The enduring relevance of endowment-style investing
Endowment-fund investing continues to offer relevant lessons for long-term investors. Aiming to deliver attractive average returns annually over a number of years, US endowment funds have continually diversified into areas such as private equity, real assets and absolute-return strategies, while reducing their exposure to more traditional asset classes. Endowments’ performance for the fiscal year ended 30 June 2020 bear the scars of the coronavirus pandemic. But based on our estimates (which take account of the rebound in assets like commodities and hedge funds, as well as equities), performance will be much better for the fiscal year ending in June 2021, and well above the nominal annual returns endowment funds seek on average.
Endowment funds are investment funds set up for the benefit of educational and other institutions and funded by gifts and donations. Particularly in the US, universities, museums and hospitals all have endowment funds. The largest belong to American universities, led by Harvard University (USD41.9 bn in assets under management (AUM) at end- June 2020), followed by the University of Texas and Yale University (with USD32 bn and USD31.2bn, respectively).
The primary investment objective of university endowment funds is to generate sufficient returns to maintain the purchasing power of their assets in perpetuity and sustain the university’s operating budget. In general, endowments target a real average annual return of 5% (adjusted for inflation) over the long term (five to 10 years).
Over time, the larger endowment funds have significantly reduced their exposure to traditional asset classes such as public equities and bonds and moved increasingly into alternative assets such as private equity, real assets and absolute-return strategies, which provide the benefits of diversification and higher returns. By nature, alternative assets offer opportunities to exploit inefficient market pricing through active management. Large endowment portfolios have a far greater weighting of alternative assets than smaller ones, whose investments remain heavily focused on domestic equities and investment grade bonds. This is because the substantial research and other resources needed to invest in alternatives is more accessible to large players.
Large US endowment funds’ allocation to public equities declined from 45% of total assets in 2002 to 30% in 2020 (having fallen to as low as 26% in 2009), while their allocation to alternative assets increased from 32% to 59% over the same period. In 2020, the Yale endowment fund, the third largest in the US, said it aimed to have around three quarters of its assets allocated to alternative assets.
“Historically, US endowment funds have delivered an average annual return of 7.5% before inflation.”
However, some individual endowments performed very well. Harvard University’s endowment fund delivered a return of 7.3%, Yale’s 6.8% and Brown University’s (which has a market value of USD4.7 bn) produced a return of 12.1%, thereby beating the US 60/40 portfolio’s 10.2% total return. According to Markov Processes analysis2, which uses return-based techniques, Brown University’s exceptional performance was most likely due to its heavy exposure to high-growth technology assets across public and private markets.
A NACUBO-TIAA survey published in April 2020 showed that the 333 institutions that responded (representing a 43% response rate) experienced losses due to the covid-19 crisis in the first quarter of 2020, with an average return of -13.4%. Over the same period, the S&P 500 index declined by 20%, while global 60/40 and US 60/40 funds fell by 18% and 7%, respectively. Small endowment funds suffered more than larger ones, although the former’s larger exposure to US equities meant they subsequently recovered faster.
The survey indicated that 70% of university endowment funds increased spending to provide financial support to institutions and students during the pandemic. The spending rate in FY2020 was 4.59%, up from 4.36% in FY2019. Furthermore, more than 40% of survey respondents reported a decline in cash flow, while new gifting fell by 16%. The increase in spending and the reduction in gifting could continue to have negative repercussions on endowments’ financial positions in the future. However, NACUBO reports that virtually all endowment funds expect to maintain their current policy spending rate in FY2021.
Asset class performance
Endowment funds’ weak returns in fiscal year 2020 can be primarily explained by their allocation to poorly performing asset classes. The average US endowment fund had over half of its assets in asset classes that delivered less than 1% in FY20 (with real assets returning -15% on average, non-US equities -4% and hedge funds +0.8%). In addition, half of their fixed-income exposure was in high yield, private debt or cash, which all produced very low returns.
Expected returns for FY2021
Given that equity markets, commodities and hedge funds have all rebounded strongly since the low points reached in March- April 2020, it is reasonable to expect endowment funds to deliver higher returns in FY2021. Based on the assumption that markets remain flat from the time of writing (mid-March 2021) to end-June 2021, different forecasting methods show US endowments producing an average nominal return of 15-21% in the fiscal year ending 30 June 2021.