An endowment fund represents permanent capital in order to support a specific mission. The endowment approach was pioneered by Yale University in the 1980s by investing less in traditional asset classes (equities, fixed income, and cash) and more in alternative investment classes and illiquid strategies. Today, many large institutional investors (endowments, foundations and other no nonprofit funds) have adopted an endowment model.
The objective of the EM model is to maximize risk-adjusted return in order to cover inflation (e.g., 2%) as well as the spending policy rate (often around 4.5-5%). In order to reach this high return requirement, institutions invest in a broad selection of uncorrelated asset classes through primarily active management. The key features of this investment approach are:
- a very broad set of investments opportunities;
- a very long (or even perpetual) investment time horizon in order to meet a minimum spending rate and retain the capacity to generate cash for future generations;
- Few regulatory restrictions and constraints on leverage and short selling, but use of specific downside risk measures.
Until the financial crisis of 2008, alternative investments and endowments used a limited number of external managers and performed well. But after the initial successes at Yale and early adopters, the endowment model failed to deliver for the following reasons:
- This multi-asset-class approach requires expensive alternative investments that are even more difficult to select in larger proportions.
- Large funds often use more than 100 managers in order to cover 8 to 12 asset classes and incur high costs while taking little active risks; moreover, the bets of the funds may cancel each other out, leading to a zero-sum game (before costs);
- The weight of Alternative Assets is often beyond a sound proportion and their diversification benefit is then limited.
- Alternative assets have exhibited poor performances in the last decade (especially in 2007-2009) compared to the high returns in public equities (and bonds) over this period.
The main lesson to remember for private investors: Endowments usually employ more active than passive managers for the investment implementation. However, low-fee passive investments is the best solution in highly efficient markets and active management should only be applied in less efficient and niche markets as there are no suitable passive vehicles for alternative investments. Like private investors over the last decade, the vast majority of institutional investors would have been better off managing their funds passively with negligible costs after taking account of risk tolerance and other preferences.
Sources: Strategic Asset Allocation for Endowment Funds, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Kathleen E. Jacobs and Adam Kobor Failure of the Endowment Model The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Richard M. Ennis Don’t Give Up the Ship: The Future of the Endowment Model Failure of the Endowment Model, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Richard M. Ennis Institutional Investment Strategy and Manager Choice: A Critique. The Journal of Portfolio Management, Volume 46 Issue 5, 2020, Richard M. Ennis