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Endowments' Hedge Fund Bet Has Time on Its Side

September 28, 2020
Points of Return
Bloomberg

Returns for the Well-Endowed

Most of us want to take the long-term perspective, but cannot. There are too many needs that come up in the short term, and too many risks in the next days, weeks or months that make it harder to get through to the next decades. That is the main reason why the big university endowments are so envied, and so admired. Even more than pension fund managers, those running endowments can look decades into the future, and they can even call on the best ideas in academe.

What follows is by far the most famous asset allocation in the endowment world, and one of the most influential experiments in long-term asset allocation of our time. It shows the great shift that David Swensen has made in the Yale University endowment since he took over in 1986. Domestic equities were the bulk of the portfolio he inherited; they now account for only 2.7%. It didn't have hedge funds or private equity at the time; now these alternative assets make up more than half Yale's assets:

Under Swensen, Yale's endowment has been mighty successful, and his success has inspired movements by many other managers into alternatives and real assets.

The critical advantage of the big endowments is that they have the liberty to look to the long run. That raises the question of what they have done and how they have performed over the very long term. And a fascinating new paper by Elroy Dimson, David Chambers and Charikleia Kaffe, all of the Centre for Endowment Asset Management at the University of Cambridge's Judge Business School, pieces together what the eight Ivy League endowments have done along with four of the most famous non-Ivy universities (Chicago, Johns Hopkins, MIT and Stanford). This is a major historical undertaking, and they had to use the book values of the equities that the endowments held in the early years. The results come up to 2017, so they include the Lehman crisis and its aftermath, but are unaffected by Covid-19.

This, according to Dimson, Chambers and Kaffe is how allocations to the core asset classes of fixed income and public equities have moved since the turn of the last century:

In 1900, the big endowments did little more than lend to safe borrowers, generally the government. Those bond allocations have now been stripped back to a bare minimum. Meanwhile, they became largely vehicles for equities by mid-century, and benefited to the full from the bull markets from 1950 to 2000. However, they were already beginning to cut back on equities at that point. This process has carried on in a big way in the last two decades.

Now, let's look at their investments in real estate, traditionally a core investment for an endowment, and alternative assets:

Real estate matters less and less to endowments. (The outlier that had more than half of its portfolio in real estate for much of the 20th century is Columbia University, which is blessed with a lot of property in Manhattan). Meanwhile, alternative assets have exploded. Endowments were already putting a lot of money to work in hedge funds by the time the dotcom bubble burst and the surge for value stocks that followed it gave hedge funds their greatest opportunity to shine. Large numbers of other asset managers rushed to join them. Of course, those bets in recent years aren't generally working out very well, thanks to low interest rates and the persistent bull market in equities. For the last decade, a simple investment in a passive tracker fund following the S&P 500 would have done better than the overwhelming majority of hedge funds. 

This has absolutely not deterred the big endowments from keeping money tied up in alternative assets, however. The following chart from Dimson, Chambers and Kaffe shows the proportions kept in alts by the "Big 3" (Harvard, Yale and Princeton), the other Ivies, the non-Ivy universities they followed and the average recorded by the large group of endowments that these days report their numbers to the National Association of College and University Business Officers each year:

The big three have led the way, with the rest of the university sector persistently playing catch-up. But the pain of 2008, which left several big endowments in difficulties as they tried to raise cash to make the regular annual payments they are required to make to their universities, seems to have had little effect. Neither have the growing difficulties for the hedge fund sector. Instead, universities across the spectrum have poured more money into alts in the last decade, and those that had less before have been even more aggressive. 

The critical question is whether this will work out for them. Calculating exactly how to benchmark an endowment is difficult, but since 1900 the data from Dimson, Chambers and Kaffe suggests that they have performed well. Here are their raw growth numbers since 1900. (Johns Hopkins appears worse than the others because its data only start in 1926, and it missed out on some of the good years at the beginning of the century):

All have compounded real growth for more than a century, and a massive accumulation of assets has resulted. Now, look at the numbers Dimson, Chambers and Kaffe produced once they broke down the returns into the standard measures of risk — geometric and arithmetic return, the standard deviation showing the typical volatility, and the Sharpe Ratio, which divides return by the standard deviation for a risk-adjusted version of return. They put this data together for the period from 1950 to 2017: 

So for those keeping score, Princeton narrowly beat Yale for the strongest risk-adjusted return. All of the universities managed a Sharpe ratio equal to or better than the risk-adjusted return that would have been available from going long equities throughout the 67 years, with the narrow exception of Brown, which had a Sharpe ratio of 0.47 compared to equities' 0.48. None managed an arithmetic return quite as good as could have been achieved by going 100% long equities; all did far better than government or corporate bonds, which had made up the great majority of their portfolios at the beginning of the century. 

