In the period following the global economic crisis of 2008–09, college and university endowments’ investment returns have exhibited considerable volatility. Some observers have questioned the validity of the “endowment model”—an investment approach characterized by a highly diversified portfolio and a willingness to accept illiquidity in pursuit of higher long-term returns—as strong U.S. stock market performance has enhanced the investment results of less-diversified, typically smaller, endowments. In this article, we review the results of the FY2013 NACUBO-Commonfund Study of Endowments® (NCSE) and set them in a longer-term context, examining their significance for endowments of varying sizes.
College and university investment committee members would probably like to mint a series of years like fiscal 2013. While it was not the highest-returning period of recent years,* at 11.7 percent (net) the fiscal year’s results generated more than enough to cover spending, inflation, and fees, leaving the excess return to be stored away for posterity.
Return data were among many findings to emerge from the 2013 NCSE, which compiled investment management and governance data from 835 colleges and universities for the 2013 fiscal year (July 1, 2012–June 30, 2013). The FY2013 return represented a strong rebound from the -0.3 percent return reported by study participants for FY2012.
Beyond the return generated in any single year for the continuing support of mission, what is significant is the trends that emerge when comparing data over several studies from recent years.
The NCSE—the largest and most comprehensive study of its kind—is conducted annually by the National Association of College and University Business Officers (NACUBO) and Commonfund Institute, the education and research arm of Commonfund. The NCSE analyzes a broad range of data from private and public American colleges and universities and institutionally related foundations. The 835 institutions participating in the current study represented $448.6 billion in endowment assets as of June 30, 2013.
Certainly, educational endowments benefited from a tailwind over the course of the fiscal year. The domestic economy continued to recover, albeit at a moderate and, at times, choppy pace; corporate earnings continued to grow; the “Industrial Renaissance” in the United States took hold; and, perhaps most important, the Federal Reserve kept short-term interest rates at record low levels while continuing to inject liquidity into the financial system through its bond-buying program. Investor optimism could not be slowed by political gridlock in Washington, fears of a softer economy in China, and continuing fiscal and economic woes in the euro zone. As a result, the S&P 500 Index advanced 20.6 percent over the fiscal year, followed by a 17.1 percent gain for the MSCI World ex-U.S. Index. In the record low-interest-rate environment, bonds were out of favor and the Barclays Aggregate Bond Index declined 0.7 percent. Commodities also lagged, as the Dow Jones Commodity Index returned -8.0 percent.
Differences in returns narrow across endowments of all sizes
One of the more interesting findings to come out of the study was how tightly compressed portfolio returns were across participating endowments of all sizes. In FY2013, as in previous studies, data were reported and grouped by endowment size and type of institution. There are six endowment size groupings, ranging from institutions with endowment assets under $25 million to those with assets in excess of $1 billion.
In most previous studies, larger endowments tended to report the highest returns. This return gap has been attributed to these institutions’ larger allocations to less-liquid alternative strategies (and their ability to access top-tier private capital and hedge fund managers); greater portfolio diversification with an equity bias; and deeper resources, including internal staff, leading-edge information technology, and trustees with experience in financial markets. It was not unusual to see data correlate across the six size cohorts—i.e., the larger the endowment, the higher the return. For example, the following are one-year returns from the Commonfund Benchmarks Study® Educational Endowment Report for FY2004, followed by 10-year returns from the NACUBO Endowment Study for FY2007:**
In FY2004, there was a 460 basis point (4.6 percentage point) difference between the one-year returns of the largest and smallest endowments. Looking over a longer horizon, in FY2007 the 10-year difference, while smaller, was still a substantial 440 basis points.
In the years following FY2007, the historic edge in performance held by larger endowments began to erode. This may be seen in two very different investment environments: the bear market year in FY2009 and the recovery in FY2010.
In FY2009, all size groups reported losses on average, but the largest endowments underperformed the smallest by 370 basis points, reversing the historic trend. In FY2010, they outperformed, but only by 60 basis points.
In the FY2011 study, the spread between largest and smallest widened briefly, rising to 250 basis points, but in FY2102 the relationship between asset size and return disappeared entirely, with a gap of only 50 basis points between the largest and smallest endowments but a larger difference of 180 basis points between the highest-performing institutions, at 0.4 percent (over $1 billion), and the lowest, at -1.0 percent ($51 million–100 million).
Thus, while outperformance by the largest endowments has tended (with the exception of FY2009) to persist over time, there has been a significantly narrower return distribution across the size cohorts in recent years. But this is largely a feature of the post-crisis world. Taking the longer view, over the 10-year period from FY2004–13 that includes the crisis and recovery, the more-diversified endowments over $1 billion have reported investment results that are a healthy 200 basis points above those of the less-diversified smallest endowments.
