In Part 1, I discussed the core tenets of the Endowment Model and how successful it has been for a few institutions (though not all by any stretch). In Part 2, I’m going to discuss why the Endowment Model will likely disappoint in the future, ways it can be changed and how to incorporate certain elements into your personal investing.
First, a quick refresher. The Endowment Model was created and championed by David Swenson and his team at Yale University. Yale has achieved a remarkable run of performance, returning over 12.5% over the last 20 years, almost double that of the S&P 500. Due to Swenson’s early and continued success, pretty much every other large university endowment and foundation has attempted to replicate this model. Few have had as much success as the Yale team.
The Endowment Model consists of a number of key building blocks:
- Wide Use of Alternatives: Swenson and his team shifted out of public stocks and bonds and into hedge funds, venture capital, real estate, natural resources, and private equity (middle market leveraged buy-outs).
- Use of the Illiquidity Premium: With the movement away from traditional, publicly traded securities, Yale was able to capture an illiquidity premium. That is, returns have been (and in theory, should be) higher for assets that are difficult to buy and sell in order to compensate the investor for taking the extra risk of potentially not being able to get out of the asset.
- Manager Selection: This is where the Yale team really shines, and many other endowments and foundations fall short. First, Yale was early into the alternative investment space, and was able to get into some of what would become top tier managers. Many of these managers have been closed to new investors for years, so even if someone had the capital and insight to replicate Yale’s portfolio, they would be unable to. Second, Yale is able to seed new managers and take risks in order to find new talent. While there are likely to be as many disappointments as successes, the ability to locate and seed new talent is a huge advantage.
- Investment Structure: The structure for many of these investments is in the form of a limited partnership. These partnerships are notorious for low liquidity and high fees. Yale and other large institutions are able to get around some of this just based on sheer size (writing a big check allows you to dictate terms).
- Going Global: Seeking out new markets and new opportunities has been a driving force in the Endowment Model. University endowments have been some of the first investors in places ranging from China to Bangladesh, and Peru to Ghana.
The Future of the Endowment Model and What Parts to Use in Your Personal Investing
The Endowment Model has been very successful for a few, but not so successful for most. With that being said, there are things that can and should be incorporated into our personal investing. There are also things that cannot and should not. Most investors in the Endowment Model should be revisiting their core assumptions at this point, because over the next ten to twenty years, the Endowment Model is likely to disappoint.
Asset allocation is where the Endowment Model initially set itself apart. Institutional investors like Yale were the first to abandon the standard stock/bond portfolio. In general, the Endowment Model follows the below asset allocation ideas:
- Increase allocation to equities: No 60/40 mix here. Yale’s investment portfolio consists of only 5% fixed income and 2% cash. The rest is some variation of equity and equity-like risk.
- Diversify, but maintain equity-like returns: The whole point of diversification is to mitigate major drawdowns in a portfolio. However, endowments attempt to do this by adding less correlated assets with equity-like returns. Natural resources, real estate, and hedge funds have (at least in theory) less than a one to one correlation to equities. Each of these, though, has an expected return that is equity-like in nature.
What the Endowment Model Gets Right: Over the long run, the risk premium earned from equities is what allows an endowment to maintain a 5% real return goal, and hopefully, also increase the overall size of the endowment on a real return basis. Fixed income and cash are only capable of maintaining the real value of a portfolio, and even that is unlikely in the future given where fixed income and cash yields are priced.
Where it will Disappoint: Equity risk is expensive right now! Everything is priced up, and this is the great challenge of investing today. The Shiller CAPE has only been higher in 2007 and 2000, right before the Global Financial Crisis and the Dot Com Bust. Even diversified equity risk like natural resources, venture capital, and real estate have all been pushed up in price to a point where it’s tough to see how any substantial risk premium is earned.
The expected diversification benefit will likely not be there when needed most. Correlations among risky assets tend to go up during a crisis or drawdown, so adding these assets may not, and probably will not, do much to diversify you on the downside. In fiscal year 2009 (7/1/08 – 6/30/09), Yale returned -24.6% vs. an S&P 500 return of -26.2%. Much of the “outperformance” was likely due to the portfolio not being marked to market as conservatively as it should have been on the private investments.
Takeaways for Our Personal Investing: The over-arching idea of having substantial equity risk is how you grow wealth over time. Lending only grows wealth when you’re able to use leverage, and at that point, you have either equity-like risk or something even worse. Having an aggressive allocation to equities is key to growing family wealth over time, but it must be done in an intelligent way. The best diversifiers in the future will not be the same as the past. Using things that can reduce drawdown, such as certain “risk premium” strategies or the use of options, will be key components going forward.
The Illiquidity Premium
The illiquidity premium has historically been earned only by institutions that do not have an immediate need for cash and can have a very long investing time frame. Most of us are not there yet with our family wealth.
What the Endowment Model Gets Right: Historically, the ability to hold assets for long periods of time has allowed for outsized returns. However, this does not necessarily tamp down volatility. Endowments are right to try and capture the illiquidity premium where they can. With a spending need of around 5% per year, much of the portfolio can be in illiquid assets.
