This article discusses the rise of alternative investment strategies within the endowment funds, especially super endowment funds like Yale and Harvard. The piece is updated with new data and information.
There are about 800 endowment funds in the US, although there are 2000 four-year colleges in the US according to the annual NACUBO-Common fund Study of Endowments. Of all the endowment funds, 44 percent have endowments worth less than $100 million, with a median size of about $128 million. Yale and Harvard’s donations are the largest globally, with respectively $27 billion and $36 billion 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 annualized returns of 12.7 percent for twenty years and consistently outperformed traditional equity/bond 60/40 portfolios. Endowment funds invest in multi-asset classes based on the modern portfolio theory of Harry Markowitz.
The portfolio theory is the central foci of asset allocation across equities, bonds, and alternative investments. The basic premise is to generate a superior risk-adjusted return. Various ratios measure risk-adjusted performance, including the Sharpe and Treynor ratios. The ratio 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 portfolio’s expected return. Bonds are considered the safest among the three major asset classes and usually offer the lowest performance, especially sovereign bonds like US government bonds. Equities carry more risk, expected to provide higher returns, wherein emerging market equities sell more risk than developed economies and offer higher performance. Alternative investment strategies like private equity, commodities, and a few hedge fund strategies carry higher risk and need a longer duration for investment. Their returns are usually not generally distributed like equities/bonds. Arguably even equities don’t display normal distribution, especially during black swan events. Varied types of structured products are designed to mitigate high risk among the alternative investment strategies.
A brief overview of Efficient Frontier | The middle Road
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The concept of efficient frontier is worth understanding to generate a superior risk-adjusted return for multi-assets. The efficient frontier is a set of optimal portfolios that would give the highest return for the lowest risk offered, combining 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 returns 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 deliver higher returns than other endowment funds. Allocating investments across multi-assets also helps diversify risk to generate superior return per unit of risk. Diversification across various assets is based on the fact that different asset classes have a low correlation. For example, equities and bonds usually have a low correlation. During the 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 the time frame of investment in private equity or venture capital show divergent returns. 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 than private equity since VCs invest in companies in an earlier stage of the business phase than PE. David Swensen, CIO of Yale endowment fund, is world-renowned for his investment philosophy of investing in alternatives. Here, caveat emptor is that within the alternative investment strategies, investment horizons are longer than traditional asset classes. The portfolio churn is much less since the portfolio’s return is not dependent on momentum or tactical allocation of assets. Both the endowment funds fared poorly with huge losses during the credit crisis. It’s not easy to predict black swan events, but both funds outperformed their peers over the long term despite a bad year. At the same time, it makes sense for endowment funds to prepare for extreme events, and it’s worth reading this article.