Endowment-style investing is an asset allocation methodology that seeks to generate high risk-adjusted returns with lower volatility by expanding the number of asset classes and strategies used to create a portfolio.
Rather than just two main asset classes of stocks & bonds (including funds which own stock and bonds) endowments and many wealthy investors have expanded their portfolios to include alternative investments such as real estate, oil & energy drilling and royalties, hedge funds, private equity, private debt, and real assets, in addition to traditional stocks and bonds. This type of investing is most widely attributed to major university endowments such as Yale, Harvard and Johns Hopkins University and, therefore, is often referred to as endowment-style investing.
What is an Endowment?
An endowment represents an institution's investments and is typically organized as a public charity, private foundation or trust. Institutions that commonly have endowments include colleges and universities, museums, hospitals, large specialty clinics and religious organizations. Yale and Harvard endowments have had the most notoriety, both having been very public about their actively managed portfolios, stellar performances and their wide variety of allocated assets. According to their annual reports they will re-allocate in, and out almost entirely from asset-style to asset-style as their advisors recommend.
Why endowments invest in alternative assets?
Over half of the typical endowment portfolio is invested in alternative investment strategies. As of June 30, 2012, the average endowment allocated 52 percent of its total portfolio to alternative investments. Yale University's endowment, widely considered the pioneer in alternative investing, has allocated more than 65 percent of its portfolio to alternative investments.
Endowments have out-performed traditional investments
Large endowments, which have significant allocations to alternative investments, generally outperformed traditional investments such as stocks and bonds over the past 10 years. The figure below compares 10-year investment returns for endowments against the S&P 500 and an investment grade bond index. Notice how the larger endowments held a considerably higher portion of alternative assets and achieved higher returns.
Why have Endowments Outperformed Traditional Investments?
Two factors help to explain the performance gap between endowments and traditional investments:
The alternatives effect
By investing in Non-Correlated, Less-liquid, or Non-Liquid Alternatives, endowments are typically able to construct a higher yielding portfolio with less correlation to the broader markets. Non-Correlated, Less-Liquid or Non-Liquid Alternative assets typically do not have the volatility of traditional stocks, bonds and funds. They don't get caught up in the wild, volatile swings of the stock markets.
The quality of the manager
Illiquid, alternative investments are more difficult to evaluate than publicly traded securities. Skilled managers that are adept at taking advantage of pricing inefficiencies in illiquid securities will have a greater impact on returns than skilled managers operating in the public markets, where price inefficiencies are fewer in number and there is generally less return potential.
Why don't individuals invest more heavily in alternatives?
While many institutions invest heavily in alternatives to build diversification, stability and generate higher returns, most individual investors have historically lacked access to alternatives due to, among other things, high investment minimums. Over the past several decades this has changed.
Investor access to popular alternatives has improved
Individual investors have longed for higher income, better overall returns, more stability and less volatility, however a small percentage of financial advisors have these asset classes available to their clients. Typically, the largest investment companies, wire-houses and broker-dealer firms do not have these popular assets. Could this be because the larger firms make their money in selling stocks and bonds to their clients, then a short time later trading that same dollar out of the first stock into another, then another then another. Could it be because the largest firms make their money by taking companies public, and they need customers to sell this stock to?
With 37 years' experience in financial and estate-planning, wealth preservation and wealth transfer, Scott has been a popular speaker to groups of attorneys, CPAs, financial and estate planning professionals. He provides continuing education to attorneys and CPAs and has presented at the Florida Bar Tax-Section annual conference, and their 1-hour March CLE teleconference.
Scott L. Olson can be reached at Scott@AtlanticFinancialAdvisors.com
Securities offered through Financial West Group - member FINRA/SIPC. Atlantic Financial Advisors, LLC, Registered Investment Advisor not FWG affiliated.
Past performance is not indicative of future results. Not an offer to buy or sell any security. Senior Secured Debt offerings and CLO's only offered by prospectus and like all investments have varied levels of risk. Many Alternative investments are Private Placements and/or Partnerships, may be speculative and are only offered to accredited investors.