Buttonwood – Lessons from the endowment model

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    IN THE WEEKS following the stockmarket crash in October 1987, the investment committee of Yale University’s endowment fund convened two extraordinary meetings. Just after the crash its newish chief investment officer, David Swensen, had bought up stocks (which had become much cheaper) paid for by sales of bonds. Though in line with the fund’s agreed policy, this rebalancing appeared rash in the context of the market gloom—hence the meetings. One committee member said there would be “hell to pay” if Yale got it wrong. But the original decision stood. And it paid off handsomely.

    A lot of investors say they have a long horizon. A new study by David Chambers, Elroy Dimson and Charikleia Kaffe, of Cambridge University’s Judge Business School, finds that America’s big endowment funds have lived up to the claim.* They have been pioneers in allocating to riskier assets, most notably to “alternatives” such as private equity. When others flee risk, they have embraced it. They are supposed to see the farthest, after all: their goal is to meet the needs of beneficiaries for generations.

    Other investors seek to emulate the success of Yale and the other Ivy League endowments. Every other pension plan says it wants to plough more money into alternatives. Yet this is only one strut of the endowment model. It also requires smart people to design and implement a sound investment policy. And, as Mr Swensen’s experience in 1987 attests, it is vital that they are allowed to follow it without interference.

    University endowments are among the world’s longest-lived managed funds. In the late Middle Ages, Britain’s Oxbridge colleges received gifts of farmland intended to provide lasting financial support. For centuries the focus was on preserving capital. But since the start of the 20th century the dozen wealthiest endowments in America have done a lot more than that. The Cambridge study finds that the elite posted an average annual real return of 5.6% between 1900 and 2017. Harvard’s endowment, the largest, is now worth a stonking $41.9bn.

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    A key to their success is asset allocation. Beginning in the 1930s (for the Ivy League) and the 1940s (for the rest), they shifted markedly from bonds into equities. By the 1950s over half of American endowment assets were in stocks, compared with around a tenth half a century earlier. This shift looks obvious in hindsight but was radical at the time. (An earlier paper by Messrs Chambers and Dimson shows that John Maynard Keynes, who managed the endowment of King’s College, Cambridge, was even further ahead of the game, allocating well over half of assets to equities in the 1920s-40s.) A second big shift in endowments’ asset allocation, starting in the 1980s, was from equities to alternatives. That change was led by the big three Ivy League schools: Harvard, Princeton and, of course, Yale.

    Such boldness is aided by a long-term focus. If you have few immediate claims on your purse, you can afford to care less about the day-to-day price of your assets. Only their long-term value really matters. So endowments should be prepared to buy risky assets when they are cheap. And the Cambridge trio find this to be the case. In the aftermath of six major crises, beginning with the panic of 1907, endowments added significantly to their equity exposure. They also lightened their exposure in the run-up to the two big stockmarket busts of the 2000s.

    The endowment approach might be reduced to two injunctions: hold alternatives and be contrarian. But there are other lessons. One is the importance of having the best people. It greatly helps your returns if you happen to have someone of Keynes’s calibre knocking about. Mr Swensen was persuaded by James Tobin, a Nobel-prize-winning Yale economist, to forgo a lucrative career on Wall Street. Canada’s big public-pension funds have been able to implement many of the tenets of the endowment model by paying good salaries. Selecting the right private-equity managers, for instance, requires expertise. And expertise costs.

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    The other big lesson is that, once an investment policy is agreed upon, the smart people have to be allowed to execute it. This comes under the dry heading of “governance”, but it is crucial. It is emotionally taxing to buy risky assets when everyone else is gloomy or to sell them when others are giddy. And, as Mr Swensen’s tale from 1987 shows, an institution with even the longest horizons can be tempted to think short-term.

    *“Seventy-five years of investing for future generations”, Financial Analysts Journal (2020).

    This article appeared in the Finance & economics section of the print edition under the headline “Gifts that keep giving”

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