Plan for Success

Terry Hartigan | Principal

Developing a road map to achieve financial success.

A Look at the University Endowment Model of Investing and the Individual Investor

February 2014

Over the past decade there has been a great deal of hype in the financial press about the superiority of the so-called “endowment model” of investing. What is the endowment model you ask? At the risk of oversimplifying, it is diversifying beyond traditional, publicly-traded stocks and bonds to include a significant allocation to “alternative” asset classes such as private equity and hedge funds. The term “endowment model” is descriptive because many major university endowments have embraced this strategy of investing.

Conventional wisdom holds that the endowments of our prestigious universities have long-term performance records worthy of emulation. Many of the chief investment officers of these endowment funds have become rock stars of the investment industry and are often paid higher salaries than the university presidents. Wall Street tries to sell individual investors on the notion that they also need “special access” and “complex” strategies to replicate the same success. But is the endowment model something the individual can or even should pursue?

Let’s take a look at the five year track record of some of the largest university endowments for their fiscal years ending June 30, 2013:
Keep in mind, the five years ending June 30, 2013 includes a significant portion of the 2008 market downturn, which is a period where we should expect to see lower returns than the historical average. But is this not when the endowment model is supposed to reveal its superiority and deliver great returns? Apparently not.

Even if an endowment model proved to provide superior returns, should an individual investor expect to be able to implement the same strategies and structures with equal results? I would argue that it would be very difficult, for several reasons.

1. Income taxes. University endowments are tax exempt, while individual investors are not. Many of the strategies endowments implement are extremely tax inefficient due to high turnover. The tax bite alone would substantially reduce the after-tax returns for an individual investor.

2. High Costs. Investing in alternative asset classes is an expensive proposition. A typical hedge fund may charge a 1.5% asset management fee plus 20% of profits. Large endowments are often able to negotiate more favorable rates due to the large sums of money they invest. The individual investor is not likely to be able to negotiate the same terms.

3. Illiquidity. In theory, endowments have an infinite time horizon and are able to forgo liquidity in pursuit of investment returns (whether or not this is rewarded is another issue). The typical individual investor has a more finite time horizon and requires a more liquid portfolio.

4. Resources and investment minimums. A university endowment investment staff may include dozens of professionals who do nothing but research and perform due diligence on investment opportunities (again, whether or not this is rewarded is another issue). Also, a manager with whom the endowment invests may require a minimum investment of between $5 million and even $50 million.

But let’s suppose you could have replicated the performance of the best-performing endowments over the past five years with similar strategies. How would you compare to an individual investor who used a more traditional, less complex diversification strategy?

During the same five-year period, Capital Directions’ Moderate Growth model portfolio, net of fees, generated a 5.5% annualized return*. This would place it number two in the above performance ranking – behind Columbia and ahead of Penn. Our Moderate Growth portfolio is broadly diversified, with 60% allocated to global equities and 40% allocated to diversified fixed income. This type of strategy is implemented using low-cost, tax-efficient mutual funds and exchange traded funds. It is a simple implementation on the surface, but it is based on the science of investing built upon decades of academic research and institutional application.

While there are some similarities between the endowment model and our approach at Capital Directions, it is the commitment to using illiquid, high cost alternative assets that separates the two approaches. And even some of the endowment experts side with us on this.

David Swensen, the Chief Investment Officer of Yale University’s endowment, is arguably the most famous manager for his success implementing the endowment model. However, in his book “Unconventional Success: A Fundamental Approach to Personal Investment”, he says (and I agree) that insurmountable hurdles confront ordinary investors and they are best rewarded by utilizing investor friendly, low cost, market-based portfolios to gain access to broad diversification. This is advice from the individual who is considered a pioneer in the use of alternative asset classes. Not what most investors would expect to hear from Mr. Swensen!

Leonardo da Vinci said, “simplicity is the ultimate sophistication.” We could not agree more. You may not have great stories of exotic investments to tell at your next party, but your probability of achieving your investment goals will likely be higher.

* Disclosure Statement & Portfolio Construction Data
Performance numbers are blended historical returns for the mutual funds used in the model portfolios, or the representative index for the periods prior to commencement of operations by the selected fund, net of its corresponding expense ratio. This portfolio commenced operation in January 1999. These hypothetical returns were calculated after the end of the periods shown and reflect the reinvestment of dividends and other earnings. Returns are shown net of fund fees, the maximum advisory fee for CD and estimated transaction costs for a typical client portfolio. Estimated transaction costs for initial purchases and rebalancing in a $1 million typical client account are approximately 0.05% on an annual basis. These model portfolio returns do not represent actual investment decisions by CD and, thus, may not reflect the impact that material economic and market factors might have had on our decision-making if CD were actually managing the money. PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.

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