Endowment Performance

Richard M. Ennis
Richardmennis.com
Richardmennis@gmail.com
June 25, 2020

 Endowment funds in the U.S., underperform consistently across cohorts of fund size.
Significant underperformance is also observed in cross-sectional analysis of the returns of
the largest individual endowment funds.

 Alternative investments have failed to provide putative diversification benefits post-GFC

and have been a drag on endowment performance.

 Given prevailing diversification patterns, endowments’ investment expenditures of 1-2%

of asset value simply overwhelm the opportunity to exploit asset mispricing.

Abstract

Endowment funds in the U.S., large and small, significantly underperform passive investment.
Moreover, an analysis of the performance of 43 of the largest individual endowments over the 11
years ended June 30, 2019, reveals that none outperformed with statistical significance, while
one in four underperformed with statistical significance. Alternative asset classes have failed to
deliver putative diversification benefits and have had an adverse effect on endowment
performance. Given prevailing diversification patterns and costs of 1 to 2% of assets, it is likely
that the great majority of endowment funds will continue to underperform in the years ahead.

Electronic copy available at: https://ssrn.com/abstract=3614875

Ennis (2020) examined the diversification and performance of large educational endowment
funds and public pension funds in the U.S. over the decade ended June 30, 2018. Alternative
investments were shown to have ceased being the putative diversifiers they were prior to the
Great Financial Crisis of 2008 and to have become a serious drag on the performance of
institutional funds. A composite of large endowment funds underperformed a passive benchmark
by an average of 1.6% per year, and a composite of public pension funds underperformed by
1.0%. Investment costs, which were estimated independently of performance measurement,
approximate the respective margins of underperformance of the institutional composites.

This paper provides further insight into the performance of educational endowment funds. It
updates returns through June 30, 2019. Additionally, using a novel dataset of returns for
individual educational endowment funds, it analyzes those returns in cross section. The paper
attempts to disentangle the performance effects of (1) equity exposure, (2) portfolio size, (3)
degree of reliance on alternative investments, and (4) style tilts. Like the prior work, this paper
underscores the fact that diversification with high cost is a recipe for failure.

THE ENDOWMENT STYLE

We have become accustomed to hearing and reading of “the endowment model.” There is, in
fact, no canonical model for managing endowment funds. There are, however, certain recurring
investment themes often associated with their management. We refer to these themes a bit more
modestly as elements of endowment style. They include:

 Active Management. The ability of endowed institutions to identify and exploit investment
skill is an overarching theme among endowments, which make little use of passive
investments (14% of assets in 2018, according to Greenwich Associates1). Their willingness
to pay for perceived skill is exemplified by their large commitments to hedge funds and
private equity.

 Equity Orientation. The belief that equity investments, broadly speaking, should
predominate portfolio holdings is widespread among endowment managers. That said, equity
exposure varies among institutions, largely based on the size of their portfolios. Large funds
maintain an average effective equity exposure of 72%, with figures of 80% or more being not
uncommon. Small funds average 63% (particulars follow).

 Private Markets. Private markets are a central focus of many endowment managers and
their advisors. They are viewed as riper for exploitation by skillful investors as well as being
a source of diversification. Along with hedge funds, private investments form the core of
what are commonly known as alternative investments, or “alts.” Larger endowments avail
themselves of private market opportunities and other alts to a greater extent than do the
smaller ones.

1
See “2018 U.S. Institutional Market Trends,” Greenwich Associates, January 2019.

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 Value Over Growth. Some observers believe there is, or at least has been in the not-so-
distant past, a bias in favor of value stocks over growth on the part of many endowments.
Any such bias may have lessened as a result of the underperformance of value relative to
growth during the last decade or so.

The endowment style of investing produced superior results in the 1990s and early years of this
century, so much so that it has become a subject of enduring interest among investors around the
world.

