Earlier this summer, we wrote about the FY 2017 returns (July 1, 2016-June 31, 2017) reported in the NACUBO-Commonfund Study of Endowments® (NCSE).1 The research comprises over 800 college and universities that self-reported their performance results and general asset allocation schema. One of the main "takeaways" from the study is that those endowments with greater exposure to investments classified as "alternatives" (e.g., hedge funds, funds of hedge funds, private equity, venture capital, distressed debt) lagged their peers who were more heavily weighted toward traditional marketable global equities and fixed income.
- "Compared with the Study universe return of 12.2 percent," across all 809 institutions, "the top decile reported an average return (net of fees) of 15.8 percent, and the top quartile reported an average net return of 14.8 percent... Top-decile performers (largely reflecting higher allocations to the best-performing asset classes, non-U.S. equities and U.S. equities) reported an allocation to alternative strategies averaging just 39 percent compared to 52 percent for the Study universe. Last year, the allocation to alternatives among the top decile was 62 percent."
- When we look back to the FY2016 study2, although "Leaders had the largest allocations to alternative strategies - an average of 62 percent for the top decile and 59 percent for the top quartile against 53 percent for Study participants," the researchers note that "Asset allocation throughout the Study is dollar-weighted, meaning that larger institutions' allocations to alternative strategies will weigh more heavily than those of smaller institutions, which generally have larger allocations to liquid securities, such as fixed income." In fact, "the three smaller size cohorts," ($51-$100 million, $25-$50 million, <$25 million) "... accounted for a clear majority of the top decile - a total of 65 percent. Among the top quartile, the two largest size cohorts totaled 14 percent of this population, while the other four size categories comprised the remaining 86 percent, with all four of them accounting for either 21 or 22 percent of the total."
Employing a dollar-weighted approach obscured the fact that the smaller institutions, which had a fraction of the exposure to alternatives relative to the multi-billion dollar outfits, accounted for a majority of those institutions that constituted the top 10 percent of performers.
Vanguard corroborated this dynamic. Francis M. Kinniry, a principal in Vanguard Investment Strategy Group, compared the returns generated by a globally diversified bond and stock portfolio within the classic 60% stock/40% bond construction against the returns generated by the NCSE respondents. Kinniry's global portfolio was designed and measured using indices, so no fees were associated with the theoretical portfolio. The 10-year average rate of return for this model portfolio of indices was 5.6%. The NACUBO-Commonfund endowment portfolios returned between 4.6% and 5.0%. Over 20- and 30-year spans, larger endowments, which traditionally have a large weighting toward alternatives, outperformed the theoretical portfolio constructed by Kinniry.
The NCSE data is helpful in analyzing the historical returns of endowment funds supporting colleges and universities. But what about the thousands of other investment pools supporting nonprofit organizations, in addition to higher education institutions?
Professors Sandeep Dahiya of Georgetown University's McDonough School of Business and David Yermack of NYU's Stern School of Business compiled and analyzed the IRS Form 990s of 28,696 nonprofit organizations between 2009 and 2016.3 Endowment returns for the organizations under analysis were measured against three benchmarks:
- The Center for Research in Securities Prices (CRSP) value-weighted equity index (a proxy for the US stock market);
- The Bloomberg Barclays US Treasury Total Return Bond Index (a basket of US Treasury notes and bonds); and
- A "balanced portfolio" comprised of 60% of the equity index and 40% of the bond index.
For endowments classified as "tiny" (<$1 million), the average return for the period was 6.40%. "Small" funds ($1 million-$10 million) averaged 7.44%, "medium" funds ($10 million-$100 million) averaged 5.83%, and "large" funds (>$100 million) returned 5.47%. The 60/40 balanced benchmark clocked in at 11%.
"The mean annual investment return for endowments was 6.65% between 2009-2016, while the benchmark returns on long-term government bonds were 7.96% per year and the equity market index returned 13.70% per year. In other words, the typical endowment fund under-performed a 60-40 combination of the equity and Treasury bond market indexes by about 4.75 percentage points annually."
A growing body of data supports the adoption of a low-cost, balanced approach to endowment investing and cautions against the status quo, which revolves around a global allocation across fixed income and equity, paired with a sizeable basket of alternatives.
"Larger funds may already have qualified board members but may be susceptible to professional money managers' sales pitches that lead to over-investment in exotic products with high fee structures."4
- Dahiya, Sandeep and Yermack, David, "Investment Returns and Distribution Policies of Non-Profit Endowment Funds" (December 7, 2018)."
We wish our readers a wonderful New Year.
3 Investment Returns and Distribution Policies of Non-Profit Endowment Funds, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 582/2018
4 Investment Returns and Distribution Policies of Non-Profit Endowment Funds, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 582/2018 (p.15)