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The Alternative Reality of the Endowment Model

The endowment model pioneered by Yale University’s David Swensen falls short when it comes to the long-term needs of investors and the economy.

The endowment investment model, which is widespread among university endowments (hence the name), is often flagged as the best-in-class framework for long-term investors. This is an approach to institutional investment that is almost entirely outsourced and seeks to generate high returns through an aggressive orientation toward private equity and other alternative assets. In 2013 the average U.S. endowment had an allocation to alternatives of 47 percent, down from the previous year’s peak of 54 percent but still much higher than a decade before.

The model was pioneered by David Swensen, chief investment officer at Yale University, through the investment policies he implemented at the school’s endowment. Using this model, Swensen managed to generate a remarkable 15 percent internal rate of return over a 20-year stretch leading up to 2007. Because of Yale’s wild success, the endowment model was copied by hundreds (and probably thousands) of other endowments and institutional investors around the world. Although the model remains popular today, some institutional investors now see it as being at odds with long-term investing and perhaps even damaging to the long-term investment challenge (see “Top Returns at Midsize Endowments Challenge the Yale Model”).

Here’s why: The success or failure of this model seems to be based on access to top-­performing managers, as endowments believe that certain managers can and do deliver alpha (returns above a market benchmark). The institutions that have privileged access to top managers see themselves as lucky passengers on an investment return rocket ship powered by hedge funds, private equity firms and other alternative managers. So most (though not all) endowments won’t do anything to rock the boat with these managers. Thanks to this fear of restricted access, the asset managers would seem to hold the power to discipline and influence asset owners. It’s for this reason that many university endowments are more secretive than the most-secretive sovereign wealth funds. They are protecting their external asset managers from scrutiny. In addition, they are protecting themselves from having to inform their stakeholders about how much they are paying in fees (if they even know what they’re paying managers).

And therein lies a fundamental problem with the endowment model: The agents seem to be in charge of the principals.

If your model of investment means you are grateful for simply having access to certain managers, then what influence can you hope to have over the policies of those same managers or the fees they charge, let alone the underlying companies in which they invest? Yes, you can vote proxies and engage in corporate governance, but the truth is you’ve neutered your real power to discipline or even influence the agents that are meant to be operating in your long-term interest.

Moreover, the top-decile hedge fund you invest in is unlikely to consider the long-term issues that are so important to sustainable economic growth. Nor is it likely to push its portfolio companies to embrace long-term value creation if it means short- or even medium-term losses. It’s not in the manager’s interest to do so for one simple reason: time.

The rewards from taking a long-term view — such as that required for mitigating environmental degradation — won’t be reaped by long-term investors for decades. This means, of course, that private managers aren’t interested or motivated to focus on them.

University endowments, however, have a different time horizon. They have the ability to look ten to 20 years out and think about how best to position their portfolios for future scenarios. But if those long-term endowments are chasing superstar managers that aren’t interested in long-term issues, it’s quite unlikely that the long-term issues will play a role in the finance and investment ecosystem.

What many institutional investors are asking today is this: Can an investment model that relies on short- to medium-term intermediaries that are immune to influence or even discipline ever hope to be a part of the plan for driving long-termism? I’ll be less diplomatic and suggest that the endowment model may be complicit in the endemic short-termism we see today. Most endowments have sacrificed their long-term competitive advantage at the altar of alpha. And that creates lots of unintended consequences in the real economy.

Also, it should be noted that although endowments’ returns are good, they can be reproduced and even topped by other models that are better rooted in the real economy, especially on a risk-adjusted basis.

See also Ashby Monk’s feature, “The New Dawn of Financial Capitalism.”

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