LONG-TERM PERFORMANCE

Hammond (2020) reviews the long-term performance of educational endowments. Over the last
50 years the average endowment earned 8.5% per year, compared with 9.3% for a 60/40
passive benchmark, for a shortfall of 0.8% per year.2 The full story, though, is richer, as
conveyed by Exhibit 1. The 60/40 portfolio beat the average in four of the five decades, with the
decade ended 2009 being the sole exception. The decade ended in 2009 coincides with the glory
days of the endowment style of investing. The cohort of large endowments, in particular, enjoyed
an advantage of 460 bps in that decade. Two additional observations may help to provide context
for the results summarized in Exhibit 1. First, the modern endowment investing style was not a
factor in the first two decades (70s and 80s) reported on there; in that era stocks and bonds
sufficed for all. Second, equity exposure, broadly defined, is not a constant across cohorts or
over time. From what we can glean from Nacubo archival data, “60/40” was probably a pretty
good benchmark across the board in the earliest decade.3 Equity exposure began to rise,
however, in the decades that followed, especially among the large endowments. We believe that
this fact largely accounts for the return spread among cohorts in the decade ended 1989, when
equities outperformed bonds by a wide margin and before alternative investments had made real
headway with the large endowments. These results leave us with insight into how investment
practice has evolved over half a century. What remains unexplained is what transpired at about
the time of the Global Financial Crisis of 2008 to cause endowments to lose their steam.

2
Nacubo archival records are the source of returns, which are represented as net of fees. “60/40”
incorporates the S&P 500 for stocks and Bloomberg Barclays Aggregate, or its equivalent, for
bonds in the early years.
3
1974 Nacubo Endowment Study

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 Exhibit 1
Long-Term Performance of Educational Endowments

Decade Large Small 60/40

Ending 6/30 Cohort Average Cohort Passive
2019 9.0% 8.4% 7.7% 10.5%
2009 6.1 4.0 3.9 1.5
1999 14.0 12.9 12.3 14.6
1989 15.0 13.7 12.7 14.8
1979 4.6 4.5 4.5 5.6
Source: Hammond (2020)

PERFORMANCE SINCE 2009

Performance by Size Cohort

We begin our analysis with a comparison of six endowment fund cohorts (774 funds in total)
defined by dollar value of investment portfolio.4 Exhibit 2 provides key statistics for the cohorts.
Note the wide range of practice in terms of the use of alternative investments (as defined by
Nacubo), from 7% of assets for the smallest cohort to 51% for the largest. Exhibit 3 summarizes
the performance benchmarks used and performance results. The start date for the analysis is July
1, 2008. As in our 2020 article, we use returns-based style analysis to establish portfolio
benchmarks, using the quadratic programming technique originated by Sharpe (1988). The
technique enables the analyst to determine which index returns statistically explain the risk-
return characteristics of a portfolio, or a composite of them as in the present case.5 Then we
regressed cohort returns on their respective benchmarks to derive risk-adjusted returns, as
reported in Exhibit 3. The benchmarks fit the returns well, with R2’s that round to .99 and (small)
standard error terms of 0.8% to 1.5%. The (derived) effective total equity allocations are
reasonable on their face, ranging from 63% to 72%. Risk-adjusted returns (alphas) for the
various cohorts fall within a range of -1.1% to -1.8%, with t-statistics of -2.7 to -4.9. These
results are consistent with the findings of our previous paper. A key takeaway from Exhibit 3 is
that risk-adjusted performance of endowments is consistent across cohorts of fund size, i.e.,
there is no evidence of larger funds doing better than smaller ones after adjusting for risk.6

4
Source: Nacubo Endowment Study 2019. While the 2019 Nacubo study reports on seven
cohorts, we combined the Over $100 million - $250 million and Over $250 million - $500 million
cohorts into one (as shown in # 4 in Exhibit 2) for consistency with past Nacubo studies where
only six cohorts are reported. All Nacubo returns are represented as net of fees.
5
The indexes used are Russell 3000, MSCI ACWI ex-U.S. and Bloomberg Barclays Aggregate.
6
We use the term “risk-adjusted return” to describe value added as the intercept resulting from
regression of a composite’s or fund’s return on a benchmark index. The terms “risk-adjusted
return,” “intercept” and “alpha” are used interchangeably throughout the paper. We use “excess
return” to describe the simple difference between the returns of a composite and its benchmark.

