degree. The ability of top endowment funds to outperform can be perpetuated by this important network of relationships, to the extent that these talented professionals either choose to work for the university's endowment fund or guarantee the endowment investment access to the funds they manage.
Barber and Wang (2013) show that the strong returns earned by endowments are directly traced to the size of their alternative investment exposure. Alphas earned by Ivy League schools exceed 3 %, while 30 other schools with top SAT scores earned an alpha exceeding 1.7 %. There is a reliably positive alpha and return spread between schools with top SAT scores and schools with average scores.
3.4.5 Acceptance of Liquidity Risk
Endowments have a perpetual holding period. With low spending rates and limited liabilities, endowments have a much greater tolerance for risk, including liquidity risk. When viewed in light of the age of leading universities, which for Harvard and Yale now surpasses 300 years, the 10-year lockup period of private equity vehicles appears relatively short term. As the longest-term investors, charged with protecting the real value of endowment principal for future generations of students, universities are seeking to earn liquidity premiums, which are higher returns earned by investing in less liquid assets that require long lockup periods. The idea is that the perpetual nature of endowments allows them to easily handle this liquidity risk. Anson (2010) estimates the liquidity premium for private equity at 2 % and for direct real estate at 2.7 %, while other studies estimate liquidity premiums as high as 10 %.
Swensen (2009) explains that less liquid investments tend to have greater degrees of inefficient pricing. On average, investors overvalue liquid assets, which leaves undervalued and less liquid assets for investors with long-term investment horizons. Investors making commitments to long-term assets, such as private equity and private real estate, know that these investments are typically held for 10 years or longer and so require a significant due diligence process before making such a long-term commitment. Investors in more liquid asset classes may not take their investments as seriously, knowing that the investment may be exited after a short-term holding period. Investments that appear to be liquid in normal markets may have constrained liquidity during times of crisis, which is when liquidity is most valued.
3.4.6 Sophisticated Investment Staff and Board Oversight
All investors need a process by which asset allocations are set and managers are selected. Traditionally, an institutional investor would have an internal staff that would make recommendations to an investment committee, which would then vote on recommendations at quarterly meetings. The quality of the votes and recommendations depends on the experience and composition of the members of the endowment's staff and investment committee.
Investors with smaller assets under management tend to have smaller staffs. In 2011, NACUBO estimated that college and university endowments with less than $100 million had just 0.4 staff members dedicated to endowment issues, meaning that a single staff member, such as the chief financial officer or treasurer, was responsible for the endowment along with a wide variety of other budget and financial issues. In contrast, the endowments with over $1 billion in assets tend to have large and sophisticated internal teams, averaging over 10 investment professionals. These teams tend to be well experienced and highly compensated, allowing them to manage some of the assets in-house as well as recommend investment managers. Whereas 79 % of the largest endowments employ a chief investment officer (CIO), less than 3 % of endowments with less than $100 million in assets employ someone whose full-time role is to oversee the endowment portfolio.
In addition to internal staff and an investment committee, many endowments employ external consultants. In 2011, NACUBO estimated that 79 % to 94 % of endowments with between $25 million and $1 billion in assets, and 68 % of the largest endowments, employed consultants. A non-discretionary investment consultant makes recommendations to the endowment on asset allocation, manager selection, and a wide variety of other issues, but leaves the ultimate decision to a vote of the investment committee. There is growing use of the outsourced CIO (OCIO) model, in which the endowment gives discretionary authority to an external consultant who may make and implement prespecified decisions, such as manager selection and asset allocation decisions, without taking those decisions to a vote. Endowments with smaller internal teams appear to find the outsourced CIO model attractive, as between 42 % and 62 % of endowments with assets below $100 million had hired OCIOs by 2011. The trend toward hiring OCIOs accelerated after the 2008 financial crisis, when investors realized that tighter risk controls and quicker rebalancing decisions were needed. Williamson (2013) reports that global OCIO assets under management had reached $1.066 trillion by 2013, including $619 billion in the United States, a growth rate of 59 % in just two years. In addition to small endowments and foundations, corporate pensions with liability-driven investing targets are increasingly likely to hire an OCIO.
The Commonfund Institute (2013) notes a number of benefits to hiring an OCIO, especially for endowments that are devoting ever-larger allocations to alternative investments. An OCIO firm will have a large staff and significant infrastructure resources that are shared across all its clients. This institutional-quality firm has resources that could not be afforded by smaller investors. There are economies of scale in manager research, as hedge fund and other alternative managers can visit the consultant or OCIO firm rather than visiting the dozens of underlying investors. The OCIO firm can be cost-effective when compared to attracting, training, and retaining investment professionals, who may be difficult to find and retain in a market where there is a growing demand for those who have experience managing foundation and endowment assets. For investors who do have staff, the OCIO may help train and educate that staff. Whereas 44 % of investment decisions take more than three months when an investment committee retains discretion, the OCIO model can make investment and rebalancing decisions on a far more frequent basis.
Lord (2014) studied the common factors shared by the largest and most successful endowments. Ideally, the investment committee would be staffed by investment professionals and others who have experience serving as corporate executives or board members. If those investors have experience in alternative investments and a wider variety of investment strategies, the resulting portfolio tends to be more diversified and experience higher risk-adjusted returns. Investment committees with significant representation from donors or employees of the universities tend to have lower allocations to alternative investments. Decision-making is improved when committee members have multiple perspectives and an ability and willingness to openly debate issues. When adding new members to the investment committee, endowments should seek members with knowledge and experience that differ from those of current committee members. Finally, top-performing endowments have a commitment to educating staff and committee members on new asset classes before allocations are made.
3.5 Risks of the Endowment Model
When applied by the largest investors, the endowment model has created impressive returns over the past 20 years. However, this style of portfolio management comes with a special set of risks. First, portfolio managers need to be concerned about the interactions among spending rates, inflation, and the long-term asset value of the endowment. Second, a portfolio with as much as 60 % invested in alternative assets raises concerns of liquidity risk and the ability to rebalance the portfolio when necessary. Finally, portfolios with high allocations to assets with equity-like characteristics and low allocations to fixed income require the portfolio manager to consider how to protect the portfolio from tail risk, which is a large drawdown in portfolio value during times of increased systemic risk.
3.5.1 Spending Rates and Inflation
There is an important tension between the spending rate of the endowment, the risk of the endowment portfolio, and the goal of allowing the endowment to serve as a permanent source of capital for the university. When the endowment fund generates high returns with a low spending rate, the size of the endowment fund increases. This may lead to concerns about intergenerational equity, as the spending on current beneficiaries could likely be increased without compromising the probability of the endowment continuing into perpetuity. Conversely, a conservative asset allocation with a high spending rate may favor the current generation yet imperil the real value of the endowment in the long run.
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