Endowments Must Stick With Their Long-Term Investing Strategy Despite Underperformance

by: Prateek Mehrotra


All investment strategies experience periods of underperformance.

Endowments outperformed the stock market over the past decade with a lot less volatility.

Endowments lagged during the current bull market because they are more diversified and invest only a portion of their portfolios in equities.

The ivory tower geniuses atop the country's most respected endowments have recently received a firestorm of criticism for failing to produce outsized returns during the current bull market. But investors must accept that all investment strategies experience periods of underperformance. It's hardly a reason for endowments to hang their heads. Investors tend to have short memories. They forget that these same endowments outperformed the stock market over the past decade with a lot less volatility.

Harvard University's $32.7 billion endowment returned an average of 10.5% annually over the past three years, through June 2013, versus 18.45% for the S&P 500, including dividends, over that same period, the Wall Street Journal reported. Yale University's $21 billion fund gained 12.8% annually over the same period.

The Endowment Index, a benchmark for endowment-style investing, returned 17% in the year ending June 30, 2014 with only 34% invested in traditional equities, according to calculations by NASDAQ OMX. That's while the S&P 500 gained nearly 25%, according to Nasdaq OMX. The Endowment Index rose nearly 8% annually the past three years and nearly 12% a year on average over the past five. It lagged the S&P 500, which gained nearly 17% and 19% annually over the same time periods. But looking over the past 10 years, the Endowment Index outpaced the stock market, rising 9% annually while the S&P added almost 8% annually. The index comprises 20 liquid, exchange-traded funds with exposure to hedge-fund strategies, private equity, real estate, commodities, managed futures, bonds, foreign equities, and U.S. stocks.

The Yale Investing Model

The main reason endowments underperformed during the current bull market is because they are more diversified and invest only a portion of their portfolios in equities. The Yale Endowment's investment policy, for example, calls for diversifying across seven asset classes that all act independent of each other in different economic environments: absolute-return strategy, domestic equity, fixed income, foreign equity, natural resources, private equity, and real estate.

"The University combines the asset classes in such a way as to provide the highest expected return for a given level of risk," the Yale Endowment wrote in its 2013 report.

About half of Yale's portfolio is invested in illiquid assets such as private equity, venture capital, leveraged buyouts, real estate, timber, oil and gas.

"Since market participants routinely overpay for liquidity and since less liquid markets exhibit more inefficiencies than their liquid counterparts, illiquid markets create opportunities for astute investors to identify mispricings and generate outsized returns," the report stated. "Intelligent pursuit of illiquidity is well suited to endowments, which operate with extremely long time horizons."

The Yale Endowment allocates about one fifth of assets to an "absolute-return" strategy, 11% to foreign markets, 6% to domestic equities, and 5% to fixed income. The absolute-return strategy aims to take advantage of special situations such as mergers, acquisitions, spin-offs, and bankruptcy restructurings.

"Unlike traditional marketable securities, absolute-return investments have historically provided returns largely independent of overall market moves," Yale's report stated. The absolute-return strategy has produced 11% annually since it started in 1990 with very little correlation to domestic stock and bond markets.

Yale was the first institutional investor to distinguish the absolute-return strategy as its own asset class. For its domestic equity exposure, Yale hires fund managers to hand pick undervalued stocks relative to their earnings potential, cash flow, and other fundamentals.

Yale's Current Portfolio

The most recent Securities and Exchange Commission filings show Yale holds a $128 million dollar position in Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO) and a $44 million stake in iShares MSCI EAFE Index Fund (NYSEARCA:EFA), an ETF tracking foreign-developed markets. It has small positions in Palo Alto Networks Inc (NYSE:PANW), a security-software developer; Coty (NYSE:COTY), a cosmetics and fragrances manufacturer; Schlumberger (NYSE:SLB), an oil and gas technology supplier; and Mid-Con Energy Partners LP (NASDAQ:MCEP), an oil and gas exploration and development company.

The Yale Endowment earned 12.5% in its fiscal year ending June 30, 2013. The $21 billion juggernaut -- second only to Harvard University -- returned 11% annually on average over the past 10 years and 13.5% annually the past 20 years, according to the Yale investment office. It's grown more than six times over two decades.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Endowment Wealth Management and ETF Model Solutions in Appleton, Wis. are the creators of the Endowment Index.