Optimal Investment Strategies for University Endowment Funds

A growing endowment benefits students, staff and alumni.

According to annual surveys conducted by the National Association of College and University Business Officers (NACUBO), the largest university endowments dramatically and persistently outperform smaller endowments. Not coincidentally, the largest endowments utilize substantially different investment strategies. While some strategies are only available to the largest endowments, many are available to investors of all sizes.

Asset Allocation

The largest difference between high-performing large endowments and lesser-performing smaller endowments is the basic allocation of assets between stocks, bonds and alternative strategies. NACUBO studies show that small universities have roughly three times the exposure to domestic stocks and bonds than that of large endowments. Large endowments, on average, have in excess of 60 percent of their assets invested in alternative strategies, more than five times the exposure of small endowments. Yale University, beneficiary of one of the largest and best performing university endowments of the last 20 years, reports that the shift away from domestic stocks and bonds in favor of foreign securities and alternative assets has resulted in significantly higher expected returns with lower volatility.

Absolute Return

Absolute return strategies make up a large percentage of alternative strategy allocations. The intent of absolute return is to generate positive return regardless of market conditions. This is generally achieved through hedge fund strategies that seek to capitalize on market inefficiencies. Common strategies include merger arbitrage, convertible bond arbitrage, currency carry trades, long-short market neutral and others. Access is usually by way of hedge fund, fund of funds or publicly traded mutual funds.

Real Assets

Tangible assets such as commercial real estate, farmland, timber and infrastructure investments can provide both inflation protection and current income. These are often long-term, illiquid investments by design. Since the investment time horizon for university endowments is potentially infinite, optimal strategies often favor long-term return potential over liquidity. Those entities less able to make long-term commitments can gain exposure to real assets through publicly traded real estate investment trusts, master limited partnerships and other exchange traded products.

Private Equity

While large endowments typically make significant allocations to venture capital (VC) and leveraged buyout (LBO) investments, smaller investors should be cautious. A Wharton School, University of Pennsylvania study shows a significant difference in performance between top quartile private equity (PE) funds and the rest. The bottom 75 percent of PE funds historically perform poorly in comparison to stocks and provide no meaningful diversification. Endowments without access to top VC and LBO firms should be aware that the average reported gains for these strategies are highly skewed by the top tier funds.

References

• National Association of College & University Business Officers: Annual Returns for Higher Education Endowments
• National Association of College & University Business Officers: Asset Allocation for Higher Education Endowments
• Yale University: Yale Endowment 2009
• University of Pennsylvania: Wharton School of Business: The Performance of Private Equity Funds

Resources

• National Association of College and University Business Officers
• Commonfund