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Commentary

3 Lessons Investors Can Learn from Endowments

Thinking like an endowment manager has its advantages.

Endowments have long been leaders, often putting new concepts into practice well before the rest of the investing world. 

In a recent issue of the Financial Analysts Journal celebrating the publication’s 75th anniversary, three coauthors investigate endowment performance and asset-allocation trends going back more than 100 years, focusing on the endowments of a dozen major universities.

In many respects, endowments operate under significantly different conditions than individual investors. For instance, endowments’ investment horizons are often considered perpetual. Nevertheless, individual investors can draw a few important lessons from this study.

Lesson One: Match Longer Time Horizons With Riskier Assets
The researchers found two major trends in the asset allocation of endowments, from bonds to stocks in the 1930s and ‘40s, and then from stocks to alternatives assets beginning in the 1980s. Early on, endowment investing was a heavily fixed-income enterprise focusing on safe assets with a steady income. Whereas common stocks in the sample averaged only 18.8% of assets in the 1930s, by the 1950s stocks accounted for 50.3% of assets and by the 1960s they accounted for 58.6%. (Preferred stock was also a significant portion of early endowment accounts but is excluded from the figures cited here.)

The next big wave occurred with the movement toward alternative assets in the 1980s, spearheaded by David Swenson of the Yale endowment, who is often given credit for pioneering modern endowment theory. From a baseline of zero, alternatives grew steadily over the subsequent decades such that the sample averages more than 50% today. The growth in alternatives was funded from equities, signaling that managers considered alternatives part of their risky asset bucket, with stocks declining from average highs in the 70%-80% range to around 30% today.

The key point is that the investment managers of these endowments recognized that emerging asset classes offered better return prospects than their current investments, and that the long investment horizon of endowments would allow them to take on the greater risk of stocks and later alternatives. While many alternative strategies have proved disappointing, particularly in liquid structures, endowments have weighted heavily toward private equity, which has provided excess returns relative to equities over the past few decades.

While few, if any of us, can take as long an investment perspective as endowments, most investors do have some area of their portfolio where they have a long horizon, at the very least in their retirement accounts. And in those cases, investors should endeavor to take advantage of the excess return opportunities of riskier assets, of course within a diversified framework. [comment on how that may vary for different investors] Another way to think about this is for investors to extend their time horizon as much as possible wherever possible. Some goals require a short-term horizon and a risk-averse approach, such as saving up to buy a home in a few years. But for other accounts without such a specific goal, taking as long a view as possible will also enable investors to ramp up risk and potential return.

Lesson Two: Avoid the Herd
In a review of the academic literature on the topic of herding behavior, the authors of this study note that institutional investors are often prone to following investment trends. This runs contrary to common perception, which holds that uninformed individual investors are the lemmings while sophisticated institutional investors chart their own path. The authors cite many cases of hedge funds, pensions, and mutual fund managers who behaved no better than individual investors during some of the major crises of the past half-century. Why might that be the case? The fact is, even institutional money managers are subject to shorter-term pressures—such as reputational risk, peer-performance comparisons, and pressure from boards and clients--that can affect the way they invest. Many hedge funds, for instance, were forced into selling during the great financial crisis of 2007-09 due to withdrawal requests from clients, even if it was against their long-term investing principles.

Endowments, by contrast, benefit from their truly long-term time horizon. Moreover, they are typically less susceptible to short-termism because they aren’t expected to contribute to expenses beyond a set spending rate, with a primary objective to grow wealth for future generations. This isn’t to say endowments are completely immune from such pressures. During the recent pandemic-driven period of financial struggles for colleges and universities, for instance, there have been some calls for endowments to provide additional financial support to institutions that have resorted to layoffs and budget cuts.

For the most part, though, endowments are not trend-chasers (if anything, they are trendsetters), and perhaps what is more important is not to engage in short-term market-timing or to sell assets in response to market turmoil. We can all take a lesson from the steadfast approach of endowments. It’s easy to get distracted by the latest hot investment types or sectors, or to panic when markets take an unexpected dive, but endowments show us that true long-term investing requires setting goals and sticking to a plan.

Lesson Three: Invest Countercyclically
This, in some ways, is the opposite of avoiding the herd, but it’s not a given that one principle necessitates the other. Avoiding the herd means staying with your plan and tuning out the noise; investing countercyclically means having the courage to take advantage of major dislocations in the market that have long-term consequences.

Perhaps the most compelling aspect of the article is the authors’ investigation into endowments’ countercyclical tendencies over the past century. Focusing on six major market crises since the early 20th century, the authors used the asset-allocation histories of the endowments in the sample to decompose changes due to market performance and those due to active manager decisions. The important finding is that endowment managers have indeed taken advantage of disruptive market events. As the authors summarize: “…averaged across all crises and separately for crises in the 20th and 21st centuries, endowments increased their exposure to equites, on average, in the three years following the onset of a crisis—that is, after prices had fallen from their peak levels.” Moreover, they note evidence of “a decrease as markets were rising towards unsustainable levels at the time of the dot-com bubble and the 2008 GFC.” In other words, endowments accomplished the difficult feat of buying when markets were low and (sometimes) selling when markets were high.

This is not the same as market-timing. Rather, it entails having a disciplined investment philosophy and the fortitude to invest when markets look scariest. Certainly, it’s not an easy thing to do. But it bears reminding that some of the greatest investment opportunities arise when market values are farthest from intrinsic values. In a world of efficient markets, it’s difficult to find sources of excess return, and investing during significant market downturns has repeatedly proved to be one of the best long-term sources of outperformance.

Individual investors lack the extremely long time horizons as well as the access to specialized private investments from which endowment managers benefit. But we can still take these important principles and apply them to our own investment plans, making appropriate adjustments for goals, financial situations, and risk tolerance.