It’s official: returns for college and university endowments for fiscal 2017 are in, and while they averaged a respectable 12.2 percent for the year, over the past decade they have underperformed funds offering a simple 60-40 or 70-30 stock-fixed income allocation.
With their average returns dragged down by the weak performance of hedge funds, venture capital and private equity, you would think endowments would be fleeing these so-called alternative investments, which are costly and mostly illiquid, as some large pension funds have done.
On the contrary, endowments are holding firm, or even adding to these holdings. Last year alternative investments accounted for an average of 52 percent of endowment assets — over 60 percent in the largest endowments — the same percentage as two years ago, according to the annual Nacubo-Commonfund study of endowments.
Yet over the past 10 years, the average endowment earned a 4.6 percent annualized return, lower than the 5.3 percent return for a low-cost 60-40 stock-bond index fund portfolio and 5.4 percent for a 70-30 mix.
For endowments greater than $1 billion, the average return was 5 percent. Had they realized that extra three-tenths of a percent, or 30 basis points, that the 60-40 portfolio delivered, they’d have on average an additional $47 million in their endowments.
The trend is likely to be even more pronounced next year, when the financial crisis results of fiscal 2009 drop out of the 10-year calculations. That’s because alternatives did provide something of a buffer during that severe bear market, but have mostly underperformed since.
Five-year averages suggest the magnitude of the gap: The average endowment had annualized five-year returns of 5.9 percent. A 60-40 mix returned 8.2 percent and a 70-30 mix returned 9.2.
“That’s tens of millions of dollars that could have otherwise funded scholarships, built a new museum wing, or bolster the corpus of the endowment to help future generations,” said Christopher Philips, head of Vanguard Institutional Advisory Services. (He’s not a disinterested observer: Vanguard is a major purveyor of — and advocate for — low-cost index and mutual funds.)
“It’s frustrating because these institutions do so much good work, and most of them could be doing so much better,” Mr. Philips said.
Even the Ivy League schools, with combined endowments of more than $125 billion, have fallen prey to the trend. As a group, they too have underperformed simple index strategies over 10 years, and their huge portfolios of alternative assets “appeared to deliver no meaningful benefits in 2017,” according to a study by Markov Processes International, a quantitative research firm that did an in-depth study of the performance of Ivy League endowments.
Last year Harvard University shocked the investment world when it announced a $1.1 billion write-down of its natural resources portfolio, much of it in alternative investments. Harvard’s $37.1 billion endowment, the country’s largest, gained only 8.1 percent last year, placing it last among Ivy League schools. Harvard said it was in the process of restructuring its illiquid asset portfolio, but hasn’t abandoned alternatives.
Even Yale University, which pioneered the so-called Yale Model now slavishly followed by many other endowments, and has a target allocation of nearly 90 percent of its assets in alternative assets, has seen its outperformance shrink in recent years. Yale delivered an 11.3 percent return for fiscal 2017, but that was below the average return for all endowments of 12.2 percent, according to the study by Nacubo, the National Association of College and University Business Officers.
Yale still boasts a stellar 20-year annualized return of 12.1 percent, far above the endowment 20-year average of 7.4 percent, according to the university. But its 10-year annualized return has slipped to just 6.6 percent. (That still puts it in the top 5 percent of all endowment returns.) Still, Yale told me that its chief investment officer, David Swensen, is bullish on the school’s portfolio relative to stocks and bonds for the next 10 years.
The endowments’ persistent devotion to high-cost alternative assets in the face of such poor performance, now documented across a decade-long span, baffles many. “We keep scratching our heads,” said Mr. Philips of Vanguard.
“Among the schools we survey, there’s a strong belief in the endowment model pioneered 30 years or so ago by Yale and a few other schools,” said Kenneth E. Redd, senior director of research and policy analysis for Nacubo. “We’re not seeing any changes in portfolio alignment or investment philosophy even though the indexes have clearly outperformed both managed funds and hedge funds. There’s still this belief that alternatives will provide some measure of outperformance.”
He noted that large endowments of more than $1 billion, which tend to have high allocations to alternatives, did on average outperform the 60-40 mix (but not the 70-30 mix) over the most recent five-year period.
Jeff Schwartz, Markov’s president, agreed. “We’re talking about true believers in the value of alternatives,” he said. Many endowment managers, he added, “aren’t completely objective. They’ve seen it work in the past, sometimes in a spectacular way. It’s hard to take an embedded belief system like that and say, just because we’ve had an outstanding bull market, that you should move to 60-40. That’s a tall order.”
Given the need to cover increased costs, not to mention the recent tax legislation that seeks to tax the wealthiest endowments, asset managers at colleges are under increasing pressure to generate higher returns, even as lofty stock valuations and rising interest rates “suggest it will be hard to get 7.5 percent with a traditional asset mix going forward,” Mr. Philips said. “So there’s a strong inclination to turn to something that promises higher returns,” he said, even if they haven’t delivered in the recent past.
He also pointed to the “massive marketing machine in the alternative space,” which is “causing investment managers to turn a blind eye to what’s really happening in financial markets.”
Universities depend heavily on draws from their endowments — typically 5 percent or more per year — to meet spending needs, and are still haunted by memories of the financial crisis. This month’s stock market volatility was a painful reminder.
So the promise of alternative investments to mitigate risk and protect against market downturns has been powerful, even if they haven’t delivered.
But with long-term — even infinite — time horizons, university endowments should be able to withstand market volatility.
“We’re aware of the need to support current spending,” Mr. Philips said, “but if growing the corpus to support future spending is a primary objective, there should be more traditional equity exposure, not less. Adding non-traditional assets would be O.K. if they were compensating for illiquidity and higher risk, but they’re not.”