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 and it’s hardly a reason for endowments to hang their heads.
Investors tend to have short memories and forget that these same endowments outperformed the stock market over the past decade with much less volatility.
The Endowment Index, calculated by NASDAQ OMX, which tracks more than 800 endowment portfolios with more than $400 billion in assets under management, returned 17% in the year ending June 30, 2014 with only 34% of that $400 billion invested in traditional equities. In comparison, 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 like the S&P 500.
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 mispricing’s 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 its 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, spinoffs and bankruptcy restructurings and hedges positions that stray from their underlying value.
“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.
The most recent SEC filings show Yale holds a $128 million dollar position in Vanguard FTSE Emerging Markets ETF (VWO) and a $44 million stake in iShares MSCI EAFE Index Fund ETF (EFA), an ETF tracking foreign developed markets.
It has small positions in Palo Alto Networks Inc (PANW), a security-software developer; Coty (COTY), a cosmetics and fragrances manufacturer; Schlumberger (SLB), the oil and gas technology supplier; and Mid-Con Energy Partners LP (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 in size — returned 11% annually on average over the past 10 years and 13.5% annually over the past 20 years, according to the Yale investment office. It’s grown more than sixfold over two decades.