Electronic copy available at: https://ssrn.com/abstract=3614875

 Exhibit 2
Nacubo Size Cohorts

Median Asset Average

Nacubo Number Value Allocation to 11-Year
Cohort of Funds (Millions) Alternatives7 Return
1. <$25 M 60 $17 7% 5.58%
2. $25-50 M 93 37 15 5.32
3. $51-100M 152 74 21 5.21
4. $101-500M 280 350 29 5.25
5. $501M to $1B 82 730 38 5.47
6. >$1 B 107 1,987 51 5.94

Exhibit 3
Benchmark Weights and Performance Statistics of
Endowments by Size Cohort for the Eleven Years Ended June 30, 2019

Derived Exposure (%) Regression Statistics

Non- Standard
U.S. U.S. Total Error Alpha Alpha
Cohort Bonds Equity Equity Equity R2 (%) (%) t-Stat
1 37 44 19 63 .988 1.1 -1.14 -2.7
2 33 46 21 67 .994 0.8 -1.52 -4.9
3 33 45 22 67 .993 0.9 -1.49 -4.3
4 30 49 21 70 .991 1.1 -1.69 -4.2
5 30 54 16 70 .985 1.4 -1.81 -3.5
6 28 56 16 72 .985 1.5 -1.46 -2.7

A Limited Value Effect

We test for the presence and possible effect of a value-stock bias, or value tilt. To do so, we
introduced an additional independent variable in the returns-based style analysis to represent the
value factor.8 Exhibit 4 presents results of the analysis. There is indeed an identifiable value
effect evident in the data, and it is most pronounced in the smaller fund-size cohorts. In Cohort
1, for example, 47 bps of 126 bps of negative excess return is associated with introduction of the
value factor. The effect diminishes as fund size increases and disappears entirely for the cohort
comprising the largest funds (#6). The intuition for this may be that funds in Cohort 1 have 46%
of their assets in domestic common stocks, whereas Cohort 6 funds average just 11%. In other

7
Equal-weighted average of underlying institutions’ allocations to alt assets within the cohort.
8
The value factor is defined as the difference between the returns of Russell 3000 Value and
Russell 3000 Growth indexes.

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words, there simply may have been greater opportunity for a value-stock bias to manifest itself
among the smaller funds (which also lack the resources and asset size for all-out investing in
alternative assets).

Exhibit 4
Breakdown of Excess Return Between Value Tilt and Other Sources
for the Eleven Years Ended June 30, 2019

Excess Return

Due to
Other Bets
Composite Benchmark Due to &
Cohort Return Return Total Value Bet Costs
1. Smallest 5.58% 6.85% -1.26% -0.47% -0.79%
2. 5.32 6.90 -1.58 -0.17 -1.41
3. 5.21 6.79 -1.58 -0.23 -1.35
4. 5.25 7.03 -1.78 -0.15 -1.63
5. 5.47 7.42 -1.94 -0.13 -1.82
6. Largest 5.94 7.52 -1.58 0.00 -1.58

Cross-Sectional Analysis of Individual Funds

For the present study, we created a dataset of fiscal-year annual returns and percentage
allocations to alternative investments for 43 endowment funds with assets greater than $1
billion.9 We created a benchmark for each individual fund using the same returns-based
methodology used for the cohort benchmarks. We then regressed individual fund returns on their
unique benchmark. Exhibit 5 summarizes key results. The schools there are ranked in descending
order of alpha.

9
The Nacubo Study reports on seven size cohorts, one of which comprises 107 institutions with
endowments greater than $1 billion in value. However, Nacubo does not identify individual
schools. To create the individual fund dataset, we began reviewing the annual reports of schools
with the largest endowments, starting with Harvard University. We soon discovered that many
either do not report endowment fund returns, do not report the 11 consecutive returns required
for the present study or have fiscal-year-ends other than June 30. We wound up acquiring
complete return series for 35 of the 50 largest endowments. From there, we added data for other
schools with assets greater than $1 billion, as best as we could locate them. An indication that the
final sample of 43 funds may not be representative of all 107 funds (with assets greater than $1
billion) is that the average 11-year annual return of the sample exceeds that of Nacubo’s $1-
billion-plus fund cohort by approximately 40 bps. While the 43 individual fund returns we
obtained are not suspect in our minds, they may not be truly representative of the large fund
cohort. Accordingly, we use the individual fund returns only in cross-sectional analysis and not
as indicative of the large fund cohort itself. We assume, without confirmation, that returns are net
of fees.

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The funds’ alphas range from a high of +2.07% to a low of -3.56%. None of the positive alphas
are statistically significant. Eleven of the negative alphas are statistically significant. Note
the wide range of effective equity exposure — from 60% (Vanderbilt) to 86% (Carnegie
Mellon). The degree of diversification (R2) also varies widely — from .835 (MIT) to .995
(Missouri). Pronounced underperformance is evident across the range of both equity
exposure and diversification.

