Developed at Yale in the mid-'80s, the endowment model generated outsize returns for mega institutions for decades. In recent years, the approach, which seeks to capitalize on an endowment's “infinite” time horizon by reducing exposure to traditional asset classes and taking on more risk and illiquidity through alternative investments, has become the preferred strategy for endowments of all sizes.
In 2004, alternative investments comprised 16% of portfolios, on average, for endowments with $101 million–$500 million. In 2017, they comprised 32%.1 But does this popularity mean the strategy is paying off?
“There are always 'winners' in this game, but too many small and midsize institutions end up falling short,” explained Jim Episcopo, a senior investment consultant with Vanguard Institutional Advisory Services® (VIAS™). “Not only do they fail to make the returns they expect, many times they underperform their composite benchmarks.”
Sources: 2017 NACUBO-Commonfund Study of Endowments and Vanguard.
Two hundred and seventy-five institutions are represented in the “$101 million to $500 million” NACUBO cohort. The NACUBO institutions' portfolios included in this chart have the following investment allocation on average: 49% equities, 13% fixed income, 32% alternative strategies, and 6% in short-term securities/cash/other types of investments. Eighty-one percent of portfolios included in the NACUBO cohort reported rebalancing at least once in 2016. NACUBO performance data is shown net of fees. The NACUBO institutions' portfolios performance was reported to NACUBO voluntarily by NACUBO member institutions and the performance reported may have been affected by changes in conditions, objectives, or investment strategies during the time period of performance displayed above. The fees deducted from NACUBO portfolios include: (i) management fees paid to direct asset managers for investment and management services, excluding performance fees which can vary widely and may not be indicative of expected rates for a given period; (ii) fund-of-fund fees, which represent aggregate blended management fee rates paid directly to fund-of-fund providers; (iii) advisory fees, which may include consulting fees in addition to fees for investment advisor services; (iv) fund operating expenses; and (v) custody fees. The NACUBO report notes that individual institutions may pay more or less in fees than is represented by the performance figures set forth above and that NACUBO's fee deduction method is intended to provide a representation of average fee levels rather than what any individual institution pays. Institutions in the over the “$101 million to $500 million” billion NACUBO cohort reported average fees of 1.54%, excluding performance fees, as noted above.
The VIAS model portfolio performance is net of advisory fees and underlying fund expenses. VIAS clients do not pay commissions or brokerage fees and the model results above therefore do not reflect the deduction of such fees. The performance for the VIAS model portfolios displayed above is net of an annual advisory fee of 0.20%, assessed quarterly at 0.05%. The 0.20% fee is based on a hypothetical portfolio value of $10 million and is not based on actual portfolio performance. Advisory fees are subject to change dependent on portfolio size and as described in the VIAS advisory brochure. VIAS portfolios are only available to qualified institutional investors with assets starting at $2 million. For additional information on the VIAS advisory fee schedule, please refer to the VIAS advisory brochure.
The VIAS model portfolios assume the reinvestment of dividends and earnings, and the model portfolios assume a rebalancing method based on the following time-and-threshold approach VIAS uses with its clients. The model portfolios assume a quarterly review to determine the deviation from target weightings and corresponding quarterly rebalancing transactions. The VIAS model portfolio returns do not reflect actual trading and may not reflect the impact that material economic and market factors may have had on VIAS' decision-making had VIAS actually managed client funds during the performance periods displayed above. VIAS portfolios are subject to fluctuations in value and investment losses.
The volatility of the VIAS model portfolios and 70/30 benchmark is materially different from that of the NACUBO institutions' portfolios. In addition, the NACUBO institutions' portfolios may have had during the time periods noted above, and may currently have, investment objectives that are not consistent with the VIAS model portfolios or with using a 70/30 benchmark.
See Notes below for important information about the VIAS Vanguard Index and VIAS concentrated active model portfolios and 70/30 benchmark.
The performance numbers are particularly striking against a 7.4% target, which was the median return NACUBO study respondents said was necessary for their endowments to support their institution's budget while maintaining purchasing power.2 Given its inconsistent history of success, why does adherence to this model persist? “Some endowments don't realize that when it comes to alternative strategies, the playing field isn't even,” Episcopo said. “Smaller endowments can get in the game, but they do so at a significant disadvantage.” He explained that smaller institutions are handicapped because they lack two important criteria: sufficient scale to attract the best investment managers; and relationships that allow them to negotiate favorable fees or even to access certain investments in the first place.
