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What is the Endowment Model?

It stands to reason that pension funds and endowments must focus first on capital preservation. Reduced volatility, then, is key. This model is based on Modern Portfolio Theory, developed by Nobel Prize winner Harry Markowitz. The model demonstrates that risk-adjusted returns can be improved with diversification across asset classes with varied correlation. The result is attractive annual returns with the benefit of moderate risk. 

The endowment model started to gain popularity in the 1990s when endowments began focusing on diversifying for the long term rather than the short term. Rather than the traditional allocation of mainly equities and bonds, endowments began increasing allocations to “nonstandard” assets such as Real Estate, Venture Capital, Hegde Funds, Infrastructure and others. By the end of 2008, the largest foundations had 50 percent of their holdings in nonstandard assets, an increase from three percent in the early 1990s (Leibowitz et al., 2013). 

Families, like pension funds and endowments, should focus on capital preservation through the same diversification strategy.

Why doesn’t everyone invest this way?

US Endowment Funds and Canadian Pension Plans have access to the best fund managers and private equity programs globally. They are extremely well resourced, allowing them to access products not available to the average investor. This is key to the endowment model, as the commitment to alternative assets, according to Leibowitz et al. (2013), necessitated a large reworking of how manager selection operated, including more intensive screening, vetting, and monitoring. This may be a barrier to entry for individual families, who do not have the time, money, or resources to select quality managers like other institutions. 

Elements of this strategy can be employed by most individuals. For example, people can focus on reducing risk, can think more long-term and can seek out alternatives to stocks and bonds. They would, however, have to access these in a piecemeal manner. 

Popularity of the 60/40 Portfolio

According to Goldman Sachs (2021), the 60/40 portfolio has been trusted for many years by moderate risk investors. Equities provide capital appreciation while bonds provide income and risk mitigation. According to the company, this type of portfolio has generated an impressive 11.1% return over the past ten years. In addition, historically, bonds and stocks had a negative correlation, which protected investors from risk and was the underpinning of this portfolio makeup (Foster, 2022). All these factors together, combined with the ease for a single investor to allocate his/her portfolio to equities and bonds, propelled the 60/40 portfolio to its high level of popularity. However, times have changed. Recently, bonds have not provided the risk mitigation against equities that investors expect, with both the S&P and bonds suffering large losses this year (Foster, 2022). Furthermore, Goldman Sachs (2021) believes that investors should recalibrate their return expectations when it comes to their 60/40 portfolios. All in all, while the 60/40 portfolio has been popular over the better part of the last decade, it faces serious roadblocks ahead.

Is an endowment/pension style portfolio always better than a 60/40?

Unfortunately, no. While this style of portfolio has its benefits, it is certainly not guaranteed to yield higher return at an equal or lesser volatility. For example, during the 2008 financial crisis, endowments at some of the largest institutions suffered larger drawdowns than the S&P 500. As Leibowitz et al. (2013) notes, “having an endowment portfolio exceed the volatility of traditional portfolios should be an entirely expected phenomenon during periods of market stress” (p. 321). But on the other hand, there are plenty of circumstances today where a pension style portfolio would shield you from large losses otherwise incurred in a traditional portfolio. In general, an investor or family seeking to invest in a pension or endowment style portfolio should not expect it to magically lessen risk and volatility. However, it is excellent at yielding incremental returns over the long term when compared to a traditional portfolio, which is a fine defense against portfolio risk.

Historical Performance of The Largest Endowments

According to Douglas-Gabriel, (2022), for the 12 months ending June 30, 2021 – which tends to be the end of fiscal years for colleges and universities – the average university endowment out of 720 colleges increased by 30.6%, a 1.8% increase from the previous fiscal year. Many of the largest endowments from the most recognizable schools outperformed this average. MIT’s endowment increased 49%; Washington University in St. Louis’s increased 61%; Vanderbilt University’s increased 58%; and Duke university increased 50% (Douglas-Gabriel, 2022). By comparison, the S&P 500 returned 38.4% during this time frame of July 1 2020 to June 30 2021. A 70/30 indexed portfolio, on the other hand, returned abut 29% (Jennings, 2022). 

But what about the long-term? The endowment at Princeton University, for example – one that has performed admirably compared to other endowments – has seen annualized returns of 16.2% over five years, 12.7% over ten years, and 11.2% over twenty years, as of June 30, 2021 (Steyer, 2021). By comparison, the S&P 500 has seen annualized returns of 11.66%, 13.46%, and 9.01%, respectively (Mitchell, 2022).

Counterarguments to the Model

Given these numbers, there are many discussions about whether the endowment model is ideal for smaller investors, given the additional fees, taxes, and complexity that comes with it. Forbes noted that there was a large dispersion in the returns for endowments in FY21, and that overall, the active public stock investment managers used by these endowments underperformed the market, among other findings from the NACUBO-TIAA study on endowments (Jennings, 2022). Jennings echoes the arguments that many make: if endowments struggle to outperform 70/30 portfolios and the S&P, what’s to say individual investors can, given these endowments have far greater resources with which to work? In addition, a further study, What Would Yale Do If It Were Taxable, concludes that if Yale paid taxes like other investment accounts and was not tax exempt, the university would actually invest closer to a 70/30 portfolio (Jennings, 2022). 