Exhibit 5
Diversification and Performance of Large Endowment Funds
for the Eleven Years Ended June 30, 2019

Effective
Rank School Equity R2 Alpha t-stat
Exposure
1 Massachusetts Institute of Technology 64% 0.835 2.07% 1.25
2 Bowdoin College 71% 0.870 2.03% 1.26
3 Michigan State University 69% 0.969 1.39% 1.94
4 Williams College 71% 0.931 0.99% 0.86
5 University of Pennsylvania 67% 0.941 0.73% 0.73
6 Columbia University 68% 0.953 0.56% 0.60
7 University of California 69% 0.957 0.32% 0.36
8 University of Richmond 63% 0.937 0.29% 0.30
9 Dartmouth College 70% 0.917 0.25% 0.20
10 Princeton University 77% 0.910 0.23% 0.16
11 Rice University 71% 0.978 0.18% 0.29
12 University of Missouri 68% 0.995 0.01% 0.05
13 University of Virginia 76% 0.966 -0.01% -0.02
14 University of Notre Dame 73% 0.955 -0.12% -0.13
15 Rutgers University 62% 0.975 -0.18% -0.31
16 Yale University 77% 0.902 -0.21% -0.14
17 Wellesley College 69% 0.967 -0.22% -0.29
18 Northwestern University 62% 0.940 -0.42% -0.44
19 Brown University 74% 0.919 -0.87% -0.66
20 Pennsylvania State University 72% 0.987 -0.92% -1.75
21 University of Rochester 70% 0.956 -0.97% -1.05
22 Amherst College 74% 0.952 -1.06% -1.07
23 North Carolina State University 71% 0.888 -1.18% -0.79
24 Stanford University 78% 0.969 -1.19% -1.40
25 Vanderbilt University 60% 0.875 -1.24% -0.93
26 Purdue University 74% 0.990 -1.25% -2.75

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 27 University of Chicago 64% 0.872 -1.38% -0.85
28 Duke University 84% 0.985 -1.42% -2.23
29 Washington University in St. Louis 71% 0.969 -1.47% -1.87
30 UCLA Foundation 74% 0.919 -1.56% -1.22
31 University of Michigan 80% 0.989 -1.59% -3.16
32 University of Pittsburgh 76% 0.987 -1.76% -3.25
33 University of Washington 74% 0.936 -1.82% -1.58
34 Carnegie Mellon University 86% 0.964 -1.84% -1.80
35 Case Western University 69% 0.964 -1.88% -2.35
36 University of North Carolina 75% 0.870 -2.00% -1.18
37 University of Southern California 78% 0.990 -2.11% -4.34
38 Tulane University 78% 0.936 -2.16% -1.79
39 University of Georgia 80% 0.992 -2.67% -6.25
40 Ohio State University 74% 0.934 -2.82% -2.34
41 Cornell University 80% 0.972 -2.93% -3.57
42 Harvard University 80% 0.956 -3.13% -2.99
43 Southern Methodist University 72% 0.900 -3.56% -2.54
Median 72% 0.955 -1.06% n/a

Conclusion
The overarching conclusion of this section is that endowment funds have underperformed
passive investment by a significant margin during the study period, no matter how one
slices the data.

THE VANISHING ALTERNATIVE ADVANTAGE

We have established the following:

 Effective equity exposure is the overwhelming determinant of risk and return, with 99%
of return variance explained by stock and bond indexes alone across size-cohorts of
funds.

 Fund size is not a determinant of risk-adjusted performance, which is consistent across

cohorts of asset size.

 A value bias is evident. It has had a negative effect on risk-adjusted performance during
the period of this study, mainly among smaller endowments. Even there, it accounts for a
minor part of observed underperformance.

Advocates of alternative investments claim that they are a source of diversification and
incremental risk-adjusted return. The sections that follow examine these propositions.

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Empirical Analysis of Alts’ Diversification Effectiveness
We use returns-based diversification analysis to determine which asset classes are the prime
contributors to the diversification of large endowment funds. (Recall that the large-fund cohort
has a 51% allocation to alts.) Our approach is to introduce explanatory variables (asset classes)
one at a time to determine their diversification effect, employing two measures: R2 and the
standard error of the regression (tracking error). Exhibit 6 shows the diversification measures for
each iteration. The first row of the table illustrates the powerful influence of investing beyond
global stocks and bonds in the decade from July 1999 through June 2008. The R2 rose from 0.75
to 0.97, and tracking error decreased from nearly 6% to 2% with the inclusion of alternative
investments. In the 11 years that followed, alternatives had a negligible impact on endowment
diversification, with the R2 already at 0.99 with global stocks and bonds alone (Column 2).

