Does the Endowment Model Need a Makeover?

(December 17, 2012) — The endowment model of investing–an approach that allocates a significant portion of assets to non-traditional, more illiquid asset classes such as absolute return, private equity, and real estate–has widely come under attack, especially following the financial crisis.

A recent article in The New York Times, dated October 12, for example, makes the case that the model is inappropriate for all but the largest endowments and that it has underperformed a traditional 60/40 stock/bond portfolio. The article by James B. Stewart–titled “University Endowments Face a Hard Landing”–argues that for the one- and three-year periods that ended June 30, 2012, a basic 60/40 portfolio outperformed a more diversified portfolio.

However, according to William Jarvis, managing director of the Wilton, Connecticut-based investment firm the Commonfund Institute, the 60/40 portfolio underperformed significantly for the trailing five- and 10-year periods. His conclusion: A longer-term outlook is needed to judge the success of the endowment model.

Endowment investors contacted by aiCIO note that the general failure of university institutions around the country to weather the financial crisis–many still struggling to reach their pre-crisis peaks–has less to do with the model itself, and more to do with the way the model was applied. The number one mistake of endowment managers was their failure to provide for adequate levels of liquidity in their asset mixes, says Lou Morrell, Wake Forest University’s chief investment officer between 1995 and 2009. “The endowment model was originally based on the principle of a willingness of educational institutions to make longer-term asset commitments in return for accepting illiquid assets, which provide higher long-term performance. Since most schools only spend about 5% of the market value of their endowments, they were in an excellent position to tie up their money for longer periods and thus demand higher returns for the use of their capital,” he says, noting that the system worked well for many years. The system began to fail, however, when some institutions placed far too much money in alternatives, which require long lock-up periods that reduce liquidity. “In effect, the schools got greedy and focused on high returns instead of the purposes for which the endowments exist,” Morrell concludes.

The real issue, many endowment managers say, has been how the endowment model was applied, not the effectiveness of the model. “The Times should have focused on management practices, not the investment strategy, and the Commonfund should have defended the endowment model and not been critical of The Times for reporting on such an important issue for higher education,” Morrell asserts. He adds that unlike individual investors, endowment funds are presumed to last in perpetuity and thus must base investment decisions on the long-term. Short-term performance conclusions can thus be faulty.

Earlier this month, State Street Global Advisor (SSgA)’s Dan Farley and the financial firm’s Foundations and Endowment Head Rebecca Schechter collaborated to produce a report combining insights from its asset management and asset servicing business called, “The Asset Owners’ Perspective: Evolving Investment and Operational Models.” The report quantified what they all had been hearing in meetings with clients–namely, that investors are altering their approach to endowment-style investing, in the wake of some hard lessons.

“Investors are looking to manage liquidity risk while also saying, ‘I have to generate returns,’” Farley said. “We’re spending a lot of time with our clients recognizing that they have dual objectives. At highest level, those objectives can be conflicting.” In total, nearly 84% of respondents found that the crisis had exposed some weakness of the endowment model, and liquidity (or lack thereof) was the number one concern. “I’m still a big believer in the endowment model,” said one US private endowment manager surveyed. “I think it works better than everything else…but the two big weaknesses that came out [of the crisis] are the two Ls–leverage and liquidity.”

Watch the video above to learn how the Commonfund Institute’s Jarvis feels the endowment model should be applied to both large and small institutions, along with what chief investment officers should consider when framing an endowment policy.

Related:

Read the New York Times article “University Endowments Face a Hard Landing”

The Commonfund Institute’s response to the New York Times article.

Contact the writer of this story:

Paula Vasan
Managing Editor, aiCIO
646-308-2742
pvasan@assetinternational.com
Follow on Twitter at @ai_CIO