Envy is a certain outcome of any serious competitive endeavour. As the endowment funds of elite US universities, such as Yale, Harvard and Princeton, continue to post investment returns well ahead of the mainstream, many institutions have tried to emulate their winning strategies by allocating aggressively to alternatives. But will strategies hatched in the past deliver the outperformance that new followers desire? And what other examples should the mainstream follow from the universities’ success? SIMON MUMME reports on the innovation, and imitation, that has been spurred by the endowments phenomenon.
Socrates deemed it an “ulcer of the soul”, after Heraclitus, speaking more than a century earlier, said that “our envy always lasts longer than the happiness of those we envy”. Writers and prophets of many nations and creeds, from Shakespeare to Mohammed, warn us of the harm that visits people who are irredeemably jealous of their peers’ success. At its worst, “our envy of others devours us most of all,” wrote the late Alexander Solzhenitsyn.
In the intensely competitive world of institutional investment, envy might not only affect individuals, but also the big licks of capital at stake. The endowment funds of elite US universities – such as Yale, Harvard, Stanford and Princeton – have shot to prominence in the past decade as they pioneered new models of asset allocation that produced stellar returns, effectively scoring a “triple crown” of market-leading returns, committed diversification and ample “sex appeal”, according to Gareth Abley, the head of asset consulting at MLC Implemented Consulting.
Their success is underscored by an emphatic consistency: between 1996 and 2005, more than 5 per cent of US endowments beat the top percentile return for an American corporate pension fund with more than US$100 million in assets.
This superiority of the leading schools was particularly visible in 2000 and 2001, when the excess returns achieved by endowments of Ivy League universities, along with Duke, MIT, Caltech and Stanford, outperformed those of other schools by up to 10 per cent. In 2000, for instance, the average excess return from endowments reporting at least 10 years of performance data between 1992 and 2005 was roughly 8 per cent, while the elites generated returns north of 26 per cent.
Such achievements have been driven by maverick calls on strategic asset allocation (SAA) that showed a willingness to invest heavily in alternatives and other illiquid assets, combined with the governance to pull it off. For example, at the end of financial 2006, Yale aimed to hold 69 per cent of its portfolio in private equity, hedge funds, and real estate. As the returns rolled in, headlined by Yale’s annual 17.2 per cent return in the decade to 2007, the institutional mainstream, stuck in dotcom wreckage, rightly took notice. ‘Endowments envy’ crept up on US pension funds and layed on the minds of investment committee members.
Since then, a surge towards managers and assets carrying the ‘alternative’ tag has reshaped the institutional landscape. As more funds’ asset allocations were reworked in the image of those published by the endowments, the dangers of replication became clear. The alternatives universe does not hold enough opportunities for everyone to shoot the lights out, and not all funds are as well resourced, or have the same tolerance for illiquidity, as the endowments.
“Everyone has an eye on it and people are moving in that direction,” MLC’s Abley says. “It’s good, it’s healthy, it could be innovative and exciting, but it could also be hard and potentially dangerous.” In Australia, industry funds have probably gone furthest in the direction of endowments. They have built large allocations to infrastructure, a sector in which they secured early access similar to the way Harvard and the largest endowments gained first-mover advantage in venture capital and oil and gas assets.
But, inevitably, markets have changed in the years since the top endowments formulated their asset allocations. This holds potentially serious implications for mainstream institutions that have gone on to invest heavily in alternatives. In a research paper discussing the success and influence of the elite endowments, Abley asks: “will yesterday’s strategy work tomorrow?
“Trying to emulate what worked in the last 15 years is a flawed approach for most investors, which could see them crank up their illiquidity without generating better risk-adjusted returns,” he says. “Given the risks that the endowment guys take, you have to ask: is it worth it?” The $2.9 billion Westscheme allocates 45 per cent of its assets to the target return portfolio within its default option, the Trustee’s Selection, which invests, usually directly with co-investors, in infrastructure, private equity, property, natural resources and other private market assets. Much of the portfolio has been built under the guidance of asset consultant Access Capital Advisors, whom Westscheme appointed in 2000. Have the endowments informed Westscheme’s SAA? “Absolutely,” confirms Howard Rosario, the chief executive of Westscheme. “They are a guide to organising our investment approach.”
