Digging into alpha, beta and the endowment model

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View of Yale University in New Haven, Connecticut © Jon Bilous /123RF Stock PhotosTo gain alpha, institutional investors have many avenues. For large investors, the endowment model has traditionally worked well. However, it can lead to overdiversification and pose challenges for smaller investors looking to replicate the model, according to a new paper.

In the endowment model, also known as the Yale model, large endowments typically outsource the management of their funds, tend to be heavily invested in alternative assets and have access to the top-quartile managers, says Michael Karris, president and chief investment officer of EndowBridge Capital and author of the paper. However, smaller plans may be chasing Yale-like returns without access to the same managers or resources.

Karris was the former director of investments for Columbia University’s endowment fund. “After I left Columbia University’s endowment, I pretty much decided to create my own firm and offer a strategy that could help smaller endowments and non-profits,” he says.

For institutional investors with limited resources, the use of alternative assets and beta can help get the best of both worlds, the paper said, noting mid-sized investors may be better off with a liquid beta core and illiquid alternative assets, whereas smaller investors can use index portfolios to achieve alpha.

The paper compared three decades of performance, looking at endowment funds, U.S. public pension funds and index funds.

It found that, in the period including the dot.com bubble, endowments strongly outperformed diversified 70/30 index portfolios because of well-timed venture capital exits. Specifically, in 2000, large endowments, on average, delivered the single greatest year of alpha compared to the 70/30 index funds, the paper found. And large endowments also outperformed these funds during the years leading up to the 2008 recession.

Even in the period between 1999 and 2009, the endowments still performed very well.  However, endowments’ annualized risk-adjusted returns were slightly lower, with major losses in 2009 offsetting the gains of the 2000.

In the more recent 10 year-period, from 2008 to 2018, many U.S. public pensions, endowments and index portfolios delivered good results, but so did beta portfolios, it noted.

Although endowments have proven successful, other institutional investors may struggle to replicate the complexity of that model since limited resources are available to navigate illiquidity, there’s less transparency and higher fees and due diligence is required to maintain diversification, the paper said.

These investors can use beta to create alpha. “There’s this misconception in the industry that index funds are synonymous with average returns and, therefore, some institutional investors shy away from it,” says Karris. “That’s probably why they also pursue an endowment model portfolio because they want to look like Yale’s portfolio with the hope of achieving similar returns. But oftentimes, they fall short, underperforming even a basic benchmark, sometimes with higher risk. And I think that a beta approach — or either a 100 per cent solution or hybrid solution — can actually probably improve their performance, alleviate the due diligence burden and improve on the complexities that an endowment model burdens a smaller investor with.”

Although beta funds can generate alpha, the paper cautioned they can’t replicate the benefits of alternatives, so it would be unwise for the top endowments to completely replace alternatives with beta. Instead, it suggested they use it for a portion of their portfolios, which some already do.

As well, for some institutional investors, the paper noted the endowment model shouldn’t be replaced with actively tilted beta portfolios because it continues to work. “People often make the comparison to like, ‘Oh, Harvard or Yale didn’t outperform the S&P 500, let’s just liquidate everything in the portfolio and go 100 per cent stocks,’ which would be just an irresponsible call to make . . . because endowments . . . live off of the five per cent annual payout to subsidize their budgets and they need stability in that,” says Karris. “Stability comes in the form of lower risk.”

Overall, he hopes people reading the paper take away the idea that asset allocation can deliver alpha. “Using index funds can deliver alpha. It may not give you the same potential that some of these alternatives can offer to the mid-sized or some of the larger endowments or the more pioneering ones like Yale, but a large institutional investor can certainly make a more efficient portfolio by using a combination of both alternative and beta positions.”

Updated: Nov. 19 at 10:48 a.m.

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