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Alternatives Explain Endowment Superiority, Academic Paper Says

A recently published academic paper claims that the average asset allocation of elite institutions and top‐performing funds is the single most important factor to explain stellar returns. 

(January 4, 2012) -- Asset allocation and investing in alternatives more specifically are the main reasons for success at elite endowments, according to a new paper co-written by Brad M. Barber and Guojun Wang from the University of California.

The paper --  titled "Do (Some) University Endowments Earn Alpha?" -- asserts: "Elite institutions and top-performing endowments earn reliably positive alphas relative to these simple public stock/bond benchmarks of 2-4% per annum. Average allocations to alternative investments explain all of documented superior performance. When we add indexes for hedge funds and private equity to our attribution model, the estimated alphas for elite institutions and top-performing endowments move into negative territory, ranging form 0 to -1.9% (albeit generally unreliably negative). These results indicate that the average asset allocation of elite institutions and top-performing funds is the single most important determinant of their superior returns during the last 20 years. We argue the results are not consistent with manager selection or market timing (or tactical asset allocation) generating alpha for investors."

According to the paper, as of June 2010, the top five educational endowments (Harvard, Yale, Stanford, Princeton, and The University of Texas) collectively managed $87 billion, while all educational endowments managed in excess of $350 billion. "While these funds are often critical to the funding of educational institutions, we know very little about the performance of endowments. Our lack of knowledge regarding the performance of endowments is remarkable given the legendary performance of some institutions, most notably the Yale endowment," the report says.

In explaining the methodology of the research, the paper states: "We analyze the returns of hundreds of educational endowments over the 20‐year period ending in 2010 using a simple attribution model that includes benchmarks related to US Stock, US Bonds, International Stock, Private Equity, and Hedge Funds. When we restrict the attribution model to public stock (US and International Stock) and bond benchmarks (US Bond), we document the average endowment earns an alpha close to zero, the public stock/bond benchmarks explain 99% of the time‐series variation in the return of the average endowment, and the attribution model yields sensible estimates of the typical stock bond allocations(roughly 60% stock and 40% bonds)."

After analyzing the returns of hundreds of educational endowments, the authors write that there is intriguing evidence of performance persistence, as elite institutions and top‐performing endowments earn reliably positive alphas relative to these simple public stock/bond benchmarks of 2‐4% per annum. The authors continue to argue that the results are not consistent with manager selection or market timing (or tactical asset allocation) generating alpha for investors.

The paper comes as data released by the Commonfund Institute and the National Association of College and University Business Officers (NACUBO) late last year found that for the 2011 fiscal year (July 1, 2010 to June 30, 2011), institutions’ endowments in the United States returned an average of 19.8%. 

“What stands out in these preliminary figures is the fact that, despite the positive returns of this year and last, endowments still have not completely recovered from the damage inflicted by the market declines that accompanied the 2008-09 credit crisis," NACUBO President and Chief Executive Officer John D. Walda and Commonfund Institute Executive Director John S. Griswold said in a joint statement. “The average endowment is still at only 86% of its value in FY2007, using return data from past NCSE reports and a 5% spending rate,” they noted, “and longer-term returns for five- and ten-year periods are only 5.0% and 5.5%, respectively – not significantly higher than the spending rate for many institutions. It will take several more years of positive returns for endowments to recover fully from the crisis.”

With respect to alternatives, the research demonstrated that institutions with assets over $1 billion reported an average allocation of 58%, while institutions with assets under $25 million reported an average alternatives allocation of 9%. In general, allocations to international equities and short-term securities/cash/other were more consistent across the size cohorts.

While the data from the Commonfund and NACUBO still reflects the painful blow institutions suffered following the financial crisis, it paints an increasingly optimistic picture about the future of US college and university endowments. The 19.8% investment return calculated for the 2011 fiscal year contrasts with the average 11.9% investment return for 2010. 

Download the complete paper by Brad M. Barber and Guojun Wang from the University of California here.