However to say the fund is merely following in the footprints of the endowments is “wrong and simplistic”, Rosario says. The $80 billion Queensland Investment Corporation (QIC) invests in alternatives funds modeled on endowments strategies and staffed, in part, by their former employees. QIC allocates to the endowment-style funds – Makena Capital Management, whose founder lead the Stanford endowment; and GEM, whose executives worked for Duke’s endowment – in search of diversification, high returns and to attain insights.
“They give us three or four different ways of tackling particular problems,” says Brad Holzberger, chief executive of QIC Asset Management. Evaluating an investment approach which has enjoyed past success is an “intrinsically beneficial” task, Abley says. However it’s essential to do so “with an unclouded and coldly analytical perspective” if institutions taken with the endowments story are to avoid burning capital in ill-fated ventures into alternatives.
Imitation or innovation?
A sure way of significantly underperforming the top endowments is to replicate their past strategies. In a 2007 paper, Secrets of the Academy: The Drivers of University Endowment Success, Josh Lerner, Antoinette Schoar and Jialan Wang from the MIT Sloan School of Management raise their concerns about the “challenges of imitation”. The authors write that the scrutiny applied to the strategies crafted by endowment managers is unprecedented and the time periods between endowment innovation and mainstream emulation are shortening. The approximate two-year gap between Harvard’s entry into forestland and the mainstream’s implementation of similar investments, for instance, illustrates how closely the endowment is now being watched. After all, it took more than a decade for institutions to grasp venture capital after Harvard first did.
A similar dynamic plays out at the individual product level: “an investment by an elite endowment into a fund can trigger a rush of capital seeking to gain access to the same fund,” the authors write. A premium applies to the astute selection of alternatives managers, and early selection of outperformers can guarantee investors access down the track. As pioneers in the alternatives field, many endowments continue to enjoy a seat at the tables of star managers.
However Lerner, Schoar and Wang have found in research pre-dating Secrets that attractive opportunities do exist for institutions who cannot access the managers they initially aim for. In Smart Decisions, Foolish Choices: The Limited Partner Performance Puzzle, the academics’ analysis of reinvestments in private equity managers suggests that endowments, and to a lesser extent, public pensions, are better than other investors at predicting whether the subsequent funds from established managers will outperform. Here, the endowments’ returns from private equity investments “are not primarily due to endowments’ greater access to established funds, since they also hold for young or undersubscribed funds”.
It appears that endowments usually select the best managers even when access is equal for all investors. Still, since there is usually a limited number of skilled managers in a given sector, a fund beginning an alternatives program now is not likely to access top or even second-tier managers, but will pay the high standard fees regardless of what managers they hire.
Abley cautions these late starters: “the average private equity fund fails to beat the listed market, and the average hedge fund will deliver something close to cash,” he says. The dearth of good managers with capacity is not the only challenge facing endowment wannabes. Trying to take maximum advantage of the demand they are witnessing, some alternatives managers have requested greater slices of outperformance, or have made it conditional to new clients that an investment in a desired strategy requires an allocation to a less attractive or less proven ‘side car’ fund.
Such sacrifices are not worth it, according to the chief investment officer of a multi-billion dollar Australian fund, who requests anonymity. He believes the endowment strategies are “yesterday’s model” since they are no longer supported by economic conditions. In a time of expensive debt, access-for-all to good private equity managers is not viable (and if you ask this CIO, private equity done badly can be painful – “it’s like amateur theatre”).
Many top-performing hedge funds are closed to new money, and the more systematic alternatives strategies are being replicated by alternative beta providers, so that some of “last year’s fantastic ideas are now tomorrow’s commoditised products”. The scholars behind Secrets agree that conditions in alternatives markets during the past 25 years have fueled the endowments’ strategies. Until 2000, aspiring entrepreneurs in robust markets made venture capital transactions attractive, and a steady supply of value opportunities and cheap debt prompted many private equity buyouts. Even so, the likes of Yale undoubtedly added a lot of value through manager selection, reflected in their consistently high returns.
