The Yale (and Harvard, Stanford, MIT...) Model

Large US endowments may be posting higher returns than their smaller peers—but only because they allocate to riskier assets, research has found.

By studying university endowments—and their size, capital returns, and portfolio allocation—from 2000 to 2013, Columbia University’s Tuo Chen argued size mattered little when it came to investment returns.

“There is no secret recipe [for] outperformers,” Chen wrote. “The higher return of bigger endowments can be attributed to risk compensation rather than to an informational premium.”

When controlled for everything except size, the data showed the biggest endowment’s capital return would be 8% higher than the smallest fund in the dataset. This observation aligns with economist Thomas Piketty’s theory, Chen wrote, that capital return inequality becomes “severe” as more elite universities are able to afford the best management teams and informational advantage.

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However, Chen found when adjusted for risk using Sharpe ratios, large endowments performed only as well as smaller ones, and sometimes even underperformed.

Tuo Chen_1 Source: Tuo Chen, “Do the Rich Know Better? — University Endowment Return Inequality Revisited”.

Furthermore, risk played a bigger role in larger funds achieving higher returns than information advantage, the author said. When using benchmark indexes’ true returns to calculate risk, the risk channel contributed an average of 3.27% to returns, compared to information channel’s mere 0.6%.

Research showed the correlation between return and size was positive during booming markets, such as from 2004 to 2008, while it turned zero or even negative during bear markets and recessions.

“This piece of evidence suggests that the bigger endowments may just surf on the wave of the market and expose [themselves] to more market risk,” Chen said.

In addition, large funds generally had a heavier allocation to risky assets such as international equity and smaller holdings in fixed income than smaller endowments, the paper said.

“People are willing to bear more risk in investments once they become richer,” Chen concluded, “and this is consistent with the empirical finding in this paper that higher capital return comes from more risk.”

Tuo Chen_2 Source: Tuo Chen, “Do the Rich Know Better? — University Endowment Return Inequality Revisited”.

Cliff Asness, AQRAQR Co-Founder Cliff Asness wants you to know he understands hedge funds.

In a blog post, the outspoken quant manager clarified he isn’t confusing correlation with beta—he knows “they are not the same.”

“Beta measures how much, on average, a fund responds to stock market moves,” Asness wrote, “Correlation measures how ‘tight’ the response is.”

For readers who may not be clear on the difference, Asness explained hedge funds are generally net long about 40% of the stock market, leaving them a beta of 0.4. The rest is where hedge funds “attempt to do ‘other things,’” he continued.

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Typically these “other things” consist of taking long and short positions that should have “no direct market exposure,” Asness wrote, resulting in the same beta of 0.4. The fund’s correlation to stocks, however, would likely change.

“Ideally, in my view, hedge funds should just do the other things and have no market exposure—a 0.0 beta—but whether at 0.0 or 0.4 beta they will look relatively worse than the stock market during big bull runs,” he said.

And it is precisely these “other things” that deliver alpha for which investors should pay fees.

However, hedge funds have been hedging less recently, Asness wrote, which have reduced both attempted and realized alpha. This phenomenon also causes correlations—but not beta—to rise, making hedge funds’ value proposition “probably worse now,” he said.

In a separate blog post, Asness again defended a position he took last year—that annual lists of top-earning hedge fund managers are “simply bad, and intentionally misleading, math.”

“Article marveling at the 2015 compensation of the top 25 hedge fund managers are about wealth when they purport to be about income,” he wrote. “This ‘mistake’ likely occurs as higher numbers sell more papers than do lower numbers… This is not about the inequality debate; rather, it’s just about exaggeration and imprecision.”

The Yale (and Harvard, Stanford, MIT…) Model

Cliff Asness’ Hedge Funds 101