Alternatives: Investment Style of Yale and Harvard Endowment Funds

This article discusses investment philosophy of endowment funds especially super endowment funds like Yale and Harvard. There are about 800 endowment funds in the US although there are 2000 four year colleges in the US according to the annual NACUBO-Commonfund Study of Endowments. Of all the endowment funds, 44% have endowments worth less than $100 million with the median size of about $128 million. Yale and Harvard’s endowments are the largest in the world with respectively $27B and $36B assets under management respectively. According to a report published by Frontier Investment Management Like the Harvard and the Yale endowment funds, Super endowment funds like Harvard and Yale have given 20 years annualized return of 12.7% and consistently outperformed traditional equity/bond 60/40 portfolio.

Endowment funds invest in multi-asset classes based on the modern portfolio theory of Harry Markowitz. The portfolio theory is central foci of asset allocation across equities, bonds and alternative investments. The basic premise is to generate a superior risk-adjusted return. Superior risk-adjusted return can be measured by various measures like Sharpe ratio and Treynor ratio which measures the return to a unit of risk like standard deviation although this measure is not ideal for alternatives. As a thumb rule, the higher the risk, the higher the expected return of the portfolio. Among the three major asset classes, bonds are considered the safest and therefore offer the lowest return especially sovereign bonds like US government bonds. Equities carry more risk and are expected to offer higher returns wherein emerging market equities carry more risk compared to developed economies and hence offer a higher return. Alternative investments like private equity, commodities and few hedge fund strategies carry higher risk, need a longer time duration for investment and their returns are usually not normally distributed like equities/bonds. To generate a superior risk-adjusted return for multi-assets, the concept of efficient frontier is worth understanding. The efficient frontier is a set of optimal portfolios which would give the highest return for the lowest risk offered combining the set of all asset classes. In the graph above, the curved line would include the best combination of portfolios in terms of superior risk-adjusted return of all the combination of portfolios below the curve. This means that all portfolios on the line would generate higher return compared to portfolios below the curve line for the same unit of risk.

The breakout strategy of using higher allocation to alternatives by super endowment funds like Harvard and Yale has helped both endowments to deliver higher return compared to other endowment funds. Allocating investments across multi-assets also helps in diversifying risk to generate superior return per unit of risk. Diversification across various assets is based on the fact that various asset classes have a low correlation among themselves. For example, equities and bonds usually have a low correlation. During credit crisis when equities fell in the US, prices of US sovereign bonds increased due to risk aversion. In times of crisis, investors would always prefer to invest in safe-haven investments like bonds and gold. However, presently both equity and bonds are doing good. At the same time, alternatives depending on the type of strategy employed by hedge funds or time frame of investment in private equity or venture capital would show divergent returns. Alternatives generally rely less on market trends and are less volatile compared to equities. Above Fig Source: Blackrock.

In times of risk aversion, exit strategy by private equity funds in IPOs would not be wise and usually is postponed until equity markets stabilize or are in the bullish phase. Venture capital is always riskier that private equity since VCs invests in companies which are in an earlier phase of business phase compared to PE. David Swensen, CIO of Yale endowment fund is world-renowned for his investment philosophy of investing in alternatives.

A caveat emptor here is that with this investment philosophy investment horizons are long especially for alternative investments. The churn of the portfolio is much less since the return of the portfolio is not dependant on momentum or tactical allocation of assets. During credit crisis both the endowment funds fared badly with huge losses. It’s not easy to predict black swan event but in spite of a bad year, both funds outperformed their peers over the long-term. At the same time, it makes sense for endowment funds to prepare for extreme events and it’s worth reading this article.