Why most endowments should avoid comparing themselves to Yale

The Ivy League university has areputation for outsized investmentportfolio returns. Yale Universityearned an 11.5 percent return on its$25.6 billion endowment in the fiscalyear ended June 30.

The Yale model, crafted by Yale’s ChiefInvestment Officer David Swensen anddiscussed in his best-selling book“Pioneering Portfolio Management,”forgoes large allocations to traditionalstocks and bonds, and emphasizesthe use of hedge funds, private equity,real estate, and other illiquid alternativeinvestments to boost returns.

While envy leads to imitation, imitationoften leads to disappointment.

Many investment committees ofendowments of less than $100 millionhave attempted to imitate the Yaleinvestment strategy. Or, at least theythink they have, because they haveused an increasing amount of“alternative” investments.

However, many have learned it’s justnot that easy. Even though there areplenty of “alternative” investmentsthat are available to these institutions,according to Callan Associates, theaverage endowment with assets ofless than $100 million earned about2 percent for the 12 months endedJune 30, with a range of approximately-0.5 percent to 4.7 percent. So muchfor imitation.

Why such a disparity?

One of the problems is that when itcomes to endowments, the amountof assets in your portfolio really doesmatter. Most years, the Yale modelworks for Yale and other large institutionsbecause such institutions canmake large, direct bets on alternativeinvestments, not to mention accessingsome of the most successful hedgefunds with very high minimum investmentrequirements.

These investments — selected in partbecause they have little correlation tostocks — often lack liquidity, makingthem difficult to sell quickly or to markto market in real time. This is often agood thing, because it forces patienceupon the investor. If you don’t markto market, and you can’t sell it, thenthere is no real concern about the“loss” because a “loss” only occurswhen the investment is “realized.”But liquidity is something that is oftencoveted by smaller endowments, andtherefore the outsized returns thatoften come with illiquid investmentsare not accessible.

In addition, these investments sometimestake years to bear fruit. Whilelarge institutions have investmentstaff and frequent meetings withinvestment committee members,smaller institutions typically do nothave dedicated investment staffmembers. The investment dutiesoften fall to the chief financial officeror other internal staff working withan investment consultant. Theinvestment committees, while oftenrepresented by people with thebest of intentions and excellentpedigrees, meet much less frequentlyand often have much less time togive to the investment process.

Investing in non-traditional assetclasses such as private equity, hedgefunds and real assets can add significantvalue to a portfolio over time ifconstructed appropriately, but theyare more sophisticated vehicles thatmay suffer through extended periodsof underperformance. And beforeinvesting in them, or any “alternative”investment, investment committeesneed to take the time to understandhow each of these investments mightaffect a portfolio to make sure it is anappropriate investment. Otherwise,when the inevitable underperformanceoccurs, significant risk canoccur at the committee level — theurge to change strategy midcourse.

Investing in alternative asset classeswill lead to the portfolio lookingsignificantly different at times whencompared to the more traditionalinvestment markets, both positivelyand negatively. And this can be verydifficult for investors to understand(and live with) when things are notgoing their way.

Many investment committees of smallerendowments that have ventured downthe path of increasing allocations toalternative investments are nowquestioning that decision because ofthe less than stellar performance ofcommodities, real assets and hedgefunds over the past five years, whencompared to more traditional markets.

While Yale was making 11.5 percentduring the 12 months ended June 30,much of this outperformance was dueto a significant allocation to illiquid,private equity and direct investments,and an extremely heavy allocation toequity-oriented assets (Yale maintainsa target allocation of only 8.5 percentto bonds and cash). Conversely, theaverage small endowment, accordingto Callan Associates, allocated24 percent to bonds and cash, with59 percent to equities and 17 percentto alternatives as of Sept. 30. Andgenerally, the alternatives held bysmaller endowments are not performingas positively as the types of alternativesYale is holding. So, as a smaller endowment,comparing yourself, and makinga judgment of your performance bycomparing it to Yale (or MassachusettsInstitute of Technology or many othermassive college endowments) is trulycomparing apples and oranges.

What is a smaller endowment investmentcommittee to do? All investmentcommittees should revisit their assetallocation decisions periodically andaffirm that they make sense given theultimate goals and objectives of theportfolio, and the committee’s abilityto tolerate performance that is“out of benchmark,” whatever thatbenchmark may be. In order tooutperform a benchmark, you can’tlook just like it, and these differenceswill lead to periods of outperformanceand underperformance.

At this stage in the market cycle, it isreasonable to expect that stock marketreturns for the next five years will havea tough time matching the performanceof the past five years, and thatthe low volatility environment stockshave enjoyed might turn more violentat times. And with the 10 year U.S.Treasury yielding in the neighborhoodof 2 percent, it is unlikely bonds willprovide outsized returns. For an endowmentthat is targeting a 4 percentto 5 percent spend rate plus inflation,this may lead investment committees toconclude they need to move towardmore illiquid, or aggressive investmentsin order to reach their goals. And thatmay be appropriate. But the risks mustbe well understood, including therisk of reaching for additional yieldsin things such as high yield bonds and bank loans, and in increasing theallocation to equities.

Endowments should evaluate theirportfolios to ensure the strategymatches their long-term goals andtolerance for risk. (By risk, I don’t justmean volatility or chance of loss.I mean the risk of underperformingwhatever benchmarks are set by thecommittee as its target.) Such anevaluation could result in doingnothing or in taking corrective actionto reduce or increase these risks. Thekey thing is to study the existing plan.Do the modeling. Quantify the risks.Affirm/change the plan.

Investors undertaking such statisticalsoul-searching five years ago, whenfew investors wanted to buy equities,would have seen real opportunitieson a risk-adjusted basis. (The stockmarket is up more than 200 percentsince March 2009.) Today, those samestatistical soul-searchers might realizethe investments that they invested infor purposes of “diversifying” theirportfolio, and that have performed sopoorly over the past five years, mightjust have the opportunity over thenext five years to add the value to theportfolio they had hoped for.

So while not truly imitating Yale,there may still benefits by diversifyinginto alternatives.