“With active investments, but especially with funds using alternative strategies, you need the best of the best—managers in the top quartile or top decile,” Episcopo said. “But these investments have limited capacity, and managers want investors who can commit the most capital. And even then, they may stipulate other requirements that most endowments just can't meet.”
In addition to a higher degree of skill, top-echelon managers are able to employ the sophisticated strategies that have paid off for many larger endowments. In fact, elite fund managers can be so sought-after that even Yale itself doesn't always have an edge. In its 2016 annual report, Yale explained, “In some markets, Yale has little bargaining power. Venture capital and leveraged buyouts present the greatest challenge, as the overwhelming demand for high-quality managers reduces the ability of limited partners to influence deal terms.”3
The effect of costs on investment performance can barely be overstated. In examining fund characteristics, including concentration, turnover, size, and past performance, Vanguard research has repeatedly found that low costs—more than any other attribute—has correlated with higher risk-adjusted future returns.4
“The largest endowments have the relationships and the leverage to negotiate lower fees,” Episcopo said. “Without that leverage, smaller endowments pay a lot more, and that fee differential makes it more difficult to generate returns that would justify the higher fees.”
This is especially important with alternative investments because costs can be considerable. For example, in a “two and twenty” arrangement, an investor pays 2% of assets and 20% of profits. “Performance would have to be spectacular to make that kind of deal worth it,” Episcopo said.
Further, not all fees are readily apparent. “When investing in a fund of hedge funds, investment managers are putting capital to work in maybe 20 different underlying hedge funds,” Episcopo said. “Each of those funds charges a fee, and then the asset gatherer charges an additional fee. It creates layers of fees that can really eat into performance. That's a lot to make up for before the investor realizes any return.”
A 2015 Commonfund study of costs suggests that many endowment managers may not recognize all the fees they pay. Few respondents were able to give a breakdown of investment costs and, although 85% reported allocations to alternative investments, only 18% said they paid incentive and performance fees.5
Interestingly, Yale itself acknowledged that the endowment model may not be sensible for many institutions. Its 2016 annual report substantiates its active management fees by citing its consistent ability to realize better-than-market returns. The report adds that low-cost index strategies “make sense for organizations lacking the resources and capabilities to pursue successful active management programs, a group that arguably includes a substantial majority of endowments and foundations.”2
Many alternative investments are complex, making it difficult to understand not only the fee structures but also the risks. “The more complicated the investment, the more important it is to clearly understand potential benefits and drawbacks, and how they can play out in the long run—especially when projected returns are unusually enticing,” Episcopo said.
“For instance, when you invest in private equity, you're usually committing your money upfront. They may target a 20% return, but often you won't see any return—zero—for five to seven years.6 What could you have earned with that money, even invested conservatively, over all that time?”
Plus, that 20% is hardly guaranteed. Return dispersion is wider for alternative investments than for traditional asset classes.6
Notes: Public U.S. active equity distributions were based on data provided by Morningstar, Inc., for mutual funds domiciled in the United States from January 1, 1994, through December 31, 2017. All funds are U.S.-dollar-denominated and have at least a three-year history, thereby adjusting for survivorship bias. Distressed debt, Fund of funds, Real estate, Buyout, and Venture capital distributions based on data provided by Preqin. Each distribution was based on an IRR (internal rate of return) calculation from a series of annual cash flows from each fund. For private equity funds that had not yet distributed 100% of the fund's capital back to the limited partners, IRR calculations were based on an ending NAV value. Each distribution has been adjusted so that the median resides at point zero, to isolate the dispersion.
Past performance is no guarantee of future results.
Sources: Vanguard calculations using data from Morningstar, Inc., and Preqin.
This wider range of outcomes makes manager selection even more important because a mistake by a less skilled manager could have a larger impact on portfolio-level performance.
If the typical 20% or 30% allocation to alternatives could present a rockier path for smaller endowments, what might be a steadier course? “Focus on the things you can control—costs being a big one,” Episcopo said.
“We really advocate applying the same tenets we use ourselves. For example, when we select managers for our funds, we find talent at a reasonable cost.” This may be easier said than done, and Episcopo acknowledged Vanguard's advantage. “Because of Vanguard's vast scale, managers are often agreeable to more equitable fees.”
Cost is just one reason why some endowments could benefit from finding a good partner. Although small and midsize endowments can't match the leverage of a multibillion-dollar endowment, they can access the expertise and resources of larger-scale investment firms who provide outsourced CIO (OCIO) services.