Abley provides another possible explanation: that the endowments are freakishly lucky. The laws of probability demand that one investor from the institutional pool must outperform just like Yale has. “If there are 1,000 institutions, the odds are that one of them will outperform for 10 years on the trot,” Abley reasons. “Investment gurus are, therefore, routinely created on the back of a return stream that is an inevitable consequence of the number of people playing the game. It is important, then, to not be seduced purely by the numbers.”
Still, no matter what the true drivers of elite endowment returns have been, it is unknown whether they can maintain their leading positions in changing markets. But if strong relationships with skilful alternatives managers remain vital to their success, they might.
Ian Kennedy, director of research at Cambridge Associates, a consultancy to clients including Harvard, Yale, Stanford and the largest American university endowments, says the supply of attractive opportunities in the alternatives universe has not been depleted. “We have seen a marked improvement in the quality of opportunities in the hedge fund world, and the number of quality hedge funds expand,” Kennedy says. Yet institutions must carefully appraise what may seem like a glittering opportunity set. “Even so, if you look around the world at the 10,000 or so hedge funds and think what percentage of that total is worth the high fees, the result would be in the very low single digits.”
David Chessell, a director at Access Capital Advisers, a consultancy known for its taste for alternatives, also rejects the notion that most of the worthwhile assets in the sector have been bought. “The world is a very big place,” he says from Mumbai, where at presstime he was scouting office properties for a co-investment deal with Indian firm Tata Realty Holdings and a portfolio of clients, including Westscheme.
Those other secrets of the academy
“The investment world is different from most other worlds,” writes Kennedy in a 2008 Cambridge Associates publication, Endowment Management. “In other professions, doing more of what has worked is usually the route to success…and committee members who cannot grasp this fundamental fact often end up chasing last year’s winners, inflicting considerable damage on the portfolio as a result.” Since asset allocations must earn approval from fund boards and committees, there is value in looking beyond the first-mover advantages gained by the top endowments in emerging sectors, and instead focusing on their decision-making approaches.
After all, their portfolios are produced by combinations of skill and governance. Secrets points out that while volumes have been written on the pricing, risks and returns of various assets, the “organisational economics of investing” are harder to quantify.
The risks taken by endowments involve being early, taking a contrary view, and sometimes being wrong. Secrets shows that the overall performance of endowments is counter-cyclical to the mainstream: in the mid-1990s, their excess returns were near 10 per cent; however, during 2000 and 2001, they generated 15 per cent alpha. In taking such risks, they draw on sophisticated advisers and contacts and exploit their high tolerances for illiquidity. When endowments are advised by the likes of Cambridge Associates (which was early in recommending venture capital, leveraged buy-outs, hedge funds, timberland, oil and gas opportunities to clients) and have networks of alumni in the top echelons of the investment world, it is difficult for the mainstream to compete seriously with the universities.
When Yale identified that oil and gas was an attractive but immature market with diversification and inflation-hedging benefits in the 90s, it saw that expertise in developing oil and gas fields would add value in any subsequent investments and that a scarcity of adequately resourced and incentivised entrepreneurs existed in this space. Pursuing this theme, the endowment sought professionals from the oil and gas industries to be involved in related investment programs. “They plucked people out of companies to essentially set up private equity oil and gas ventures that managed fields directly,” Abley says. Within a decade, Yale had seeded 16 specialist managers.
Endowments have developed resources and expertise in areas they “correctly saw as structurally neglected and inefficient,” he writes in an MLC implemented consulting research paper. Often, such proficiencies have been derived from their heritage. MIT, for instance, first attained real estate expertise by developing land in and around the university campus.
“Herein lies an important lesson,” Abley writes. “Institutions clearly need to research mainstream asset classes, but arguably, by the time an asset class is developed enough to have been categorised, many of the inefficiencies will have gone. Perhaps more enlightened institutions will begin to employ people whose exclusive role is to identify – not managers – but market inefficiencies. Find the inefficiency and then identify or create the strategies to exploit it.”