Exhibit 6
Diversification Patterns of Large Endowment Funds Pre- and Post-GFC:
R2 and Tracking Error

1. 2. 3. 4. 5.
U.S. Stocks Admit Admit Admit Admit
and Bonds Non-U.S. Real Private Hedge
Only Stocks Estate Equity Funds

0.66 0.75 0.75 0.91 0.97

1999-2008 (6.7%) (5.7%) (5.7%) (3.4%) (2.0%)
0.98 0.99 0.99 0.99+ 0.99+
2009-2019 (1.6%) (1.4%) (1.4%) (0.8%) (0.5%)

Exhibit 7 graphically illustrates that the benchmark comprising U.S. stocks and bonds plus non-
U.S. stocks is the near-exclusive driver of return for the large fund composite. It shows the
regression of the large fund composite on its benchmark consisting solely of stocks and bonds in
the proportions shown for Cohort 6 in Exhibit 3. The slope (beta) is 0.99. R2 is .993 and the
standard error of the regression is a minimal 1.4%. The intercept, or alpha, is -1.46% (t-statistic
of -2.4). We note in passing that the annual standard deviation of return for composite and
benchmark are nearly identical, at 11.10% and 11.16%, which is to say there is no evidence of
“volatility dampening” in the return series of the alts-heavy composite. Moreover, in this
analysis we make no attempt to adjust for the return-smoothing characteristic of alternative
investments, which account for 51% of the assets of the composite.

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 Exhibit 7
Regression of Large Endowment Fund Composite on Benchmark Returns
Eleven Years Ended June 30, 2019

25.0%
Endowment Composite Return

20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
-20.0%
-25.0%
-30.0% -20.0% -10.0% 0.0% 10.0% 20.0% 30.0%
Benchmark Return

These are remarkable results: Stock and bond indexes capture the return-variability
characteristics of alternative investments in the composite of large endowment funds for all
intents and purposes. Alternative investments do not have a meaningful impact. The finding
that the correlation between a composite of funds averaging 51% alts exposure and a marketable
securities benchmark is near-perfect runs counter to the popular notion that the return properties
of alts differ materially from those of stocks and bonds. That, after all, is an oft-cited reason for
incorporating alternative investments in institutional portfolios. But as we see here, alt returns
simply blend in with broad market returns in the context of standard portfolio analysis.
Furthermore, evidence of volatility-dampening is absent.

Performance Impact of Alternative Investments

Our previous paper indicated that the alts-heavy style of implementation has been a serious drag
on the performance of public pension funds during the decade following the Great Financial
Crisis of 2008. Exhibit 8 (from the earlier paper) illustrates that the risk-adjusted return of
public pension funds decreases sharply as alt exposure increases. (The slope coefficient of -
0.049 has a t-statistic of -2.9.)

10

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 Exhibit 8
Public Pension Fund Alpha vs. Exposure to Alternative Investments
Ten Years ended June 30, 2018

Exhibit 9 is similar to Exhibit 8. It shows total fund alpha versus alts allocation for the six
endowment fund size-cohorts (described in Exhibit 2) through June 30, 2019. The regression line
pertains only to Cohorts 1-5. The R2 is .89. The slope coefficient is statistically significant (t-stat
of -4.9), and the standard error of regression is a mere 0.10%. A very strong relationship exists,
in other words. For funds with alts allocations of up to about 40% of total assets, the story is
the same as for the public funds, namely: (1) alts detract from performance and (2) the
more you have, the worse you do. For Cohorts 1-5, a reduction in total fund alpha of ~20 bps is
associated with every 10% of assets allocated to alts. A 40% alts allocation results in a penalty of
79 bps.

11

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 Exhibit 9
Relationship of Total Fund Alpha to Alts Allocation Percentage
For Nacubo Endowment Fund Cohorts
(Eleven Years Ended June 30, 2019)

-0.90%

-1.10% #1
Intercept (Alpha)

-1.30%
#6
#3
-1.50%
#2
-1.70% 64 bps
#4 #5

-1.90%

-2.10%
0% 10% 20% 30% 40% 50% 60%

Exposure to Alternatives

In terms perhaps better suited to trustees of endowment funds with less than a billion in assets
and others who may not be conversant with statistical jargon, the message here is this: Liquidate
your alternative investments and put the proceeds into index funds. Do it now.

