College endowment performance is out for 2016 and there is a surprising winner with a not so surprising investment strategy, at least to us.
Many endowments have been known for following the “Yale Model” made popular by Yale’s Chief Investment Officer, David Swensen. While the bulk of assets remain in typical allocation of stocks and bonds, where it starts to depart from typical asset allocation is its large allocation to alternative investments. These types of investments include private equity, real estate, hedge funds, managed futures, and other structured products. Their allure, or “pitch” as we like to call it, is the ability for higher risk-adjusted returns given their low correlation with more traditional investments like stocks and bonds. The allocation to alternative investments is typically 10-15%, with some endowments making much larger allocations.
Although the model has worked out well for Yale’s endowment, it has faltered for many other college endowments that have attempted to replicate it, leading many to question whether or not alternative investments are worth their high management fees and costs.
2016 was a year in which David beat Goliath. According to a recent article in The New York Times, some of the big heavy weights like Yale and Harvard experienced sub par investments results. For the 1-year period ending June 30th, 2016, Harvard’s endowment lost 2% while Yale gained 3.4%. Over the same time period, the S&P 500 delivered a 4% return. But the winner in terms of performance went to Houghton College in western New York, which experienced an 11.85% return for their fiscal year, which ends Sept. 30th.
What's their secret?
According to the article, “Houghton got out of hedge funds and all alternative investments a year and a half ago, and moved the entire portfolio to a mix of low-cost index funds and mutual funds at the fund giant Vanguard.” Houghton College’s Vice President of Finance, Vincent Morris, stated, “I went to the University of Chicago, where I sat in a lot of investment classes. I am a big believer in passive investment.”
NACUBO, the National Association of Colleges and University Business Officers, attributes most of the outperformance of smaller endowments over larger ones due to the allocation made to alternative investments, especially hedge funds.
Although markets rallied quite a bit between June 30th and Sept. 30th, it begs the question of, "what exactly are alternative investments providing in terms of benefit for the exorbitant fees they charge?"
IFA applauds Houghton College's efforts to move towards a passive investment strategy and possibly give them some further guidance, free of charge. Just like many individual investors, the first step is to understand that passive investing is a better strategy over the long term. The next step is to understand not all index funds are created equal. Some follow a traditional indexing approach where they try to replicate commercial indices, while others attempt to capture known dimensions of expected return (market, size, relative-price, and profitability). Vanguard represents the former while Dimensional Fund Advisors represents the latter. Understanding the main drivers of stock market performance and building diversified strategies around those drivers can increase the expected return of the portfolio. For the 2016 calendar year, Houghton delivered a 7.54% return, which is still a great year in terms of performance. If instead they structured their asset allocation towards known dimensions of expected return, like we do at Index Fund Advisors, they would have seen an almost 5% additional return with the exact same stock/bond allocation of 76%/24%. See bar chart below.
As the article points out, “no major college endowment has publicly turned its back on hedge funds, as the California Public Employees’ Retirement System did in the world of pension funds in 2014” But we at IFA are hopeful that endowments will continue to not only learn the pitfalls associated with active management, but more importantly, it is their fiduciary duty to donors to make sure that they money is well managed so that their respective colleges can continue to provide high quality education and make an impact in their communities.
About the Authors
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.