Return spreads remain tight in FY2013
Returning to our analysis of one-year results, the trend of a smaller range in returns remained in place in the NCSE for FY2013. The difference in returns across the six size cohorts was 60 basis points, ranging from a high of 12 percent for institutions with assets between $501 million and $1 billion to a low of 11.4 percent for institutions with assets between $25 million and $50 million.
This shows up in long-term returns as well. Participating institutions’ trailing three-year returns averaged 10.2 percent and, like the FY2013 returns, were separated by just 60 basis points from high to low. Trailing five-year returns averaged 4 percent, with the return spread widening to 110 basis points. As we have seen, however, over the trailing 10 years the return gaps of earlier years have the effect of widening the spread. Ten-year returns averaged 7.1 percent, with a 200-basis-point spread from high to low.
Asset allocation affects return patterns
What’s shaping the recent trend of spread narrowing? The answer lies in one of the other key subjects on which the annual NCSE focuses: asset allocation. One factor, which has already been mentioned, is smaller endowments’ higher allocations to fixed income, which served as an anchor to windward in the financial crisis. While participants in the FY2009 study reported an average loss of 25.5 percent in their domestic equity allocation, their fixed-income allocation produced a positive return of 3 percent.
Returns were uniformly negative for all size groups in the FY2009 study. But endowments with assets under $25 million were buffered somewhat because of their 27-percent fixed-income allocation. This compared with just 10 percent for endowments with assets over $1 billion, with the other four size cohorts’ fixed-income allocations falling between the two. In addition, in FY2009, endowments with assets under $25 million reported a 9 percent allocation to short-term securities/cash/other, versus 3 percent for institutions with assets over $1 billion. In the most recent report, for FY2013, the difference in the fixed-income gap actually widened. Endowments with assets over $1 billion lowered their allocation by two percentage points to 8 percent, while endowments with assets under $25 million reduced their allocation one percentage point to 26 percent.
Another factor behind the tighter return spreads is smaller endowments’ larger allocations to publicly traded domestic equities. Beginning in early March 2009, public equity markets entered into a five-year bull market. This made it difficult for alternative assets to keep pace. The following table summarizes returns for selected asset classes and strategies over the past 10 years:
Domestic publicly traded equities have outperformed other asset classes and strategies in recent years. In FY2013, institutions with assets under $25 million benefitted from this trend, as they allocated 43 percent of their portfolios to domestic equities versus just 13 percent of the assets of endowments with assets over $1 billion (with all other size cohorts falling in between). An even wider disparity emerged in the allocation to alternative strategies; here, endowments with assets under $25 million reported an allocation of 11 percent for FY2013 versus 59 percent for endowments with assets over $1 billion. The performance of international equities had relatively little impact on the performance differences by size cohort, as allocations did not vary as widely. For example, in the study for FY2013, endowments with assets over $1 billion allocated 17 percent of their assets to international equities compared with 14 percent for endowments with assets under $25 million.
For the most part, the disparity in performance lessened as the timeframe lengthened. That was most notable in private equity. As the index table above shows, although this strategy produced a strong 16.5 percent return in FY2013, it was topped by exceptional performance in the public equity markets. Over the past 10 years, however, private equity produced the highest average annual return. The two public market indices were within 60 basis points of each other for the period.
Conclusion
In years past—and, more recently, from 2006 to 2008—more-diversified portfolios handily outperformed those that were less diversified. In FY2009, those positions reversed, with less-diversified endowments losing less than their more-diversified counterparts. Since then, portfolios with relatively high allocations to domestic equities and fixed income have continued to perform better than expected. That is contrary to investment theory and to past experience prior to the 2008–09 global economic crisis. It has led some commentators to claim that highly diversified portfolios, with their large allocations to alternative investments, are not required for investment success.
That conclusion may be premature. A few years’ experience is not sufficient to make a final judgment, and it is unwise to declare that principles whose veracity has been confirmed over many years no longer apply. Moreover, since the financial crisis, investment markets have operated in a policy environment strongly influenced by the Federal Reserve in America and central banks throughout the rest of world.
Looking at 10-year trailing returns, more-diversified endowments have delivered better returns. As of June 30, 2013, the trailing 10-year returns for endowments with assets over $1 billion participating in NACUBO/Commonfund studies averaged 8.3 percent versus 6.3 percent for endowments with assets under $25 million. And returns were correlated with size and diversification across the six size cohorts—the larger and more diversified the endowment, the greater the 10-year return.
Finally, it is worth noting that while we have analyzed these results in the context of endowment size, the relevant differences lie in the asset allocation choices and resources available to each institution. In this sense, while larger institutions obviously have some advantages that cannot be matched by smaller ones, the policy choices that can be made—within the scope and resources available to each—are similar.
Notes:
*That honor goes to the NCSE for FY2011 at a 19.2 percent return.
**These studies are the predecessors to the NCSE; NACUBO Endowment Study size breaks are slightly different from those used in the NCSE.
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