Burnishing the Endowment Myth
In his essay, “Don’t Give Up the Ship: The Future of the Endowment Model,” Laurence Siegel extols what he considers to be a powerful advantage of university endowment fund managers and encourages us to believe that the time is right for their ship to come in after a long dry spell. By contrast, my recent work, “Failure of the Endowment Model,” concludes that large educational endowment funds in the U.S. face the prospect of continued underperformance owing to the failings of the endowment model itself.
Siegel concedes that endowment funds have underperformed for many years, and that their alternative investments, or alts, which he describes as having become a “crowded trade,” were a contributing factor. His principal theme, however, is that educational endowments, in comparison to, say, Big Dumb Public Pension Funds, possess “...structural advantages that should [emphasis added] allow them to earn above-market risk-adjusted returns in the long run.” In the spirit of the Chicago School, Siegel avers that the main reason that endowment funds should be able to outperform in the future is that they operate freely. In other words, unlike public pension funds, which are elephantine investors mired in restrictions, politics and bureaucracy, and offering below-market pay, endowment funds are able to put their considerable and highly paid talent to work nimbly, sans fetters. Siegel also notes that the endowments, in addition to enjoying great latitude to make savvy investments, tend to be nestled within elite institutions, a number of which boast Nobel laureates on the faculty who can provide intellectual heft to the investment management effort. Excelsior!
Excuse the purple prose: I confess I’m a public school guy. In any event, Siegel claims that endowment managers’ putative freedom is the primary reason that their funds should outperform passive investment in the future and knock the socks off straightjacketed and lumbering competitors such as public pension funds. Freedom, in principle, is a good thing. But freedom, per se, is no where near enough to enable endowment managers to overcome these stubborn facts:
- Overwhelming evidence accumulated over more than half a century, including by some of those Nobel laureates, tells us that active management doesn’t pay. There is no exemption in that literature, by the way, for investment managers that deem themselves to be participating without restriction. The evidence is that markets are efficient enough such that mangers simply cannot and do not recover their costs over the long run.
- Large educational endowments in the U.S. employ an average of more than 100 investment managers, commingled funds and partnership interests. They appear to believe they need this many to fill the several asset-class silos that are integral to the endowment model. With that many managers, it is no surprise that the endowments exhibit a typical R2 with stock and bond indexes of approximately 96%. In other words, they exhibit strongly market-like diversification, their alternative investments notwithstanding.
- Large endowments, with approximately 60% of their assets invested in pricey alternative investments, incur annual costs at the total fund level of 1.5 to 2.0% of asset value.
A simple statistical calculation reveals that an investment portfolio with the characteristic diversification and cost structure of the typical large endowment doesn’t have a snowball’s chance in hell of generating positive risk-adjusted returns over the long run. And no amount of latitude can begin to alter the economic realities of high-cost, diversified investing in highly competitive markets.
As for the elitist-investor angle, I don’t buy it. There is no inherent difference between endowment funds and public pension funds in terms of how they might be expected to perform. Both are tax-exempt investors. Both are institutional funds in the U.S. that would describe themselves as having an amply-long investment horizon for equity investing. Both operate in the same markets. Both diversify their investments carefully and extensively. Both are overseen by fiduciaries operating under trust law that originated with Harvard v. Amory (1830). Dollars invested don’t “know” whether they are working for an Ivy League school or public school teachers. Endowment funds are not merely competing with one another. They are competing with public pension funds on a daily basis. And they haven’t been doing well in recent years. My research shows that large endowment funds have consistently underperformed public pension funds on a risk-adjusted basis by 50 bps per year, which approximates the incremental cost incurred by the endowments as a result of their much heavier reliance on costly alternative investments.
