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Why foundations generate below-average returns.

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Foundations have a special investment style that has proven itself over many years in early market phases. Alternative investments were and are an important part of this style. However, their role has changed considerably over the last 20 years.

Figuratively speaking, large foundations and pension funds can be compared to tankers on the high seas: they have a clear objective, are on a direct, previously calculated course and are usually heavily loaded - in other words, almost fully invested. This means that in the event of turbulence, the course taken cannot be changed quickly. Instead, they rely on their investment process, due diligence and the diversification effect. This allows them to weather even severe storms on the markets, as previous experience has shown, before returning to calm waters.

However, the forces of nature on the markets are quite different from those on the high seas - and far more difficult to calculate. Just how challenging the environment really is was illustrated by a paper recently published by Richard M. Ennis entitled "Endowment Performance", which documents recent underperformance by foundations. [1]

The investment style of foundations

According to the study, there are recurring elements that are common to various foundations in their investment style. In addition to a general tendency towards value investing, there are the following three points in particular: [1]

The investment style of foundations:

Active management: The (assumed) ability of investment managers of foundations to identify and exploit special expertise in target funds. According to the paper, large foundations usually rely on a large number of different target investments, of which passive products account for only about 6 percent on average. The willingness to pay for the perceived skills of external managers is particularly evident in the considerable proportion of cost-intensive investments, for example in hedge funds.
Focus on equities: The view that equities in particular should determine the allocation is widespread among investment managers of foundations. However, the proportion of shares varies depending on the size of the overall portfolio: large foundations have an average effective equity exposure of 72 percent, while small foundations have 63 percent.
Private Equity / Debt / Real Estate: Private markets are another focus of many investment managers of foundations and their advisors. It is often assumed that these markets offer good diversification and that experienced managers can benefit more from them. In addition to hedge funds, this is the alternative component of the portfolio.

This roughly defined investment style of foundations has achieved very good results in the 1990s and at the beginning of this century. Market participants' perception of it was high, so that this style has met - and in some cases still meets with - sustained interest among investors worldwide.

excess returns of large endowment composite
Figure 1) Excess returns of the Large Endowment Composite
Shown are the excess returns of a selection of large university foundations. These experienced a heyday with their investment style until 2008. However, this was followed by a clearly recognizable paradigm shift.
Source: Ennis, R. M. (2020), Endowment Performance, p. 16

Long-term returns

Let us return to the underperformance mentioned at the beginning. In his study, Richard Ennis looks at 43 large foundations in the period from June 2008 to June 2019, which manage more than USD 1 billion. He examines these foundations in comparison to individually defined benchmarks. As a result of his regressions, he obtains alphas that range between -3.56 and + 2.07 percent. While none of the positive alphas are statistically a significant positive, about one in four negative alphas are significant. The author concludes from this that large foundations clearly underperformed their benchmarks in the period under review. [1]

This result is also confirmed in the long-term study by Dennis Hammond, which analyzes the entire available data period on the performance of university foundations of 58 years. [2] According to the study, foundations achieved an average annual return of 8.5 percent, which is worse than the traditional 60/40 benchmark of stocks and bonds, which achieved 9.3 percent per year. The large foundations still performed best overall. This could be due to the fact that - unlike small foundations - they have better or even exclusive access to the really profitable target investments and/or can enforce lower fees.

Other points of view

However, there are also other voices. This is mainly due to the fact that the assessment of under- and outperformance can depend on both the benchmark and the time horizon. Hossein Kazemi of the University of Massachusetts argues that an appropriate benchmark is not always used. Instead of a US benchmark, which has been difficult to beat anyway due to the high returns over the past 20 years, a benchmark must be used that also includes international equities - after all, these are usually an essential component of portfolios. In addition, cash holdings are often not taken into account. Although this is small in most cases, it does have a systematic influence. Taking these aspects into account, the average returns of foundations since 2000 - including the eight good years until 2008 - have been above the benchmark, according to Kazemi. He also points out that classic alternative investments, which are increasingly used by foundations, have performed well overall over the past 20 years. [3]

Alternative Investments

As an explanation for the observed underperformance, however, the study by Richard Ennis uses precisely these alternative investments - i.e. hedge funds and investments in the private markets already mentioned. This is initially in contradiction to the advantage often described by representatives of alternative investments, that they would offer better risk-adjusted returns and diversification potential.

But the argument carries weight. Another study by the author examines which asset classes actually contribute to diversification. 4] For this purpose, these are added step by step as explanatory variables to a regression model and the corresponding statistical variables - specifically the coefficient of determination and the standard error of the regression - are calculated in parallel. This is used to check how well the returns are explained in the model.

