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Robert M. Cheney, CFA, CFP®

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Featured Wealth Management Article

How a Sensible, Simple Portfolio Approach Beats the Endowments:

The Re-Simplification of Portfolio Management

by Robert M. Cheney, CFA, CFP® Dated 1/29/2018

American university and college endowments have traditionally been seen as some of the most sophisticated investing platforms. Because they regularly have tens to hundreds of millions or even many billions to invest, they are staffed with well-educated professionals, have access to top institutional consultants, and access to investments that even wealthy individuals do not. They are perceived to invest with the very best and most exclusive managers for both public (stocks and bonds listed on exchanges) and private/alternative asset classes (non-traded private investment funds).

Surprisingly, their results trail those of a sensible, low-cost portfolio approach over longer periods. Why?

Every year the NACUBO-Commonfund Study of Endowments releases their report on the performance of endowments. Their study of the fiscal year ending June 30, 2017 was just released last week and included more than 800 colleges and universities representing more than $560 billion in assets. On average, these school endowments received 4.2% annual net return for the three years, 7.9% annual net return for the 5 years, and 4.6% annual net return for the 10 years ended June 30, 2017. However these results are exceeded by the net returns on a simple, passive low-cost 2-fund portfolio over the same time periods, even after advisor fees are included. Here is how the results compare:

 Net Performance for Years Ending 6/30/2017:

 

                        2-Fund                                    Average          Top Quartile

                        Portfolio                                  Endowment     Endowment

3-year              Above Top Quartile                4.2%                5.0%

5-year              In Line with Top Quartile       7.9%                 8.7%

10-year            Above Top Quartile                4.6%                5.2%

 

*Source: NACUBO-Commonfund Study of Endowments 2017. 2-Fund Portfolio comprised of 60% a broad stock market ETF and 40% a broad bond market ETF after all fees including 0.87% annual advisory and custody fees.

 

What explains the shortfall of school endowment performance? I will propose several explanations and welcome suggestions from readers for others.

First, endowments continue to use active fund managers for listed stock and bond portfolios which have higher fees than passive approaches. Their status allows them access to the “best” performing managers but often those managers that have exhibited the best past performance are those that go on to underperform in the future in a reversion to the mean. Also, the Standard and Poors Index Versus Active (SPIVA) studies show that over the past 15 years ended December 31, 2016, more than 92% of domestic active stock fund managers failed to meet their respective equity benchmark. This was a 15-year period including various phases of multiple economic cycles.1 The data would seem to favor using passive or indexed investing approaches to a great extent as opposed to active managers.

Second, most endowments have gone all-in on the “Yale Model” approach which heavily relies on alternative investments. The NACUBO study details that endowments have 46% of their assets allocated to alternative investments.  These alternative investments are private investments not listed on exchanges and include hedge funds, venture capital, private equity, private real estate, natural resources, and infrastructure investments. Unfortunately, it seems that this approach has not been paying off for endowments. Because these alternative investments are not liquid, they should be generating a “liquidity premium,” an additional return in excess of liquid investments like the 2-fund portfolio, because the alternative investments cannot be readily sold when the investor desires. It could simply be that passive portfolios have simply been in a better market environment than a Yale Model but I suggest that there may be other explanations:

  • The fee structure for alternative investment managers continues to eat away at returns. Many alternative managers charge 2% of assets managed annually plus 20% of profits achieved. These fees for alternative investments have remained high while fees for traditional portfolios, both passive approaches (such as the 2-fund portfolio) and active approaches, have been dropping.
  • There are so many alternative investment managers now that any opportunity for premium returns have been compressed. Managers bid up the price of assets and limit potential returns.
  • Sophisticated institutional investors like endowments do not have the culture to adopt the notion of a simple portfolio approach because there is a psychological and/or behavioral bent toward complexity.
  • Many endowment board members plus the consultants that advise them have staked their reputations on alternative assets and are possibly waiting for a bear market before being proven wrong.

It seems fair to conclude that if endowments, which have access to the best managers, fail to outperform a low-cost, passive approach in their use of alternative investments, then even the wealthiest individual investors should approach alternative investments with great selectivity and attention to fee structure.

As a reminder, the 2-fund portfolio net returns above also include the advisor fees that are charged on portfolios that my firm oversees. In other words, not only is the simple 2-fund portfolio generating returns in the top quartile of endowment performance, but these advisor fees pay for critical services outside the investment portfolio. This is where comprehensive advisors really deliver their value. These comprehensive advisor services include helping the investor set and attain financial planning goals, confirming that risk assumed in a portfolio is appropriate to the individual, rehearsing actions and attitudes to be taken in a stock market correction, maximizing tax efficiency, ensuring that financial risks are insured or covered, and protecting assets and planning for estate preservation among others.

A simple, sensible portfolio approach teamed with comprehensive advisor services is a valuable package. Sometimes simplicity is elegant!

As stated, I welcome your suggestions, comments and questions.

1) S&P Dow Jones Indices 2016 SPIVA US Scorecard

Institutional Endowments may have significantly different investment objectives and access to financial resources than individual investors. Endowments have limited liquidity needs, significantly longer time horizons and the ability to pursue less liquid asset classes more aggressively than an individual retail investor. Individuals typically have higher liquidity preferences and a finite time horizon. You should consider how your individual needs may be different from that of an endowment.

Investing involves risks including the potential loss of principal. No strategy can assure success or protects against loss. Past performance is no guarantee of future results. Diversification and asset allocation do not guarantee a profit nor protect against loss in a declining market. They are methods used to help manage risk.