To build such “uncomfortably idiosyncratic portfolios” a “sustained contrarianism” is required. It involves making decisions that, at the time, are very painful – “usually because you’re virtually the only one doing them”. Yale and Harvard, for example, diversified away from US equities in the mid-90s and missed years of great returns. And in the late 90s, the oil price caved to US$12 a barrel. “At that time the exposure to oil and gas wasn’t an easy one to live with. It is only now it looks obvious.”
The president of the Princeton University Investment Company, Andrew Golden, says the job of running the school endowment requires the team to “optimise discomfort” – to “push us to the limit of doing things that are uncomfortable, because that’s the way you make money, but not so far that we later become so uncomfortable we abandon the plan we started with.”
Abley points out that mainstream funds have not pushed themselves this far because this type of bahaviour is, in many ways, ‘uninstitutional’. “The optimal level of ‘discomfort’ varies widely between fiduciaries and it is important to understand this. It is much better to be realistic than idealistic,” he writes.
With their track record of having accessed infrastructure early, Australia’s own industry funds can claim a similar aptitude for finding promising investment themes in their infancy.
Secrets reveals three common governance features among the top endowments. First, they maintain an active investment committee, whose members are usually drawn from alumni, that are involved not in micromanagement of the investment staff but in setting strategy. Second, their investment teams have often worked together previously, so this shared experiences helps them grapple with problems and resolve differences of opinion. Third, their academic orientation promotes regular self-evaluation of their structure, processes, people and direction.
The endowments’ capacity to wear significant illiquidity risk, and continually justify this in the face of related short-term volatility, is crucial. In past episodes, the paper notes, some schools have instigated bold strategies that would, in maturity, have been successful, but were pressured to abandon them after early losses brought media attention and complaints from the alumni. Here, “the pressures against contrarian strategies became too great”.
In other scenarios, some endowments attempted to hedge their exposures to venture capital in the late 1990s, but after losing money for several quarters through the hedges, were forced by their investment committees to abandon their positions – right before the dotcom crash.
The best way to cope with endowments envy, Abley says, is to study the endowments’ governance processes in conjunction with their asset allocations and deployment of resources. “The real advantage is trying to work out what the next area is and getting in there early. The governance structures of the endowments allows them to do different things that look very unfashionable and dangerous at the time, but that’s often the best way to invest for a long-term investor,” he says. “Partnering with who you invest in and being able to tolerate massive periods of underperformance over a number of years is far more replicable than trying to emulate a strategy that worked 10 years ago.” Obsessing over what worked well yesterday is an all too common mistake, Kennedy of Cambridge Associates says.
“But if you have a strong governance structure, it forces you to seek to understand what is likely to work well tomorrow.” Returns aside, other side effects from the rush into alternatives could siphon money from members’ balances. “In 10 years time, the big irony will be that even though the successful alternatives managers would have been massively successful in generating wealth for their stakeholders they will have indirectly caused wealth destruction for the average investor,” Abley argues. “A lot of people will be paying the high fees and, since the global economic pie available to investors in capital markets doesn’t change, if you increase the fees the investor pays for each slice of capital pie you’re going to decrease the overall pie available to the average investor.”
“There will be some great winners and they will get great airtime and exposure but on average the everyday investor is going to be worse off through endowments envy. And that’s a really big issue for the industry.”
Effective investing, for endowments and institutions, “is about understanding what you have a competitive advantage in and exploiting that,” Kennedy says. Some endowments now staff teams searching only for new inefficiencies, similar to the way teams are traditionally assigned to specific asset classes, such as global equities or domestic equities. “They have people responsible for the next timberland or the next oil and gas,” Abley says. However the majority of endowments, like many institutions, have only modest numbers of staff, numbering between 10 and 12. Harvard is an exception. It employs more than 100 staff, including a proprietary trading desk, and most are generalists, looking at various asset classes.
