments accounting for about 90% of the population. The following table, which is from the study, summarizes the results:

 

 

One important observation is that, with the exception of the most recent five-year period, small endowments (those with under $1 billion in assets) tended to underperform larger ones.

Part of the explanation might lie in the greater negotiating power of larger endowments for lower fees. Another explanation might be that the larger endowments have more resources that allow them to make superior choices. And a third explanation might be that the larger endowments have access to superior managers that the smaller endowments don’t—possibly explained by 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.

Increasing Alternatives Allocations

Vanguard found that, over the decade through June 2013, large endowments had, on average, increased their alternatives allocation from 31% to 59%, medium endowments from 16% to 36%, and small endowments from 5% to 18%. While these figures show that small and medium endowments have more modest allocations to alternatives, the increasing allocations to alternatives 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 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 alternatives.

Another important trend to note is the deterioration of the relative performance of the larger endowments. While they did outperform the simple 60/40 benchmark over the long term, the evidence 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 the small and medium endowments has been disappointing performance as their allocations to alternatives increased.

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

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

Vanguard’s findings were consistent with those of Brad Barber and Guojun Wang, authors of the 2013 paper “Do (Some) University Endowments Earn Alpha?” They found that 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 venture capital), there was no evidence that the average endowment is able to deliver alpha relative to public stock/bond benchmarks. They also found that once adjustments were made to include factors that reflect the way the top Ivy League schools invest (such as hedge funds and private equity), they generated negative alphas (-0.7%).

Summary

The evidence makes clear that endowments, in general, would be better off focusing their efforts on deciding which factors and sources of returns they want exposure to, and in what amounts. Once those decisions are made, they should use low-cost, publicly available vehicles whose strategies are based on evidence (not opinions), are transparent and are implemented in a systematic manner.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

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