investors now allocate more to international equities than to U.S. equities, more to hedge funds than to fixed income, and more to private equity and venture capital than to domestic public equities. The largest endowments have increased their allocations to alternative investments from 32.5 % in 2002 to 57 % in 2014.
EXHIBIT 3.5 Exposure to Alternative Investments within Large Endowment Funds
Source: NACUBO, 2014.
Swensen believes strongly in an equity orientation, seeking to participate in the ownership of both public and private equity securities and real assets. The role of fixed income is to provide liquidity and a tail hedge that serves to reduce potential losses in the portfolio. Yale University chooses not to invest in either investment-grade or high-yield bonds due to the inherent principal–agent conflict. As Swensen explains the conflict, corporate management explicitly works for stockholders and may choose to make decisions that benefit stockholders, even when those decisions are to the detriment of bondholders. Given this conflict and the fact that the total returns to corporate bonds are less than 1 % above government bonds on a long-term, net-of-defaults basis, the incremental return to corporate bonds may not warrant inclusion in the endowment portfolio. While sovereign bonds provide liquidity and a tail hedge in a time of crisis, corporate bonds can experience a reduction in liquidity and a disastrous loss of value during extreme market events, producing the opposite effect to what fixed income should have on a portfolio. Similarly, foreign bonds are not held in the Yale University portfolio because, while the return may be similar to that of domestic sovereign bonds, the addition of currency risk and unknown performance during times of financial crisis is not consistent with Swensen's goals for the fixed-income portfolio.
Not all endowments have a similar affinity toward alternative investments. Exhibit 3.6 shows the asset allocation of the equally weighted endowment, which averages asset allocation across all 832 endowments surveyed by NACUBO, ranging from those with assets below $25 million to those over $1 billion. While the average endowment has a smaller allocation to alternatives than the largest endowments, the equal-weighted average allocation to alternative investments more than doubled (from 11.8 % to 28 %) between 2002 and 2014. In fact, the allocation to alternative investments at college and university endowments increases monotonically with asset size: endowments between $25 million and $50 million have a larger allocation than those below $25 million, while those with $100 million to $500 million in assets have larger allocations than endowments with assets between $50 million and $100 million. Returns over the past 10 years reflect the same patterns: the largest endowments have both the highest returns as well as the largest allocations to alternative assets.
EXHIBIT 3.6 Asset Allocation of Large versus Average College and University Endowments
Source: NACUBO, 2014.
3.4 Why Might Large Endowments Outperform?
Investors worldwide, from pensions, endowments, and foundations to individual investors, have become attracted to the endowment model, seeking to emulate the returns earned by the largest endowments over the past 20 years. However, evidence shows that not all aggressive allocations toward alternative investments necessarily earn similar returns. This may be due to key advantages particular to large endowments. The literature discusses at least six such advantages that may explain the excellent returns earned by large endowments in recent years:
1. An aggressive asset allocation
2. Effective investment manager research
3. First-mover advantage
4. Access to a network of talented alumni
5. Acceptance of liquidity risk
6. Sophisticated investment staff and board oversight
Investors lacking these advantages may find it difficult to earn top returns, even when following the endowment model.
3.4.1 An Aggressive Asset Allocation
In the world of traditional investments, a number of studies – including those by Ibbotson and Kaplan (2000); Brinson, Hood, and Beebower (1986); and Brinson, Singer, and Beebower (1991) – show that the strategic asset allocation of pension plans accounts for between 91.5 % and 93.6 % of the variance in fund returns. The remaining portion of the variance in fund returns, just 6.4 % to 8.5 %, can be explained by security selection and market timing. (Note that it was the variance in returns that was measured rather than the amount of returns.)
The returns from strategic asset allocation are measured by multiplying the targeted long-term asset allocation weights by the benchmark returns to each asset class. Security selection is defined as the return within asset classes relative to a benchmark, such as the return to the domestic fixed-income portfolio when compared to the domestic fixed-income benchmark. Market timing is measured as the return earned from the variation of asset class weights versus the policy or target asset class weights. Value is added from market timing, or tactical asset allocation, when the returns to overweighted asset classes outperform the returns to underweighted asset classes. For example, when the actual equity allocation is 42 % and the target equity allocation is 40 %, the return to market timing is positive when the equity index outperforms the returns of the other asset classes in the portfolio.
Swensen (2009) explains the role of tactical asset allocation and rebalancing. Investors are encouraged to be contrarian and consider valuation when making allocations. Rather than considering what his peers were doing, Swensen entered alternative asset classes earlier and more aggressively than did other institutional investors. In contrast to the common practice of increasing allocations to asset classes after a period of outperformance, Swensen sought to aggressively rebalance (i.e., transact so as to cause portfolio weights to return to prespecified values) to strategic asset allocation weights by selling outperforming asset classes and buying underperforming ones. This can be psychologically difficult, as it requires buying equities during a crash and selling certain assets when other investors are clamoring to increase their allocations to those assets. Market timing between risky and less risky asset classes, such as equities versus cash, can be dangerous due to the large difference in expected returns. While generally eschewing market timing, Swensen suggests tilting the portfolio toward undervalued assets and away from overvalued assets between asset classes with similar long-term return expectations, such as real estate and natural resources. Rebalancing can add significant value, so Swensen sought to aggressively rebalance in real time. In a volatile year, such as 2003, Yale's rebalancing activity added as much as 1.6 % to annual returns.
Brown, Garlappi, and Tiu (2010) analyze the returns to endowment funds over the period 1984 to 2005 and find a much different story than that seen in prior literature regarding return attribution in pension plans. This study shows that just 74.2 % of the returns can be explained by the endowment's strategic asset allocation. With market timing explaining 14.6 % of returns, and security selection explaining 8.4 %, endowment funds show a much larger contribution to returns from dynamic asset allocation and manager selection.
While it can be easy to replicate the asset allocation of endowment funds, investors seeking to emulate the success of the endowment model will find it much more difficult to profit from market timing and security selection. One reason may be that while pension plans are seen to focus largely on passive allocations within each asset class, endowment funds place a much greater emphasis on manager selection. Brown, Garlappi, and Tiu also find that the return from policy allocation is quite similar across endowments. The contribution from asset allocation explains just 15.3 % of the return differences across endowments, while selection explains