Such endowments, particularly those of highly-ranked universities, have another advantage over mainstream funds: their constituents are a source of knowledge. Some universities can deeply analyse certain asset classes because they have research expertise in that area, with resources on campus. Most other funds don’t have these immediate starting points, or can only access them at a higher price. The highly educated constituency of endowments gives them another advantage over most super funds, whose member base of workers are mostly unaware of historical market behaviour and the undulations in performance that are inevitably experienced while investing for the long-term. Instead, they are usually sensitive to short-term results.
“It’s difficult to take a maverick risk if your constituency is relatively uneducated,” Kennedy says. This lack of sophistication takes place in a market where funds compete for members.
In this world of choice and three-year performance figures, “the more difficult challenge is managing money with a really long-term horizon in a peer agnostic way,” Abley says. “Would people really be comfortable underperforming by 7 per cent over four years?”
Where a super fund has thousands of stakeholders, an endowment has one: its university. Unlike most superannuants, it is an extremely astute constituent with many faces. And while a super fund answers to plenty of members, endowment managers must answer to various academic departments and councils, which can also be frightening. “How would you like it if part of your constituency was the economics department of Harvard?” Kennedy asks. Super funds must manage liquidity to meet multiple timeframes, while endowments have a timeframe of forever. As a general rule, endowments must pay out their real rates of return to patron institutions to fund research, curriculum development and other activities.
The investment and capital management division of The University of Sydney, which manages an endowment portfolio, aims to distribute 5 per cent of assets, adjusted for inflation, each year.
Endowments seek to provide “inter-generational equity”, in which they spend as much on the current student corpus as the next, Kennedy says. In times of short-term pain, the constituents of endowments are more engaged and understanding, and generally more forgiving, than super fund members. “Because they don’t have members they can take a longer-term view than Australian super funds, which is a nice luxury to have,” Chessell of Access Capital Advisers says. “Our clients operate in a market where there is a short-term fetish: people pay lip-service to long-term returns but everyone gets excited by short-term results.” For super funds to invest on a longer time horizon, say 20 years or more, is a pipedream: “At the trustee level, all of our clients focus on the three-to-five year timeframe,” Chessell says.
Holzberger of QIC says short-term underperformance an Achille’s heel for trustees, who fully understand the case for championing long-term strategies. “Every effort we make is to force clients to think long-term and to remind them of the mandates they’ve given us.”
He says Makena, the endowments-style alternatives manager, entertains more risk and diverges further from benchmarks than QIC does in any of its own products. By observing the manager, and taking part in quarterly day-long meetings and grilling sessions with senior Makena management as a foundation investor, some of the endowment culture rubs off on QIC and helps shape its communication to clients. “We’d like to be closer to the way endowments manage money,” Holzberger says.
One Australian fund that exploits long-term horizons, Westscheme, maintains conviction in its substantial illiquid holdings because it is confident that its members will stay for a long time, chief executive Howard Rosario says. “But, unlike the endowments, we have to be very careful about liquidity risks. Then again, we have been cash-flow positive for the whole time and we see no reason why that would change.” The fund uses market surveys to learn how peers are deploying their money, and forms assumptions about how the fund is likely to perform in comparison to competitors for the years ahead. “From that we derive business risk.”
The fund’s alternatives book, part of what it calls its ‘target return’ portfolio, apparently holds many income-bearing illiquid assets: it has “thrown off double-digit returns” in each year of its existence. While the prospect of a run on a super fund has seemed unlikely to date (our unnamed CIO says it is an “unfounded fear”), it should never be dismissed.
A university, in contrast, can’t leave its endowment -but it can fire the investment team. In searching for attractive alternative assets, both endowments and pension funds encounter limits on the resources available to aggressively scour markets for opportunities. Here, Kennedy says, the challenge is to deploy internal and external resources for the purpose of exploiting strong competencies. “The key is not to always be looking for niche investments, but to understand what your key competitive advantage is and focus on this far more than what competitors are doing. And if you don’t have the resources in-house to exploit it, you have to reach out,” Kennedy says.
“It comes down to aligning good governance with explicit policies aimed at achieving explicit objectives, and the discipline to implement these through asset allocation and resource allocation decisions to exploit your competitive advantage. What’s hard is getting a group of people to implement this in a disciplined way. “You don’t need a board or a committee of investment professionals per se, but you do need people who understand how to make informed decisions on the basis of incomplete information, because we never have enough information going forward.”
