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% have endowments worth less than $100 million with a median size of about $128M(M: million). Yale and Harvard’s donations 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 annualized return of 12.7% for twenty years 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 performance is measured by various ratios, including the Sharpe ratio and Treynor. 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 expected return of the portfolio. Among the three major asset classes, bonds are considered the safest and therefore usually offer the lowest performance, especially sovereign bonds like US government bonds. Equities carry more risk and expected to provide higher returns wherein emerging market equities sell more risk compared to developed economies and hence offer higher performance. Alternative investment strategy 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. It can be widely argued that even equities don’t display normal distribution especially during black swan events. Types of structured products can be designed to mitigate high risk among the alternative investment strategies.
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 different 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 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 invests in companies which are in an earlier stage 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 within the alternative investment strategies, investment horizons are longer than traditional asset classes. The churn of the portfolio is much less since the return of the portfolio is not dependent on momentum or tactical allocation of assets. During the credit crisis, both the endowment funds fared poorly with huge losses. It’s not easy to predict black swan events, 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.