Yale’s endowment model is flawed and likely unsustainable, the former and current CIOs of Hewlett-Packard (HP) argued in a co-authored paper.
According to Ken Frier—who also served as CIO at Stanford Management Company and the UAW Retiree Medical Benefits Trust upon leaving HP—and Gretchen Tai, the heyday of the endowment model is likely over.
“The need for change is motivated by current market conditions, certain shortcomings in the endowment model, and the sheer difficulty of reproducing in the future what has worked so well for Yale in the past,” the authors wrote.
A survey of large endowments’ current investment strategies revealed that most are focused primarily on manager selection, not asset allocation.
“It’s disappointing that there is no evidence that the average endowment created any additional value from either asset allocation or investment manager selection.”Asset allocation among peer endowment was similar, Frier and Tai observed, resulting in also similar returns, risks profiles, and exposures. They also noted that investors changed asset allocation targets only once every few years, and external forces drove large adjustments, rather than deliberate actions.
The current endowment model also exhibited almost “exclusive dependence” on equity-like investments and risks, the paper said.
On average, each major asset class in endowment portfolios had a 0.8 or higher correlation to public equities, according to the authors. The correlation between the annual performance of an average endowment and global stocks also hit 0.99 from 2005 to 2014.
“Despite the efforts to increase investment complexity and provide diversification, it’s disappointing that there is no evidence that the average endowment created any additional value from either asset allocation or investment manager selection,” Frier and Tai wrote.
Highly illiquid investment also hindered endowments’ tactical potential, and external managers’ opacity limited investors’ understanding of what they actually own.
To overcome these shortcomings, Frier and Tai suggested asset owners enhance the asset allocation process by breaking down asset classes more granularly.
Analyzing each regional stock market, sector, etc. on valuation, fundamentals, momentum, sentiment, and volatility would return more control and consistency to the asset owner.
Boosting relative-value positions could help reduce the model’s equity risk dependency, the authors recommended.
“It’s possible to diversify further [from equity beta] by adding risk and style betas like value, momentum, carry, and so on, by going beyond leverage and derivatives by utilizing long/short implementation,” Ryan Abrams, portfolio manager at the Wisconsin Alumni Research Foundation (WARF), told CIO.
WARF’s team manages the $2.7 billion fund with a risk-balanced—or risk parity—philosophy and an alpha overlay portfolio.
Layering pure and uncorrelated alpha on top of a diversified portfolio has the potential to “deliver consistent performance across a lot of different environments—and you don’t have to be illiquid to do it,” Abrams added.
In fact, Frier and Tai wrote investors should keep alternatives allocations below 20% of the portfolio “so that illiquid and opaque positions do not overwhelm the portfolio and reduce flexibility.”
The capacity to take on illiquid investments does not alone justify doing so, the authors concluded.
Read the full paper, “Improving the ‘Endowment Model’ Recipe,” published by the Family Office Association.