The results illustrate the paradigm shift. In the period from July 1999 to June 2008, alternative investments had a significant diversification effect: by adding them to a portfolio of stocks and bonds, for example, the coefficient of determination increased from 0.66 to 0.97. But since July 2008, the diversification effect has been almost negligible. Here, the coefficient of determination was 0.99 if global equities and bonds are included, which means that the returns of the foundations could be almost completely explained by these two asset classes alone. According to the author, the same pattern is also found in the returns of public pension funds during this period. [4]

Figure 2) High correlations (July 2008 to June 2019)
Source: Ennis, R. M. (2020), Endowment Performance, p. 12

These are amazing results. Although the portfolios of many foundations have a significant proportion of alternative investments, returns can be explained by only two variables, global stocks and bonds. Specifically, the selection of large university foundations examined by the author during the period under study can best be described by a benchmark of three indices with the following weightings: 53 percent Russell 3000, 17 percent MSCI ACWI ex US and 30 percent Bloomberg Barclays Global Aggregate Bond. [4]

Although the portfolios of many foundations have a significant proportion of alternative investments, returns can be explained by only two variables, global stocks and bonds.
Ennis, R. M. (2020), Institutional Investment Strategy and Manager Choice: A Critique, Journal of Portfolio Management – Manager Fund Selection 2020, S. 104-117

Why are the correlations so high?

The crucial question at this point is: Why have the correlations increased so much that almost all diversification potential is destroyed?

Richard Ennis also has a plausible answer to this question. According to him, the alternative asset classes have changed dramatically since the 1990s: The extremely high inflows of funds have led to a multiplication of the originally small investment niches in hedge funds and private markets. Today, for example, real estate accounts for around 40 percent of the assets of listed companies. This means that their cash flows and valuations are factored into share prices. Or to put it another way: if you buy a stock ETF, you also get a large chunk of implicit real estate investment. But this also means that the returns of private real estate have become increasingly correlated with those of the stock market over time. The same is true for private equity and private debt, which in a similar way have increasingly correlated with the broader stock market. And even with hedge funds - apart from special sub-strategies - increasingly high correlations with classic, actively managed equity funds can be observed. [5]

The costs

Apart from the lack of diversification potential, however, the classic alternative investments have one thing above all: a cost problem. In his paper "Endowment Performance" Richard Ennis estimates that the costs of near-market portfolios - depending on the mix of equities and bonds as well as active and passive investments, portfolio turnover and investment volume - are between 0.5 and 0.7 percent per year. For alternative investments, the costs are much higher and can be as high as 2 to 4 percent. Therefore, the average costs of a foundation can ultimately amount to 1 to 2 percent, which is an unnecessarily high value for a diversified portfolio. [1]

Instead of the extra diversification and extra returns of the past, alternative investments today - to put it somewhat exaggeratedly - only seem to deliver extra costs. At least that is how Richard Ennis sees it. In his paper, he mentions an underperformance of the examined selection of large university foundations compared to the passive benchmark of 1.6 percent and of one percent for public pension funds. [1]

pension funds total return vs. allocation to alternatives
Figure 3) Pension funds: total return vs. share of alternatives (July 2008 to June 2018=
The chart shows the returns of public pension funds as a function of their allocation to alternative investments. There is a statistically significant negative correlation that speaks against classical alternatives.
Source: Ennis, R. M. (2020), Institutional Investment Strategy and Manager Choice: A Critique

The conclusion is therefore to avoid alternative investments as they are mainly a burden. The funds freed up can be invested in very cost-effective index products, which considerably and permanently reduces the average cost burden. In the simplest case, three instruments are sufficient for this purpose, which, in addition to the broad US stock market, map the international developed and emerging markets and a global investment-grade bond index. Large institutional investors can obtain this allocation for "costs" in the low single-digit basis point range. In a world where many competitors pay between 1 and 2 percent, this is a competitive advantage that maximizes the probability of achieving a higher return than the peer group - or in other words, strategically "winning" markets in a loser's game of largely efficient markets.

Due to a lack of diversification effects and the high costs of alternative investments, it is likely that the vast majority of foundations and pension funds that stick to their previous investment style will continue to underperform in the coming years.

[1] Ennis, R. M. (2020), Endowment Performance, (accessed 09.09.2020)
[2] Hammond, D. (2020), A Better Approach to Systematic Outperformance? 58 Years of Endowment Performance, Journal of Investing, Vol. 29, Nr. 5, p. 6-30
[3] Segal, J. (2020), All Those Studies Showing Endowments Lost to 60/40? Cherry-Picked Data, Academic Says,, accessed 09.09.2020
[4] Ennis, R. M. (2020), Institutional Investment Strategy and Manager Choice: A Critique, Journal of Portfolio Management – Manager Fund Selection 2020, p. 104-117
[5] Asness, C. (2018), The Hedgie in Winter, Cliff’s Perspective, AQR Capital
[6] Peng, J. / Wang, Q. (2019), Alternative Investments: Is it a Solution to the Funding Shortage of US Public Pension Plans?, Journal of Pension Economics and Finance, p. 1-20

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