- Unlike years past, many large universities and other endowments made headlines for their negative returns in fiscal year 2016. Endowments at Harvard, MIT, Ohio State, and others reported modest losses for the year, while the median endowment lost 1.2 percent, according to data provided by Callan Associates.
- While smaller endowments didn’t all necessarily fare better, the returns of those that used simpler portfolio structures that emphasize traditional stocks and bonds actually performed better than their larger peers. As a result, illiquid investments have once again come under fire for not compensating portfolios with returns that justify their higher costs and increased complexity.
- So the question remains, what’s the best way for institutional investors to construct their portfolios? The “less is more” approach that smaller endowments tend to follow, or the “Endowment Model” popularized by many of today’s large universities?
- In the long run, organizations of all sizes can construct their portfolios in a number of different ways that are reasonable and likely to produce similar results. The key aspect is understanding the goals and limitations of the organization and implementing a strategy that can be maintained over time.
Around this time last year, many within the investment industry, including Plante Moran Financial Advisors, were talking about recent portfolio success that large prominent endowments, such as Yale, had for the 2015 fiscal year. For the year ended June 30, 2015, Yale’s endowment had earned an 11.5 percent return while many of its peers also had experienced similar returns, primarily thanks to investments in illiquid alternatives such as real estate and private equity, which outperformed traditional stocks and bonds. As a result, many smaller endowments and institutions that typically invest in public markets and use less alternative investments had developed a bit of “large endowment envy” as they watched their portfolios lag.
Just one year later, the story has changed dramatically, as many large universities and other endowments are making headlines for their dismal returns in fiscal year 2016. Endowments at Harvard, MIT, Ohio State, and others reported modest losses for the year while the median endowment lost 1.2 percent, according to data provided by Callan Associates. To be fair, Yale once again exceeded a majority of its peers with a relatively impressive return of 3.4 percent. And while smaller endowments didn’t all necessarily fare better, their returns were in line with their much larger counterparts despite simpler portfolio structures that emphasize traditional stocks and bonds. As a result, the illiquid investments that boosted performance in the year prior have once again come under fire for not compensating portfolios with returns that justify their higher costs and increased complexity.
So the question remains: what’s the best way for institutions to construct their portfolios? The “less is more” approach that smaller endowments tend to follow, focusing on traditional stocks and bonds, higher liquidity, and lower costs? Or the “Endowment Model” employed by many large universities that emphasizes alternative investments and seeks to achieve a higher return through illiquidity premiums and alpha generation?
First of all, we advise against drawing any meaningful conclusions from analyzing returns over a one-year period. Although the 2015/2016 endowment results are certainly interesting in hindsight, investment returns in any given year are almost entirely unpredictable. In the long run, we believe both approaches are likely to produce fairly similar results (notwithstanding differences due to risk levels and implementation aspects such as manager selection, etc.) and both represent reasonable strategies for organizations of all sizes to use in constructing an investment portfolio. Norway’s Government Pension Fund, one of the world’s largest sovereign wealth funds at over $800 billion, employs a fairly simple investment strategy focused primarily on investing in public stocks and bonds, with very minimal exposure to alternatives. While vastly different from Yale in terms of investment strategy, both institutions are great examples of how each approach can be used to achieve investment success.
The good news for smaller endowments seeking to replicate the “Endowment Model” is that alternatives are increasingly becoming easier to access via investment vehicles that offer higher liquidity and lower investment minimums than most illiquid options. While it’s not exactly the same as being able to make a direct investment into private markets, increased accessibility to such strategies does allow smaller portfolios to take advantage of the broad diversification benefits that many alternatives exhibit relative to traditional stocks and bonds.
However, all alternatives (even liquid alternatives) require significant up-front education on the specific strategy being pursued, unique risk/return considerations, and how the investment fits in with the rest of the portfolio. Organizations must consider the potential limitations of alternative investments when it comes to successfully implementing the “Endowment Model” or attempting to do so, as well as how the inclusion of alternatives may impact portfolio risks and returns patterns over the course of a market cycle. While many alternative investments such as hedge funds and real assets have come under fire in recent years due to their expenses and/or lack of performance in the current market environment, there will be a different market environment at some time in the future when they will have a better opportunity to add value. Many large endowments continue to hold these investments, including Yale. But while Yale’s investment philosophy has been imitated many times over, few institutions are able to replicate the conviction it takes as a committee to maintain that philosophy through good times and bad.
That last point is extremely critical when it comes to managing a successful endowment or any investment portfolio, for that matter. Some years will reward investors for complexity and illiquidity (2015), while others will favor a relatively simple mix of stocks and bonds (2016). Ultimately, the “best” investment plan is the one that the investor and/or Committee is able to stick with over the long run, throughout multiple cycles and various market environments. While large institutional portfolios such as Yale’s endowment and Norway’s Government Pension Fund are vastly different in terms of investment process and strategy, the one thing they have in common is a consistent, disciplined approach over time. And that’s what most organizations should focus on imitating.