Endowments’ Investment Beliefs, By the Numbers

(September 23, 2013) – US endowments have high expectations of private equity, above all other asset classes, a study has found.

The typical endowment expected private equity to achieve 3.9% alpha above a portfolio of conventional stocks, as of the end of 2012, the researchers found.

The authors of “Investment Beliefs of Endowments” were Andrew Ang, a Columbia business school finance professor, Andres Ayala, a PhD candidate at the same institution, and Yale School of Management finance professor William Goetzmann.

The three researchers used a Bayesian probability framework to estimate endowments’ implicit beliefs about their ability to capture excess returns. The study’s core dataset covered asset allocations for approximately 800 US university endowments from 2006 to 2012, which schools voluntarily reported to the National Association of College and University Business Officers and Commonfund’s endowment institute.

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Endowments were less optimistic on hedge funds. According to the study, alpha projections for this asset class averaged 0.7% per year.

These expectations for alternative asset classes have increased over time, as have allocations, despite a dearth of long-term evidence to support a favorable risk-return profile.

Indeed, based on past returns of alternative indexes—the HFRI fund of funds and S&P’s listed private equity tracker—endowments could have the reverse expectations, the authors stated.

The hedge funds index had an average Sharpe ratio of 0.65 from 1990 through 2012, trumping the S&P 500 (0.31), Ibbotson’s long-duration government bond index (0.25), and the MSCI non-US equities index (0.24). From 1994 through 2012, the private equity tracker earned a Sharpe ratio of 0.14.

Endowments’ expected level of alpha from private was significantly higher than it had been historically, the authors pointed out.

The researchers identified two possible explanations for this: “First, endowments may think that they have superior selection skills and are able to pick the managers that generate the highest alpha. This selection skill is not reflected on historical measures of performance. Second, they may expect higher conditional risk premia on liquidity or other risk factors in the future.”

Access the entire paper here.

US active equity funds on consultants’ shortlists performed no better than average, but consultants’ recommendations focused on more than past returns.

(September 20, 2013) — Investment consultants' recommendations can significantly alter fund flows, but do not necessarily add value to plan sponsors' portfolios, according to a study.

Finance researchers Tim Jenkinson, Howard Jones, and Jose Vicente Martinez, all of Oxford University's Saïd Business School, examined the performance of US active public equity managers relative to their recommendations by institutional investment consultants.

The main data set used in the study derived from Greenwich Associates consultant surveys for the 1999 through 2011 period. The authors based their findings on the stated public equity product recommendations from an average of 29 investment consultancies annually. In 2011, respondents' firms had a cumulative 91% share of the US consulting market, according to the paper.

The researchers found that recommendations tended to be based in part on past fund performance, but foremost on “soft” factors, such as the capability of the portfolio manager and consistency of a fund’s investment philosophy.

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Fund flow data for the 1999 through 2011 time frame indicated that consultants’ recommendations had a substantial effect on the volume of assets entering and exiting.

The authors further found that recommended funds were significantly larger on average ($4 billion under management) than non-recommended ones, which averaged $0.8 billion.

“This finding provides evidence that consultants’ recommendations have a large influence on investor allocation decisions and confirms survey data which reports that manager selection is one of the most highly valued services offered by consultants,” Jenkinson, Jones, and Martinez wrote.

However, recommendations did not have a similarly positive link with returns. Active US public equity products that had the backing of consultants showed “insignificant outperformance” relative to benchmarks, the study found. On an equally-weighted basis, “we find that average returns of recommended products are actually around 1% lower than those of other products,” the authors wrote. This result stayed consistent when they used one, three, and four factor pricing models, and were in every case statistically significant.

All returns calculated were gross of fees.

“Our analysis focuses on one asset class, US active equity, which may be more efficient than other asset classes, and it is possible that elsewhere the recommendations of investment consultants are more prescient,” the authors acknowledged. “However, US active equity is a major asset class for plan sponsors, and our analysis of flows indicates that consultants’ recommendations in this asset class are highly influential.”

Read the full paper here.