All of this is not to say the endowment style of investing is a sham and a guarantee at underperformance. It simply is a warning to investors and families to consider these arguments and work to minimize the risks associated with this strategy and style of investing. As underlying fees to managers build up and extra time and resources are expended to invest in this way, the return from an endowment style portfolio may not yield high enough returns to cover these added costs. At worst, it may yield lower returns outright.

Summary: Pros and Cons of the Endowment Style

While the characteristics presented here are supported by research as being generally observable across all endowment style portfolios, this list is not exhaustive nor is it necessarily accurate for single, specific portfolios. The performance of a certain portfolio depends on its own underlying holdings and may or may not exhibit these characteristics.

endowment style pros and cons of investing

Case Study: How Forthlane makes this style of portfolio work for families

To give an example of how this style of investing can be implemented on an individual or business level, allow us to give a quick overview of how Forthlane uses this style of investing to benefit families. Keep in mind, of course, that investing in this style can take many forms – with different allocations to different asset classes – and may or may not look similar to the outline that follows.

At the core of Forthlane’s investment philosophy is Strategic Asset Allocation. Rather than solely focusing on picking good stocks and investments, we strive for long-term exposure to major and nonstandard asset classes, in keeping with the endowment style theme. Our office has connections to the best fund managers that are necessary for a successful endowment-style portfolio, allowing the families we work with to benefit from them. Our “Safe Capital Portfolio” is a prime example of this. Predicting the future is impossible, so we believe one should spread out their bets so one can win regardless of the macroeconomic environment. This portfolio is comprised of six “building blocks,” each invested in different areas, including the previously discussed “nonstandard assets”:

 

  1. Global Equity: Portfolio of global public equities via low-cost ETFs and select active managers.
  2. Private Opportunities: Portfolio of institutional Private Equity managers and high- quality direct investments, accessing the asset class as efficiently as possible.
  3. Absolute Return: Portfolio of various hedge fund strategies designed to protect capital and provide low-volatility growth.
  4. Real Assets: Portfolio of three low-cost ETFs: gold, diversified commodities and inflation-linked bonds.
  5. Credit Opportunities: Diversified portfolio of institutional credit managers opportunistically investing across credit markets.
  6. Fixed Income: Portfolio of primarily Canadian bonds, implemented in a tax efficient manner.

Each of these strategies is designed to perform best in different environments to ensure the portfolio maximizes gains, as displayed to the right.

Forthlane's investment strategy chart

 

With these building blocks, our endowment-style Safe Capital Portfolio has outperformed traditional 60/40 Canadian portfolios with less risk.

 

Note: The above depicted ‘Safe Capital Portfolio’ represents the performance of several of our portfolio ‘Building Blocks’ in the following weighting: 17% Global Equity, 13% Fixed Income, 25% Absolute Return, 25% Credit Opportunities and 20% Real Assets, with rebalancing occurring quarterly.

 

Forthlane Safe Capital returns chart

References

Cunningham, N. (2021). Is the 60/40 dead? Goldman Sachs. https://www.gsam.com/content/gsam/us/en/advisors/market-insights/gsam-connect/2021/is-the-60-40-dead.html#:~:text=For%20context%2C%20the%20classic%2060,levels%20of%20around%206%251

 

Douglas-Gabriel, D. (2022, February 19). College endowments aren’t piggy banks. But some experts say wealthy schools could spend more. The Washington Post. https://www.washingtonpost.com/education/2022/02/19/wealthy-university-endowments/

Foster, L. (2022, May 13). The 60/40 portfolio is having its worst year ever. What to buy instead. Barron’s. https://www.barrons.com/articles/stocks-bonds-portfolio-investing-51652394644

Jennings, J. (2022, February 28). Should you invest like a university endowment? Forbes. https://www.forbes.com/sites/johnjennings/2022/02/28/should-you-invest-like-a-university-endowment/?sh=66ceae5a7593

Leibowitz, M. L., Bova, A., & Hammond, P. B. (2010). The endowment model of investing: Return, risk, and diversification. John Wiley & Sons.

 

Mitchell, C. (2022, January 10). Average historical stock market returns for S&P 500 (5-year up to 150-year averages). Trade That Swing. https://tradethatswing.com/average-historical-stock-market-returns-for-sp-500-5-year-up-to-150-year-averages/

Steyer, R. (2021, October 29). Princeton endowment roars to 46.9% return for fiscal year. Pensions & Investments. https://www.pionline.com/endowments-and-foundations/princeton-endowment-roars-469-return-fiscal-year

 

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