US endowments and most notably those of the largest universities, are renowned for their high allocation to alternative assets. This approach is most closely associated with David Swensen, chief investment officer of the Yale University Endowment.
In his 2000 publication Pioneering Portfolio Management, Mr Swensen discussed what at the time was considered an unusually high exposure to alternatives, citing this allocation as the biggest contributor to the 16.2 per cent annualised returns achieved over the first 14 years of his tenure.
This was substantially better than the returns from other US endowments, and indeed from those in the UK, where a figure of 12 per cent to 13 per cent would have been achieved.
Moreover, the collapse in the stockmarket after 2000 enhanced Yale’s outperformance further: their high exposure to private equity, hedge funds and other alternative assets, and lower weighting in listed equities performed particularly well as the dot.com bubble burst.
This was well publicised, and many UK endowments started to allocate larger weightings to hedge funds and private equity from 2003 onwards.
At this point, there appeared to be a strong case for diversification away from conventionally managed equities which offered a possible means of avoiding 20 per cent to 30 per cent drawdowns in the future.
We are now 14 years on from the burst of the dot.com bubble, and with two further bear markets in 2008 and 2011 behind us, how have US endowment portfolios fared compared to the average UK endowment? Have hedge funds and private equity lived up to their billing of providing ‘absolute’, attractive and uncorrelated returns? The National Association of College and University Business Officers (NACUBO) common fund study of US Endowments data provides an interesting case study of US endowment portfolios. Two things are apparent.
First, the larger the endowment, the greater the allocation to alternative assets. Second, large endowments have performed better than their smaller brethren, and by a greater margin than could simply be explained by fees.
In chart 1, we have shown a breakdown of the NACUBO data, together with the returns achieved by the average UK endowment and our own multi-asset charity fund record, the AlphaCIF for endowments.
These returns have been shown after the impact of fees and inflation: these are the ‘real’ returns generated in dollars and sterling for US and UK charities respectively, in the 10 years up to 30 June 2013.
We have deliberately not adjusted for currency: our working assumption is that US investors aim to make money in dollars to spend in the US and UK investors aim to make money in sterling to spend in the UK.
Clearly, the largest US endowments have, on average, outperformed significantly, with the gap between the largest and smallest endowments amounting to a fraction less than 3 per cent a year. It would also appear that the average UK endowment has done better than all but the very largest US endowments.
So, over the last 10 years, there is no evidence to suggest that a US style of endowment management with high exposure to alternatives has proven any better than a more conventional UK approach.
Chart 2 draws out the exposure to alternative assets (including property) over this time period.
Across all the different types of charities, there has been a steady drift upwards in exposure to such investments.
Size continues to be a factor, with the largest US endowments still allocating the greatest exposure to alternative investments, while the figure in the UK only compares to the smallest US endowments.
However, it is also worth noting that these are just averages, and we believe that the range around the average is much greater in 2013 than 10 years ago.
For example, if one considers the flagship multi-asset class CIFs (common investment funds) managed by some of the UK’s leading charity investment houses (all with much the same ultimate return objectives, but achieved in keeping with their own house style), the exposure to alternatives and property ranges from just a couple of per cent to over 30 per cent.
Assuming that these allocations are reflected in segregated portfolios too, allocations in the UK charity market place have become more varied, and many will have an allocation of 15 per cent to 25 per cent – a significant change compared with 10 years ago. Can we reach any firm conclusions?
On the one hand, in the US, there seems strongly positive correlation between the amounts invested in alternatives and better investment performance.
On the other, there is little or no evidence of this in the UK, and indeed some indicators to the contrary.
If one was to reach any conclusion, it would be that at least in the US, the very largest endowments have managed their portfolios better than their smaller counterparts. But whether this is through asset allocation, stock selection or manager choice remains unclear.
It is also worth noting that not all of the largest US endowments managed their exposure to these illiquid alternative investments particularly well during the collapse of 2008.
In 2013, Andrew Ang wrote a paper entitled Liquidating Harvard. Ang, a professor at Columbia Business School, examined the composition of Harvard’s endowment (the largest in the world) and also the role the endowment had in the financing of the university at large.
He found that a third of the operational expenses of the university were funded from the income derived from the endowment. Not only did the value of their portfolio decrease by 22 per cent in 2008, but the lack of income it produced and its inherent illiquidity meant that they came close to running out of cash. Many businesses and investment strategies fail not because they lose all their assets, but because their cash flows do not cover their short-term expenses.
In the case of Harvard, they were able to borrow their way out of their immediate problems (with loans amounting to some $1.5bn (£870m) at 6.5 per cent).
This is a cautionary tale: even if Harvard’s investment strategy resulted in the appropriate allocation for their long-term endowment monies, most would agree it was not an appropriate way to invest their shorter-term operational reserves.
Lastly, it is worth reviewing the underlying performance of the key asset category where most investors have the bulk of their alternative allocation: hedge funds.
Hedge funds have not really lived up to their billing as the ‘absolute return’ or ‘all-weather’ strategies many hoped they would be.
In the 10 years prior to 2003, they managed to produce positive returns when other asset categories were failing.
However, in 2008, hedge funds designed to produce absolute returns for dollar investors typically fell by 22 per cent, and those designed for sterling investors fell by 22 per cent.
In 2011, hedge fund strategies in dollars and sterling also fell, by roughly 6 per cent. From a simple absolute return perspective, hedge funds have produced returns of about 1 per cent per annum in the past 10 years, which compares poorly with equity returns in excess of 7 per cent a year.
Even though the small returns achieved by hedge funds since 2003 were delivered with low volatility, one questions whether this justified the foregone return.
So, while investors like the largest US endowments would appear to have reaped an ‘early mover’ advantage, those who have allocated significant sums since 2003 have probably limited their investment return, not achieved an appreciably ‘less bad’ result in either 2008 or 2011, and are finding that low volatility with virtually no return is not a particularly appealing proposition.
Richard Maitland is head of charities and partner of Sarasin & Partners
