Each year, the National Association of College and University Business Officers publishes a report on the investment returns of US college endowments. The report is widely followed, since institutions like Harvard and Yale are considered to be among the most sophisticated investors in a highly competitive market. Yet recent experience does not inspire much confidence in the investment methods of the Ivy League. The report shows a negligible difference between the investment returns of large and small institutions. It also shows that many endowments have underperformed a simple index portfolio of 60% stocks and 40% bonds.
The rise and fall of alternatives
The poor performance of large institutions is explained by two points. First, the larger the institution, the greater the allocation to alternative assets, such as hedge funds and venture capital. Second, alternative assets have not done well in recent years. The reason for this declining performance is “over-grazing”. What started as pioneering portfolio management under David Swensen at Yale is now the mainstream. Demand for alternatives has outpaced the supply of worthwhile investments. Some institutions have simply tried to copy the tactics of the Yale investment program, without fully considering its underlying strategy. While on the surface, the tactics might appear to suggest allocating more to alternatives, the strategy is more complex and nuanced. We argue that the strategy consists of deeply reflecting on where a sustained advantage can be found for a long-term investor and then patiently building an organizational capability, culture and reputation that enables the institution to exploit that advantage. In the past, the strategy implied an allocation to alternatives but in the future it could imply something different. Merely trying to copy the tactics without deeply understanding the strategy will lead not only to disappointing results but also unforeseen risks. One of the signal examples of this was the University of Toronto endowment and pension fund, which lost 30% in the market crash of 2008.
Bucking the trend
The conventional thinking is that large institutions should outperform their smaller peers, because of the size of their assets, experience of their investment teams and preferred access to deals. We want to invert this conventional approach and suggest that small and medium institutions are well placed to outperform their larger peers over the next decade, assuming the Ivy League continues to allocate heavily to alternatives. Small institutions, if they admit that alternatives are outside their “circle of competence”, will benefit from the following:
- Cost. Small institutions will refuse to pay management fees of 2% or more, when a simple solution can be managed for 0.5% or less. This difference of 1.5% is a high hurdle for large institutions to clear and many will fail to do so.
- Risk. Small institutions will refuse take risks that have not been tested over periods of decades. The performance of a balanced portfolio of stocks and high-quality bonds has held up quite well for North American investors from 1929 to the present. The same cannot be said for mortgage pools, buyout deals and other opaque strategies, which often have not been tested over a single market cycle, let alone several.
- Complexity. Small institutions will refuse to make investments that come with a 100-page offering memorandum. Just because the firm promoting the offer has a convincing pitch doesn’t indicate they understand the investment better than anyone else. In fact, the pitch is likely to be exceptional, given that it has to persuade investors to accept high costs, unknown risks and lock-up periods of 5-10 years, in exchange for a high likelihood of underperforming a simple portfolio of stocks and bonds.
If small institutions can control cost, reduce risk and keep it simple, they have a good chance of beating the returns of large institutions over the next decade. They also have the potential to exert an advantage that is often acknowledged but seldom realized – the advantage of a long time horizon. By not trying to “keep up with the Yales”, small institutions can invest to meet their own objectives over the long term.