An OCIO also helps with investment oversight. “We conduct ongoing due diligence, which includes the discipline to ride through some turbulence. We've found that, just as investors try to time the markets, people tend to fire active managers at exactly the wrong time. A well-informed, vigilant, and long-term view is crucial to prevent the kind of impulsive mistakes that could cripple a portfolio.”
A final critical factor is trust. “You need to have a high degree of confidence that you're working with someone who is highly skilled and is always looking out for your best interests,” Episcopo said.
For more information on Vanguard Institutional Advisory Services, call 888-888-7064, email NPOCIO@vanguard.com, or visit institutional.vanguard.com/VIAS.
1 The 2017 NACUBO-Commonfund Study of Endowments.
2 The 2016 NACUBO-Commonfund Study of Endowments.
3 The Yale endowment, 2016.
4 Shopping for alpha: You get what you don't pay for, Vanguard, 2015.
5 Understanding the cost of investment management, Commonfund Institute, 2015.
6 The allure of the outlier: A framework for considering alternative investments, Vanguard, 2015.
Written by Vanguard.
© 2018 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds.
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Data from Morningstar®, Inc.
Returns through 12/31/2017; Portfolio returns assume semiannual rebalancing to target allocations, and are net of fund expenses and a 0.20% advisory fee (based on a $10 million investment) assessed quarterly at 0.05%. Portfolio equity allocation is 49% U.S. and 21% international equity through December, 2014; 42% U.S. and 28% international equity thereafter; portfolio fixed income allocation of 30% U.S. fixed income through May 2013, 21% U.S. fixed income and 9% international fixed income thereafter. Returns for Total International Stock Index reflect Investor Shares through November, 2010, Admiral Shares thereafter. Return since inception for Total International Stock Index are for Admiral Shares.* 70/30 benchmark is 49% Spliced Total Stock Market Index (Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter); 21% Spliced Total International Stock Index (Total International Composite Index through August 31, 2006; MSCI EAFE + Emerging Markets Index through December 15, 2010; MSCI ACWI ex USA IMI Index through June 2, 2013; and FTSE Global All Cap ex US Index thereafter. Benchmark returns are adjusted for withholding taxes); 30% Spliced Bloomberg Barclay's US Aggregate Float Adjusted Bond Index through May, 2013; thereafter, fixed income portion is 21% Spliced Bloomberg Barclay US Aggregate Bond Index, 9% Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index Hedged; after December, 2014 equity portion of the benchmark is 42% Spliced Total Stock Market Index, 28% Spliced Total International Stock Index.
** Expense ratio as reported in the most recent prospectus. Expense ratio is charged in addition to an advisory fee.
Data from Morningstar®, Inc.
Returns through 12/31/2017; Portfolio returns assume semiannual rebalancing to target allocations, and are net of fund expenses and a 0.20% advisory fee (based on a $10 million investment) assessed quarterly at 0.05%. Portfolio equity allocation is 49% U.S. and 21% international equity through December, 2014; 42% U.S. and 28% international equity thereafter; portfolio fixed income allocation of 30% U.S. fixed income through May 2013, 21% U.S. fixed income and 9% international fixed income thereafter. Returns for Total International Stock Index reflect Investor Shares through November, 2010, Admiral Shares thereafter. Return since inception for Total International Stock Index are for Admiral Shares.* 70/30 benchmark is 49% Spliced Total Stock Market Index (Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000 Index) through April 22, 2005; MSCI US Broad Market Index through June 2, 2013; and CRSP US Total Market Index thereafter); 21% Spliced Total International Stock Index (Total International Composite Index through August 31, 2006; MSCI EAFE + Emerging Markets Index through December 15, 2010; MSCI ACWI ex USA IMI Index through June 2, 2013; and FTSE Global All Cap ex US Index thereafter. Benchmark returns are adjusted for withholding taxes); 30% Spliced Bloomberg Barclay US Aggregate Float Adjusted Bond Index through May, 2013; thereafter, fixed income portion is 21% Spliced Bloomberg Barclay US Aggregate Bond Index, 9% Bloomberg Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index Hedged; after December, 2014 equity portion of the benchmark is 42% Spliced Total Stock Market Index, 28% Spliced Total International Stock Index.
** Expense ratio as reported in the most recent prospectus. Expense ratio is charged in addition to an advisory fee.