The legendary David Swensen took over Yale University’s endowment in 1985 when it was worth $1.5 billion and grew it to $31 billion. He revolutionized endowment investing and recently passed at the age of 67. Is there a place for the retail implementation of an endowment investing approach?
The demonstrated outperformance of some endowments, especially Yale, naturally begs the question of its applicability in a retail setting. Although some aspects of endowment style investing are transferable, there are factors unique to retail investors that we need to be aware of while considering implementations of this approach. A financial endowment is a transfer of money or property donated to an institution, usually with the stipulation that it be invested, and the principal remain intact for a defined time period. Endowments have limited liquidity needs, significantly long investment horizons and the ability to pursue less liquid asset classes more aggressively. In contrast, individuals have higher liquidity preferences and a finite investment horizon that is closely linked to one’s particular unique circumstances.
The goal should not be to simply copy the leading university endowments for these differ from individual investors in many important respects. Here is why.
Liquidity needs for traditional endowments are vastly different than for individual investors. Endowments and the institutions they benefit are managed on the basis that they will exist in perpetuity. As a result, liquidity is not a major priority as the endowment is tasked to provide enough inflation-adjusted annual income to support operations. These distributions are determined by very specific spending policies. Because these limited spending policies dampen the consequences of portfolio volatility, portfolio managers gain the freedom to accept greater investment risk with the expectation of achieving higher returns without exposing the institution to unreasonably large probabilities of significant budgetary shortfalls. Individuals do not operate in this manner. They have a limited life span and spending needs can be highly uncertain, thereby resulting in very different liquidity preferences. In a retail application, advisors tend to address individual liquidity needs through four, and perhaps more, mechanisms:
a) An increase in allocation to investments in liquid absolute-return alternative mutual fund and hedge fund like vehicles;
b) Use of a tender process to control and dampen the volatility associated with uncontrolled redemption pressures;
c) Letters of credit to meet temporary shortfalls in liquidity in the case of private bank sponsors; and
d) Utilization of subscriptions to offset redemptions.
These mechanisms are not needed in a traditional endowment, but are essential components in a retail setting.
Traditional endowment portfolio fiduciaries place asset allocation at the heart of the investment process, emphasizing policy portfolio decisions over market timing and security selection activities. Satisfaction of long-term institutional goals depends in large part on the underpinnings of successful asset allocation: an equity bias to provide high returns, and diversification to produce an acceptable level of risk. In a retail setting, however, individual client needs necessitate the re-tooling of the purist endowment model to meet liquidity preferences and finite time horizons.
Pricing & Valuation
Another major issue in a retail platform is pricing. Endowment trustees do not manage their portfolios on a month-to-month basis. As such, the reliability of an NAV in any given month is not of critical importance. However, in a retail solution, the need to produce reliable NAVs is crucial if one is to drive a successful client experience. Even when a reporting procedure is decided, fund sponsors are burdened with the challenge of striking a reliable NAV each month. Retail investors and their advisors would rightfully ask questions such as “are they averaging up or averaging down? How will the NAV be adjusted to reflect this and at what intervals?” These are very practical questions that one must be prepared to answer. Unreliable, pro-forma NAVs undermine the client service experience so essential in the retail segment.
Valuations of portfolio assets also present another hurdle. The combination of liquid and illiquid asset classes in the traditional endowment make accurately valuing such assets very difficult and costly. Traditional endowments have vastly different investments across an unlimited time horizon with different risk and return characteristics. Trustees are well aware of this fact as policy portfolios are constructed to take this into account. In contrast current and precise valuation is of particular importance when the retail investor has to undergo tax and/or estate planning – issues endowment trustees do not have to grapple with.
A corollary to the pricing and valuation issue is investor transparency. Because of the highly illiquid and proprietary nature of endowment portfolio investments, it is exceedingly difficult to ascertain precise allocations. Underlying manager secrecy, in the retail world, can create information asymmetry between investment advisors and their clients – something that is frowned upon.
Taxation and Tax Reporting
Endowments do not pay income tax. Taxation and tax reporting are concerns that retail investment advisors and their investors are not only tasked to do, but obligated to perform under state and federal laws. Folks invested in alternatives already accept a delayed K-1 due to private equity investments. The addition of real assets, such as land and timber, oil and gas, would delay this mandatory reporting even more which has the possibility of eroding valuable client relationships. Of particular importance in regards to taxation is the generation and subsequent reporting of income sourced via investments in multiple states. A high level of transparency is needed, especially in regards to real estate and private equity investments, to identify income earned for nonresident partners. Investors need to know two seemingly basic facts: a) do they need to file a composite return? and b) are multiple state filings required? This issue is not a significant concern to educational endowments due to their tax exempt status, but can have major operational implications for investment advisors that have to determine this in the most timely and efficient way possible.
Endowments, given their large size can negotiate special arrangements with investment managers. Retail investors, unless they are part of aggregated pools in feeder vehicles cannot usually have access as well as strike preferential agreements with product sponsors.
In theory, universities can live forever and therefore have a much longer investment horizon than an individual. Harvard, for instance, has been around since shortly after the Pilgrims landed on Plymouth Rock. Because of that longer view, elite endowments typically depart from the traditional liquid stock and bond mix by allocating a significant portion of their assets to less liquid, often non-publicly-traded alternative investments such as venture capital, private real estate, managed futures, natural resource partnerships as well as oil and gas.
This piece explored the applicability of an endowment style approach to investors in the retail investing space, discussed specific issues unique to retail and suggested how multi-asset class model portfolios may be constructed. Understanding the differences between endowments and individual investors allows discerning advisors to determine the tools, vehicles and techniques that can successfully translate the success of endowment investing down to the household level – thereby better addressing retail investors’ special investing needs. In general, for the reasons outlined earlier the endowment approach is not easily transportable to retail investing.
Author: Sameer Jain
Lightly excepted from a previous article by the author “The Household Endowment Model – Adopting Lessons Learned from the Nation’s Top Education Endowments”