Now, the endowment sector has made what could almost be called a counter-cyclical bet on alternatives, at a time when it would have been easier to load up on public equities. And this, it turns out, is typical of their behavior. The greatest advantage of their long-term outlook is that they are free to be counter-cyclical. Institutional investors tend to be guilty of herding, for example blatantly crowding in to internet stocks in the late 1990s. This isn't necessarily because they were dumb or easily misled, but more because they had big institutional incentives to do what everyone else was doing. Herding is a natural result from judging investors against their peers, rather than against some distinct and absolute benchmark.

The endowment managers certainly do have some sense of competing with each other. When speaking off the record, there is a lot of schadenfreude about the difficulties in recent years of Harvard, which continues to have the largest endowment. But since 1900, on average, endowments have been very counter-cyclical, cutting equity exposures a little ahead of major stock market crises, and loading up on stocks immediately afterward. These are the crises that Dimson, Chambers and Kaffe used in the research:

1.Panic of 1906–1907 (for which economist Robert Shiller estimates a decline of –38%)
2.Wall Street Crash of 1929 (–84%)
3.Economic recession of 1937 (–45%)
4.Stock market crash of 1973–1974 (–25%)
5.Bursting of the dotcom bubble of 2000 (–43%)
6.GFC of 2008 (–51%)

And this is how the big endowments shifted their allocations to equities in the three years before and after these big market breaks:

Being able to look to the very long term does, it emerges from this evidence, help investors deliver bigger returns. It's not a luxury that many of us have, but the more we can try to look to the long term, and look through the turbulence straight ahead, the more things will tend to work out. 

75 Years of FAJ

The work by Dimson, Chambers and Kaffe was commissioned to celebrate the 75th anniversary of the Financial Analysts Journal, which has guided the debate between investors and theoretical academics over how to manage money ever since. This is what its first issue, initially known as the Journal of Finance, looked like:

These day, the FAJ is primarily about asset management, and it is run by the CFA Institute, which controls the CFA designation and effectively leads the profession. It is edited by a Who's Who of the great and the good in the investment world. Time spent digging around for research on the FAJ's website is almost always well spent.

That doesn't mean, however, that we can't poke fun at it. In the lead up to the 75th anniversary, someone somewhere started publishing on Twitter the "Journal of Rearview Mirror Portfolio Management", in the style of the FAJ. The lead item was called: "Endowment Performance: What You Should Have Done 10 Years Ago." Here is the cover:

A second edition has since plugged a landmark piece from 2006 recommending diversification by investing in commodity futures, which sparked a big rush into the asset class just in time for the beginning of the current commodity bear market. There is also a trail for a piece on "How Mad-Libs, Astrology and a Gluten-Free Diet Can Generate Alpha (and Clicks)." by Mebane Faber, the quant who serves as chief investment officer of Cambria  Investment Management, and who has deservedly amassed a large and devoted podcast following.  

Unfortunately, the rear-view mirror is always going to be clearer than the view ahead. It's still fair to say that the FAJ will help you see what's happened behind even more clearly, and that is very useful.

 

Survival Tips

As you read this, Yom Kippur, the Jewish Day of Atonement is under way. The holiest day in the Hebrew calendar, Yom Kippur also in many ways deserves its reputation for being the most miserable day of the year as well. It involves fasting for 25 hours, while concentrating on all that has gone wrong in the previous year and looking for ways to improve in the year ahead. But even though this sounds unpromising, it often leaves participants in an almost euphoric state as they head for their break-fast after dusk falls.

To try to get across why many people who are barely religiously observant for 364 days per year put themselves through this, it is worth listening to this beautiful song by Daniel Cainer. Like many religious rituals it has a power rooted in human nature that tends to transcend the religion itself. Cainer is a brilliant songwriter, but he is normally more of a comedian. For another example of this oeuvre, try Bad Rabbi: it tells the true story of a rabbi in Manchester who became a drug dealer. 

Have a good fast, if you are observing Yom Kippur. And have a good week everyone. 

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