Such a governance structure and culture requires dedicated groundwork. “You need to create the governance structure and manage the expectations of stakeholders, and clarify the objectives first,” Abley says. “You need to create that culture in the institutional mindset, and to do that is a multi-year task. It’s kind of embedded in the DNA of Yale and Harvard.” Ideally, this culture would be sustainable, too. Writing in Endowment Management, Kennedy asserts that “the best governance structure is an empty shell unless populated by knowledgeable people capable of making sound decisions.”
He recommends that at least some investment committee members have professional institutional experience, but not to over-specialise: too many investment professionals with similar backgrounds “may lead to deleterious group-think”.
Representatives of stakeholders in the fund, such as those representing employee members of a super fund or from the university board – should be included. Specialised investment knowledge should not be considered a qualifier for entry. Also, “neither eminence nor expertise are sufficient to compensate for a failure to participate in meetings”. The best committee members are open-minded, act quickly to fix problems, ask appropriate questions, and are accustomed to making decisions, Kennedy continues. The very worst are overconfident, successful, ‘can-do’ individuals who are impatient with developing a consensus and believe that any lack of knowledge they have should not impede how they manage the fund portfolio. While staff turnover does not usually carry positive implications, and some endowments have benefited from the decades-long tenures of investment committee members, there are just as many examples of “sclerosis endured by institutions that have failed to inject new blood into their committees,” Kennedy writes.
Tenures should be long enough to ensure consistency and accountability for decisions, but limited to ensure vibrancy. It is important to have the flexibility to renew or extend terms so that the services of excellent committee members are retained. And when it comes to consultants, only those with spine should make the second interview. “Yes-men are useless and poodles come cheaper,” Kennedy says.
Smaller funds that have come late to alternatives can learn much from the successes of the elite endowments and the mixed results from the mainstream’s charge into the sector. The investments and capital management division of The University of Sydney, which oversees approximately $1.1 billion, including an endowment component worth approximately $700 million, initiated its alternative investments program towards the end of 2006. Its director, Greg Fernance, agrees that the endowments’ asset allocations can or should be adopted effectively by other institutions; rather, it is the qualitative attributes that should be interpreted and applied where appropriate.
The university’s investment and commercialisation committee oversees the management of Fernance’s division. Among its members are the chief investment officer of MLC, Chris Condon, the co-founder of CHAMP Private Equity, Joe Skrzynski, and the managing director of boutique incubator Pinnacle Investment Management, Ian Macoun.
While it does not constitute an endowments-esque alumni network, these professionals have knowledge, contacts and networking ability that can benefit the endowment. “We rely on their knowledge and expertise in what we are developing,” Fernance says. To date, however, the committee has not broken open relationships for the fund. Opportunities have arisen, open also to other institutions, in which the division has invested. These include an allocation to Makena, which was introduced to the university by specialist alternatives placement agency Brookvine, in addition to unlisted domestic and global infrastructure, equity long/short and, most recently, private equity secondaries through US manager HarbourVest.
Alternatives comprise between 17 and 20 per cent of the division’s long-term portfolio, which is comprised of gifts and endowments accrued over the decades and accounts for 70 per cent of its total funds, which are invested in growth assets, including farmlands. The remaining 30 per cent represents the short-term portfolio, which is managed internally, and is invested in short-term debt instruments. “We’ve been careful,” Fernance says. “Not just any alternative will do. And when you find the right alternative, not just any manager will do.” The division now has enough funds under management to warrant an expansion of its internal team of five, he says.
Coming up with outperforming strategies inspired by the elite endowments requires innovations not only in asset allocation, but also in the deployment of resources to exploit long-term horizons and governance processes. “More alternatives is not the answer,” Fernance says. “It’s not that easy.” It follows that any envy of the top endowments should be transformed into a spur for innovation, rather than emulation, in the pursuit of higher sustained returns.
Here some words from 19th century American intellectual Ralph Waldo Emerson especially apply: that envy is ignorance, and imitation suicide.