While in 2011 the largest endowments had the top-ranked performance in almost every category (the sole exception being fixed income), the rankings for 2016 appear to be almost random. They had the best performance in only three categories and were tied for best performance in two other. Equally important, the indexes representing the asset classes held by endowments appear to outperform the securities selected by them. Of course, reported returns of endowments are net of fees while returns on some of the indexes are gross of fees. However, endowments' reported returns are not net of all costs. NACUBO reports that in addition to the fees paid to external managers, endowments spend around 60 basis points internally to manage their assets.
Why has there been such a lack of alpha on the part of endowments, and why has the performance deteriorated in recent years?
It is hard to imagine why endowments should underperform indexes representing liquid, publicly traded securities. Here, for instance, the U.S. equity market is represented by the Russell 3000 while non-U.S. equity is represented by an 80/20 portfolio of MSCI's EAFE and Emerging Market indexes. Liquid exchange-traded funds that represent these and a few other classes (e.g., indexes of publicly traded securities were used to represent fixed income, private real estate, and energy and natural resources) are readily available. Endowments could easily have matched the performance of these indexes.
Their hedge fund, private equity and venture capital investments have not performed well in recent years. Given the large allocations that endowments make to these asset classes, it is crucial for them to find best of breed and not to allocate to these asset classes only because they have a target weight to meet.
Also, fees spent on managing assets that are unlikely to be sources of alpha have reduced performance. Finally, staff turnover at some of the largest endowments has not helped either.
What should they do to improve performance? First, increasing liquidity and reducing costs can go a long way toward improving returns. Increased liquidity will allow endowments to take advantage of temporary market dislocations and be buyers when others are sellers. It also would prevent the forced liquidations seen during the 2008-2009 financial crisis.
Second, they should move most of their allocations of traditional assets classes into liquid ETFs.
Third, they should use a bottom-up approach to determine optimal allocations to alternatives. The largest endowments allocate around 50% of their assets to alternatives, and there is remarkably little variation among them. It is hard to believe that all large endowments can identify about the same number of highly skilled managers in this space such that they end up with the same allocation. Herd mentality appears to be the driving force here. Using a bottom-up approach, the endowments will invest in these highly heterogenous asset classes only if they are certain that they have identified a reliable source of alpha.
Finally, the so-called endowment model, which advocated aggressive allocations to illiquid assets to harvest the illiquidity premium is no longer valid. The supply of illiquidity premium is finite and not every illiquid asset is a source of illiquidity premium.
At the extreme, if an endowment values liquidity highly and/or cannot find any reliable source of alpha, a highly diversified portfolio of ETFs will do fine. In fact, a portfolio of 18 ETFs using allocation weights provided by NACUBO has performed remarkably well since 2000.