The Endowment Strategy: How to Build an Armor-Plated Portfolio
The year was 1985, and David Swenson of Yale University was about to change the world. The investment community had no idea that a new strategy was under development that would change the way that those in charge of university endowment funds thought about how they could invest university funds.
How Funds were Handled Before
When Swenson began to develop his strategy, the funds that Yale invested were generally about 80 percent U.S. stocks and bonds, with the remainder being cast about between foreign stocks and equities. Swenson looked at this and felt like Yale’s funds were too heavily invested in equities and real estate, and he wanted to change that. His plan? To start placing more funds in private equity investments, absolute return hedge funds, and other diversified assets.
The change was a break from traditions and norms, but it was also a move that is now respected and imitated by many different types of funds all across the country and the world. It is not often the case that one individual shifts the way that the entire investment community makes decisions as much as the actions of Swenson clearly did. This strategy would become known as the endowment strategy, and it has only strengthened and become more widespread since 1985.
Why is the Endowment Strategy so Respected?
There are a few characteristics of the endowment strategy that have earned it such respect from the broader investment community. The most important part of what the endowment strategy offers investors is the opportunity to earn consistent and strong returns. Wealthmanagement.com admits that the short-term results might not always be as pretty as other strategies, but it comes out better than most in the long run:
While it may not always deliver the best investment results in the short term, over a reasonable time frame, the endowment model has consistently produced strong risk-adjusted returns with less volatility than most any other investment approach. As a result, over the past several decades, the endowment model has essentially become the standard portfolio model for nearly all sizable institutions, including large college endowments and pension funds.
Most universities want to protect their endowment funds as effectively as possible, which means looking for a strategy to keep their funds relatively safe. Also, just like everyone else, endowments would like to see their capital increase over time as they invest. However, consistency is the key when it comes to endowment funds. It is certainly something that plenty of individuals are also on the lookout for when examining what they should put into their investment strategy.
To create a more consistent performance, the endowment strategy seeks to break away from the 80/20 model relied upon in the past. Instead, this method seeks to leverage opportunities that are beyond the US and foreign equity markets. Instead, it works to place funds into more diverse and alternative investments than what was done before. Instead of being held largely by the whims of the equity markets alone, the endowment strategy allows for a diversified investment portfolio.
Changes in the Economic Landscape Provide Greater Opportunities
There is no question that the economic landscape has changed since 1985 and before. At that time, it might have seemed fairly reasonable to invest heavily in U.S. markets and leave only a small portion of funds invested in foreign markets. However, many things have changed, and we must look at some of those changes, including:
- More Transparent Trade Policies – The trade policies negotiated throughout the world are now more transparent and more open than they ever were before. Most countries feel more comfortable and more included in the wider global community than they might have felt before. Thus, there are more open lines of communication between countries than ever before. This means that investors can trust their funds in more foreign markets than they could have in the past.
- More Markets are Democratized – There are more investment markets than ever before that are democratized for retail investors to take the leap and start investing in them. This means that a greater number of players are invited into the markets with wide open arms. This adds to the liquidity of various markets, and it means endowment funds are more interested than ever before in placing their funds in more diverse markets. Markets that were once locked off for only the most elite of investors to play around in are now opening up to a greater extent, and endowment funds are happy to participate.
- A Great Appetite for Alternative Investments – There is a greater appetite for alternative investments, particularly among younger investors. Hard-hitting issues such as record-high inflation are causing many investors to scramble and look for alternative investments that potentially provide an outsized return. It is the only way to beat inflation and watch an investment fund continue to grow despite the headwinds.
These are just a few of the reasons why universities across the country and even many individual investors are now using the endowment strategy to produce strong and consistent results for their portfolios. The longevity that this specific strategy has enjoyed is a testament to how much investors believe in it and the kind of results that they have seen from it in the past.
How do University Endowment Funds Operate?
Wait, you might ask yourself how a university endowment fund works in the first place. These funds are something that we hear about regularly, but most of us are blissfully unaware of what they really mean.
Investopedia provides this simple definition of what an endowment fund is:
University endowments are comprised of money or other financial assets that are donated to academic institutions. Charitable donations are the primary source of funds for endowments. Endowment funds support the teaching, research, and public service missions of colleges and universities.
As good stewards of those funds, universities will attempt to invest the money into profitable investments. These funds and the people who manage them cannot do whatever they want to do. Instead, they must follow the specific legal structure that they have set up for them. Generally speaking, it is common for an endowment fund to be set up with specific guidelines to invest in long-term and stable investments. Those rules also cap how much risk an endowment fund may take on.
Colleges and universities intend to use the capital that they gain from the investments that they make to fund ongoing operations. In addition, they might also use the funds to supply cash for scholarships, fellowships, and more. Many colleges pool all of the endowments that they receive into one giant endowment fund that allows them to maintain a steady investment approach across all of the entire endowment fund.
Which Universities Have Some of the Largest Endowments in the United States?
The universities with some of the largest endowments in the United States are the envy of every other college and university. The reality is that the largest endowments belong to some of the most prestigious universities in the country, and they often dwarf the funds available at other universities. Not surprisingly, Yale University, where David Swenson started the endowment strategy, is on the list of top university endowments by size. There are others that join them on that list, including:
- Harvard University: $53.2 billion
- Stanford University: $37.8 billion
- Princeton University: $37.0 billion
- Massachusetts Institute of Technology (MIT): $27.4 billion
- University of Pennsylvania: $20.5 billion
- University of Notre Dame: $18.4 billion
The list goes on from there. For the record, Yale comes in at second with $42.3 billion in its endowment fund. Every one of these universities is extremely privileged to have earned a spot on this list, and they are all in a great financial position to add even more to the programs that they fund.
Based on the most recent statistics, it appears that endowment funds have continued to outperform the markets. Although endowment funds fell by a median of 10.2% in 2022, that was still a better performance than the loss of 19.4% by the S&P 500 over the same time period. It might not have felt like a win for the endowment funds, but outperforming the markets is always a sign of strength regardless of the total numerical performance. A drop of 10.2% is still better than the market overall, and that is all that matters at a time like this.
The world of endowments is an interesting and complicated one. The strategies initially developed by David Swenson have been expanded on and used time and time again across various universities and even by some individuals. The strategy has a long track record of winning, and the people and endowments that use it can generate impressive returns for themselves.
Here at Infinium, we fully embrace the concepts and spirit of the Endowment Strategy. Please be in touch if you would like more information on this very important portfolio construction method.
Mark is a +24 year financial advisor veteran and Certified Financial Planner™. He founded Infinium in 2009 to bring a more personal, and truly client-centric offering to investors.