The secondary theme of Siegel’s essay is that this is the wrong time to abandon alternative investments. Before addressing this theme, a few facts are in order. First, and as noted, alternative investments account for approximately 60% of large educational endowment portfolios. The aggregate market value of all the alternative asset types popular with endowment managers, however, accounts for only about 10% of the value of endowments’ investment opportunity set. Individual alt components, e.g., hedge funds, private equity, venture capital and private real estate equity, are mere slivers of the whole, each accounting for just 1 to 3% of the value of the opportunity set. The balance of the opportunity set comprises tens of trillions of dollars of publicly-traded stocks and bonds. Viewed in this light, the endowments have a huge concentration of their holdings in assets that are small potatoes in the full context of the capital markets. Second, the correlation of alternative investments is much greater than their advocates would like to believe. The reality is that typical correlation coefficients for principal classes of alts with U.S. equities is on the order of 0.9. So much for setting the stage: on to the timing argument.
Siegel’s timing argument is based on the fact that stocks and bonds (generally) have performed much better than alternative investments (generally) over the last 10-12 years. Siegel opines that because stocks and bonds have done so well, relatively, this is the wrong time to dump the laggard alts. Note that this is an active-investment outlook, not a matter of long-term strategy. It is an active-investment outlook of the every-dog-has-its-day variety, which is to say not a particularly elegant one. That’s fine; Siegel is entitled to speculate. And time may prove him right. Two facts remain, however. First, it is an illusion to think alts are somehow disconnected from equity and bond markets, and that their boats simply were not lifted by the rising tide of public market values during the past decade or so. My research shows that during the last 12 years, alts moved with the equity market in accordance with their betas and produced large negative alphas. The main culprit in the alts’ underperformance was their annual cost of 2-4% of asset value. And, second, in light of the composition of the endowments’ investment opportunity set, a 60% allocation to alternative investments is a very big bet.
Siegel’s essay merely serves to burnish the myth of endowment investing. We have certainly had plenty of that over the years. My work addresses the deficiencies of the endowment model that have become apparent as it has evolved: its clumsy asset-class silos; the mind-boggling proliferation of investment managers; the implausible cost structure. I would much prefer to read about how to improve upon the endowment model. That, in my opinion, is the journal article that is waiting to be written and which many of us in the profession would eagerly take up.
Ennis, Richard M. 2020. “Institutional Investment Strategy and Manager Choice: A Critique.” Journal of Portfolio Management (Fund Manager Selection Issue): 104-117.
Ennis, ______. 2021. “Endowment Performance.” The Journal of Investing, April: _________.
Ennis, ______. 2021a. “Failure of the Endowment Model.” Journal of Portfolio Management (Investment Models issue): _______.
Siegel, Laurence B. 2021. “Don’t Give Up the Ship: The Future of the Endowment Model.” Journal of Portfolio Management (Investment Models issue): ______.
 Siegel (2021)
 Ennis (2021a)
 South African divestment mandates impinged heavily on the investment latitude of educational endowment managers in the 1980s. The Harvard Crimson was a thorn in the side of the university’s trustees as it railed about Jack Meyer and his fellows at Harvard Management being overpaid, even as they were adding billions of dollars to the treasury. (As a result of this kerfuffle, Meyer & Co. decamped to set up their own hedge fund.) Now educational endowment managers are coming to grips with ESG investment mandates, with some being forced by powers above to divest themselves of fossil fuel investments. Freedom, it turns out, can be elusive.
 See Ennis (2021), Exhibit 9.
 See Ennis (2020), p.108.
 Assume an endowment fund has an R2 with market indexes of .96 with attendant annual tracking error of 2.0% versus its benchmark. We can describe its distribution of future annual excess returns as having mean of zero and standard deviation of 2.0%. Annualized standard deviation of 10-year excess returns works out to be 0.63%. Shift that distribution to the left by 1.5% to account for costs. The area under the curve to the left of zero indicates the probability of a negative 10-year excess return: 99%, in this case.
 Ennis (2020), p. 108.
 Ennis (2021a), Exhibit 2.
 Ennis (2021), Exhibit 11.
 Ennis(2021a), p. ___.
 Ennis (2021a), p. ___.