David Swenson

The Endowment Model: Beating a Dead Horse

David Swenson

“Those institutions [state pension plans and endowments of state universities] are placing risky bets on private equity and similar funds, to some degree at the taxpayer’s expense. They are relying on consultants who, on average, add no value and no prospect of delivering alpha…Taxpayers would be better served if public institutions adopted a low-cost index-based approach to endowment management.”

                       -Robert Huebscher, Advisor Perspectives (10/8/2013)

Recently, several articles have appeared that call into question the continued viability of the endowment model of investing that was popularized by Yale University’s David Swensen and Dean Takahashi. Within the last five days alone, we have “Time to Ditch the Yale Endowment Model” by Matthew C. Klein on Bloomberg.com and “The Futility of the Endowment Model” by Robert Huebscher on Advisor Perspectives. This article will attempt to summarize the important points of both of them.

To review, the endowment model consists of broadly dividing a portfolio into five or six roughly equal parts and investing each in a different asset class. The hallmark of the endowment model is the shifting of funds away from publicly traded equities and bonds and towards asset classes with very low liquidity such as private equity, hedge funds, and real estate such as timber forests. After Swensen published Pioneering Portfolio Management in 2000, the Yale endowment model was often imitated but Yale’s returns never quite duplicated. Even Yale itself has had a tough time keeping up with its past greatness as it has underperformed the S&P 500 Index over the past five years, according to the Bloomberg article. For the fiscal year ending June 30th, 2013, Yale posted a return of 12.5%1, slightly higher than both Harvard and MIT, but not as high as IFA’s Index Portfolio 60 which gained 13.0% over the same period. IFA’s all equity Index Portfolio 100 gained 22.2%. Although Swensen himself utilizes active management, he emphatically tells other investors to stick with a low-cost indexing strategy in Unconventional Success: A Fundamental Approach to Personal Investment.

The question of “Do (Some) University Endowments Earn Alpha?” was addressed2 by Brad Barber and Guojun Wang of UC Davis. They found that for the average endowment, virtually all of the variation in their returns is explained by the returns of the public equity and bond markets and no alpha was captured. The elite institutions have performed well relative to the public markets because of large allocations to alternative investments during a time period before they became popularized. The authors found no evidence that manager selection, market timing, or tactical asset allocation generated excess returns. The excess returns that were achieved via the allocation to alternative investments are unlikely to be repeated due to the very large amount of capital that has flowed into these types of investments. Simon Lack, the author of the Hedge Fund Mirage, hits the nail on the head when he observes that hedge fund investors as a whole have done worse than if they had invested in Treasury Bills because the high returns occurred early in the game when there were fewer dollars that earned those returns. Regarding private equity, Steven Kaplan and Per Stromberg of the University of Chicago Booth School of Business document3 a similar situation where the amount of capital that flows into private equity is negatively correlated with subsequent returns. The problems faced by endowments are not solely caused by their reliance on alternative investments. As Barber and Wang point out,

“The vast majority of endowments choose to play the loser’s game, with mixed results. The average endowment allocates 73% of its domestic public equity portfolio and 66% of fixed income assets to active management – markets in which it is notoriously difficult to beat public indexes.”

Beyond the elite institutions, many of the smaller endowments rely on investment consultants to guide them in their asset allocation and manager picking. We recently published this article about the investment consulting industry. The academic paper that we cited in that article found no evidence that the consultants’ recommendations add value to plan sponsors—quite the opposite, as the consultants’ recommended funds underperformed non-recommended funds by about 1% per year. Robert Huebscher cites this same paper and extends its findings to endowments and other institutional investors when he says, “Anyone using – or contemplating using – a consultant should insist on a fully transparent record of their recommendations and an analysis of whether those recommendations resulted in risk-adjusted outperformance.” We humbly suggest that anyone waiting for a full disclosure of such a record not hold his breath.

The lesson is clear—if the endowment model is irrelevant for most endowments, then it is doubly irrelevant for individual investors. As Mr. Huebscher observes, if the average endowment fails to deliver alpha and the average consultant does not add value, the odds against an individual investor successfully adopting the endowment model are daunting indeed.

If you would like to speak with a wealth advisor who will help you implement an investment strategy that is in line with the recommendations of David Swensen, please call us at 888-643-3133.

 

 

1http://yaledailynews.com/blog/2013/09/25/yale-posts-12-5-return/

2Barber, Brad M. and Wang, Guojun, Do (Some) University Endowments Earn Alpha? (May 7, 2013). Available at SSRN: http://ssrn.com/abstract=1972317 or http://dx.doi.org/10.2139/ssrn.1972317

3Kaplan, Steven N. and Strömberg, Per, Leveraged Buyouts and Private Equity (June 2008). Available at SSRN: http://ssrn.com/abstract=1194962 or http://dx.doi.org/10.2139/ssrn.1194962