Endowment-style investing explained

The approach adopted by US endowment funds has many lessons for long-term investors.
Many institutional investors have adopted the endowment approach to investing.

The endowment investing approach, pioneered by David Swensen [1], continues to arouse growing interest from institutional investors and wealthy individual investors alike.

The endowment model is characterised by a heavy allocation to equities and alternative assets such as private equity, real assets and hedge funds, and involves significant active management to add alpha. The underlying philosophy of the endowment approach is that long-term investors have the ability to bear short-term volatility and therefore can forgo some liquidity to pursue superior returns.

Many institutional investors have adopted the endowment approach to investing, including universities, foundations, pension funds, sovereign fund and even wealth managers. The focus of this article is on American university endowments.

The largest university endowment fund belongs to Harvard University (USD51.5 bn in assets under management (AUM) at the financial year (FY) ending 30 June 2021), followed by the University of Texas and Yale University (with USD42.9 bn and USD42.3 bn, respectively, at the same date).

“The shift from traditional to alternative assets in endowments’ asset allocation started in the 1980s.”

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 spend 4-6% of the moving average of assets under management over one to three years and target a real average annual return of 5% (adjusted for inflation) over the long term. Low liquidity needs mean endowments can tolerate relatively high short-term volatility to focus on the long-term pursuit of superior returns. As a consequence, many university endowments have relatively high allocations to public equities and illiquid private assets and smaller allocations to fixed income than classic investment firms.

The shift from traditional to alternative assets in endowments’ asset allocation started in the 1980s. The shift was led by Yale and Harvard, followed by others, mostly large ones (those with AUMs of over USD1 bn). This resulted in a big reduction in exposure to public equities and bonds (see chart 1) in the early part of this century as endowment funds moved increasingly into alternative assets that were perceived as providing diversification and higher returns. However, endowment allocations have been almost stable since 2009.

Large endowment portfolios have a far greater weighting of alternative assets than small ones (AUMs of less than USD25 mn), whose investments remain heavily focused on domestic US equities and investment-grade bonds. This can be explained by the greater resources available to the larger players.

Large US endowment funds’ allocation to public equities declined from 45% of total assets in 2002 to 29% in 2021 (having fallen to as low as 26% in 2009), while their allocation to alternative assets increased from 32% to 59% over the same period. Small funds’ asset allocations have been more stable on average and mirror those of classic 60/40 portfolios, with approximatively 60% of their assets invested in equities, 32% in fixed income and the rest in alternative assets.

Chart 1: Larger US endowment's asset allocation, 2002-2021[2]

Strong performance in 2021 improves long-term returns

Thanks to their strong FY21 performance, endowments’ average annual return over 10 years jumped from 7.5% to 8.5%. Table 1 shows the FY21 average annual return over different time periods for endowments of various sizes. It also shows average returns specifically for the Yale endowment fund as well as for classic 60/40 portfolios.

Table 1: FY21 average annual rerturns over different time periods

In general, endowments have an historical average annual nominal target return of between 7% and 7.8% over 10 years. In FY21 the target nominal return stood at 7.51%. This figure takes into account spending requirements (4.61%), long-term inflation expectations (2.08%) as well as fees and expenses (0.82%). For the current financial year, however, due to rising inflation expectations, the target nominal return has increased to 7.94% (4.60% spending, 2.3% inflation and 1.04% for fees and expenses). Endowment fund managers will therefore be more challenged to meet long-term targets in the coming years.

Have endowments achieved their long-term objective?

As mentioned, the long-term objective of university endowments is to preserve the real value of the assets they manage while supporting the university’s operating budget. This objective is generally stated as producing an average real return of 5% in excess of inflation rate. However, after accounting for gifts and donations, the annual net spending rate is usually lower (below 4% of assets). Chart 2 compares the rolling 10-year average return of Yale and large endowments in general to the combination of the spending rate and the Higher Education Price Index (HEPI, a inflation index used in institutions of higher education) over a 10-year time period, assuming a fixed average spending rate of 4% . While Yale has consistently generated returns far above target, endowments with assets over USD1 bn in general averaged slightly below the required return in 2009-2011 and again in 2018. Overall, however, large endowments can be considered to have achieved their long-term objective over the period 1999-2021 (older data are not available).

Chart 2: 10-year average endowment returns versus 10-year average inflation and spending rate

Since 1995, large endowment have consistently achieved cumulative returns above the required return (US HEPI+5%), even when assuming a spending rate of 5% . They have also constantly outperformed US 60/40 portfolios (60% S&P 500+ 40% 10-year US Treasuries, see chart 3).

Chart 3: Cumulative annual returns for all endowment funds, for Yale's endowment fund and for a 60/40 portfolio, FY1996-FY2021

Our return expectations for a standard US 60/40 portfolio over the next 10 years has been revised upwards to an annual average of 4.3%. But according to our analysis, endowment funds could provide an average annual return of 5.6% over the same period, with the largest endowments returning 6.4%.

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