The endowment investment model, which is widespread among university endowments (hence the name), is often flagged as the best-in-class framework for long-term investors. This is an approach to institutional investment that is almost entirely outsourced and seeks to generate high returns through an aggressive orientation toward private equity and other alternative assets. In 2013 the average U.S. endowment had an allocation to alternatives of 47 percent, down from the previous year’s peak of 54 percent but still much higher than a decade before.
The model was pioneered by David Swensen, chief investment officer at Yale University, through the investment policies he implemented at the school’s endowment. Using this model, Swensen managed to generate a remarkable 15 percent internal rate of return over a 20-year stretch leading up to 2007. Because of Yale’s wild success, the endowment model was copied by hundreds (and probably thousands) of other endowments and institutional investors around the world. Although the model remains popular today, some institutional investors now see it as being at odds with long-term investing and perhaps even damaging to the long-term investment challenge.
Here’s why: The success or failure of this model seems to be based on access to top-performing managers, as endowments believe that certain managers can and do deliver alpha (returns above a market benchmark). The institutions that have privileged access to top managers see themselves as lucky passengers on an investment return rocket ship powered by hedge funds, private equity firms and other alternative managers.
So most (though not all) endowments won’t do anything to rock the boat with these managers. Thanks to this fear of restricted access, the asset managers would seem to hold the power to discipline and influence asset owners. It’s for this reason that many university endowments are more secretive than the most-secretive sovereign wealth funds. They are protecting their external asset managers from scrutiny. In addition, they are protecting themselves from having to inform their stakeholders about how much they are paying in fees (if they even know what they’re paying managers).
And therein lies a fundamental problem with the endowment model: The agents seem to be in charge of the principals.
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Photo by Chaval Brasil