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Richest Colleges: What Makes an Endowment Outperform?

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Endowments with active management receive higher returns net of fees from U.S. equity allocations, according to a new white paper released by Commonfund Institute.

Commonfund conducted a longitudinal analysis of the NACUBO-Commonfund Study of Endowments results from 2006 to 2013 to evaluate whether active management was related to higher endowment returns in U.S. equities over time.

Researchers also analyzed the data to evaluate which endowment characteristics were related to higher levels of performance over time.

ThinkAdvisor presented the 20 richest colleges in the 2013 NACUBO-Commonfund Study last week.

The white paper said active management for endowments was significantly positively related to higher returns net of fees from U.S. equity allocations over the evaluation period.

Moreover, endowments with chief investment officers or offices of CIOs were better able to earn incremental positive returns from active management than those without them.

In addition, larger endowments were better able to earn incremental positive returns from active management than the smallest endowments. However, the effect appeared to diminish as endowments increased in size.

Researchers determined that the effectiveness of an actively managed investment portfolio depended not only on the skill of the investment managers, but also on how truly active they were.

The paper said many mutual funds purport to be actively managed, but stay fully invested regardless of market conditions, with only minor allocation adjustments over time.

This is because they are “closet indexers” — funds whose portfolios look like indexes and whose performance is very closely correlated to an index.

Active Investors and Managers

The white paper noted that active investors need the ability to evaluate managers’ opportunity sets in different economic environments and to allocate dynamically to managers whose style is suited to the expected market environment.

As well, active investors need to perform ongoing analysis of active manager fund holdings in order to detect style drift or closet indexing.

Endowments, the paper said, are a specific type of long-term, sophisticated institutional investor whose distinct objectives and risk tolerances make them uniquely capable of capturing the long-term benefits of active management.

For their part, active managers have risk characteristics that match well with endowment risk appetite, according to the study. These risks are typically slightly higher volatility, somewhat lower liquidity and higher portfolio concentration than passive managers.

(Related ThinkAdvisor story: Top 20 Richest Colleges for 2013)