Where it will Disappoint: Is there even an illiquidity premium anymore? Uber is bigger than the vast majority of the S&P 500, and they have no need to go public to get liquidity (that and the fact that they lose $2 billion a year…). With the drive to find returns anywhere and everywhere, dollars have flown into illiquid assets, essentially crowding out any illiquidity premium.
Takeaways for Our Personal Investing: The illiquidity premium is something that I do not have a strong belief in. Has it been there in the past and will it be there at some point in the future? Probably. From a personal investment perspective, there are only two appropriate places. The first is in retirement accounts, and that is both tricky from a legal/setup perspective, and should only be done if you have a decade or more until hitting age 60. The second is in your Get Rich allocation. Remember, if you are maxing out retirement accounts to get the tax break, fully funding or have fully funded your F-You account, then feel free to put money into assets with option-like payouts. This allocation is the best place for venture capital or a speculative real estate investment.
Beyond the overall asset allocation model, manager selection has been the primary return driver for groups like the Yale Endowment.
What the Endowment Model Gets Right: For a group with the history, experience, and track record of selecting good managers, this can be a real advantage. As discussed in the previous post, certain asset classes lend themselves to spending the time to pick top tier managers. Yale has proven exceptionally talented at picking high quality managers, while most other groups have not.
Where it will Disappoint: The amount of dollars and sheer number of new entrants to the investment manager world has continued to increase. Finding alpha in the world was much easier ten years ago, just as it was much easier ten years before that, and ten years before that. The competition among managers is intense and to a large extent, has crowded out many alpha possibilities. At some point, the law of large numbers (in this case the large number of managers) makes finding the right manager that much more difficult.
Takeaways for Our Personal Investing: The only takeaway from this is to not play this game. Focus on finding interesting return streams that maintain an equity-like return but mitigate drawdown risk. The increase in factor based investing has created new “beta” exposures that are fairly easy to invest in. Find ways to add positive optionality to your portfolio and stay away from the loser’s game of manager selection.
A good investment is at the intersection of a good idea, good management, and appropriate structure. Most endowments use a partnership model for investing. This has benefits and drawbacks, although many more drawbacks than benefits.
What the Endowment Model Gets Right: The biggest pro of the Endowment Model structure is the co-investment of management alongside the investor. Having skin in the game is the key to having proper alignment of incentives.
Where it will Disappoint: There are two major ways that the partnership model disappoints. The first is fees. Many hedge funds are just factor investors in drag. Why pay them 2 & 20 when you can get the same portfolio of exposures for .5% or less? The second drawback is that using a partnership structure often changes a liquid asset into an illiquid asset. For example, a long/short or relative value equity hedge fund can take an asset with daily liquidity (stocks) and turn it into an asset with, at best, monthly liquidity. At worst, getting out of these structures can take as much as two years or longer. Yes, you read that correctly. I’ve seen managers with a 10 quarter redemption structure.
Takeaways for Our Personal Investing: Similar to manager selection, the best takeaway from this is to not play this game. Try to maintain control and liquidity in your portfolio. The only place that this would be appropriate is when you’re trying to score big wins with your Get Rich money. Venture capital or investing in a private business directly would be the appropriate assets for a partnership type structure.
Endowment Model investors have been pushing the envelope of investing geographies since day one. These were some of the first groups into places like China and India, and they continue to be aggressive in looking for new investments globally.
What the Endowment Model Gets Right: U.S. equity risk is not the only risk worth owning in the world. Granted, in my opinion, it is the best, as it still offers better than average growth potential with better than average protections (legal, political, etc.). However, limiting your portfolio to only US risk exposure reduces your opportunity set and decreases any potential diversification impacts.
Where it will Disappoint: Going global worked really well, up until the Global Financial Crisis. Since then, not so much. Also keep in mind that much of that performance is related to China and South Korea (MSCI considers South Korea an emerging market due to capital restrictions), both of which have outsized weights (China ~15-25% and South Korea ~15%) and strong returns. Just because there is large economic growth in places like emerging or frontier markets does not mean that there will be good investment returns. This is the one of the biggest fallacies in investing. Good returns are a combination of good growth, a good entry point, and a better exit point.
Takeaways for Our Personal Investing: Going beyond U.S. risk is easier today than ever before. Even adding assets such as frontier market equities and emerging market bonds can be done efficiently and fairly inexpensively. While adding these new risks can help grow your portfolio over time, remember that they may not do much to manage drawdown risk on the way down.
Given the expensive pricing of assets across the board, maintaining the status quo will likely disappoint in the future. Endowments tend to over-allocate to risky assets. This is important for growing a portfolio through time, but also requires buying in at reasonable prices. Things like illiquidity premium and manager selection are far more challenging today than in the past. Given that most of us will never have the skill, the balance sheet, or the contacts to succeed at manager selection like Yale has, we should instead focus on where we can improve our portfolio. Finding alternative risk strategies and building positive optionality will be key for the next five to ten years at least. Focus on those, instead of trying to find the next best manager or the next private investment fund.
Keep building my friends.