Cohort 6 (funds with assets greater than $1 billion) stands apart from Cohorts 1-5 in Exhibit 9,
statistically as well visually. Total fund alpha of Cohort 6, although still negative by nearly 1.5%,
is 64 bps better than the regression equation would indicate for an average allocation to alts of
51% (a 6.5-sigma outlier relative to the regression line). It is reasonable to conjecture that the
more skilled practitioners of alternative investing are to be found among those with the heaviest
allocations there. Which is to say, there is arguably an indication of skill among at least some of
the practitioners of alternative investing. Anecdotally, three (and only three) stand out with
positive total fund alphas of greater than a percentage point. They are MIT, Bowdoin College
and Michigan State University. All maintain alts allocations of 55% or more and, yet, achieved
alphas at the total fund level of +2.07%, +2.03% and +1.39%%, respectively. Alas, even these
fetching figures do not rise to the level of statistical significance.10

10
There is a parallel here with the experience of professional gamblers. We know that the
majority of amateurs entering a casino will depart losers. Studies have shown that a tiny
percentage (about 1%) of professional gamblers exit winners with some consistency. (These

12

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Exhibit 10 provides support for the results reported above. It shows the simple average of annual
excess returns for private real estate, buyout funds and hedge funds before and after the GFC.11
Positive added value in the early period turned negative in the one that followed.

Exhibit 10
Average Annual Excess Return of Alternative Investments
Before and After the GFC
Pre-GFC Post-GFC
(1994-2008) (2009-2019)

3.3% 3.4%

1.3%

-1.0%

-2.9%

-6.6%
Real Estate LBOs Hedge Funds Real Estate LBOs* Hedge Funds
* Post-GFC LBO return of -2.9% is for the period 2009-2014

Sources: Cambridge Associates, FTSE NAREIT, L’Her er al. (2016), Sullivan (2020)

Exhibit 11 illustrates the excess return of the large endowment composite over 21 years. It is the
picture of a paradigm shift that dates to fiscal year 2009.

happen to be the whales.) Another group (about 5%) usually exit losers, albeit with smaller
losses than the Average Joe. The three large endowments cited above are analogous to the group
of about 1% of gamblers cited in a study of fantasy-sports betting by McKinsey & Co. In both
cases, there are rare winners in a game marked by a preponderance of losers of varying degree.
11
For real estate, we subtract the returns of the FTSE NAREIT All-Equity REIT Index from
those of the Cambridge Associates Real Estate Index, using quarterly IRRs to estimate TWRs for
the Cambridge series. For buyout funds these are the average excess returns reported by L’Her et
al. (2016) in Tables 3 and 4 for size-, leverage- and sector-adjusted returns. The hedge fund
excess returns are as reported by Sullivan (2020).

13

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 Exhibit 11
Annual Excess Return of Endowment Composite Relative to Benchmark
(Fiscal Years Ended June 30)

20.0% 18.5%

15.0%
Annual Excess Returns

10.0%

6.4%

5.0% 3.6%
3.1% 2.9% 2.9%
2.3%
1.5%
0.5% 0.5% 0.4%
0.0%
0.0%
-0.9% -0.6%
-1.1% -1.5%
-2.4% -2.3%-2.3%
-3.2%
-5.0% -3.8%
2009
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
COST AND DIVERSIFICATION

We posit that portfolios of marketable securities cost the investor 0.5% to 0.7% of asset value,
the percentage varying with the mix of stocks and bonds, the use of passive versus active
management and turnover rates. The cost of alternative investments begins at about 1% of asset
value for open-end diversified core equity (ODCE) real estate funds. Estimates of the cost of
private equity investing approximate 6.0% of invested capital.12 The cost of hedge funds, non-
core real estate and private debt fall between those extremes. We put the cost of a typical
portfolio of diverse alternative investments in the range of 2 to 4% of asset value annually. We
estimate that across the spectrum of endowment funds, their cost of investing ranges from 1 to
2% of assets.13 Assuming a cost of 0.6% for marketable securities and 2.5% for a diverse
portfolio alternative investments, a portfolio with an allocation of 50% to alts would incur an
annual cost of 1.55% of assets. The median R2 of the individual funds reported on in Exhibit 5 is
.96 with an associated standard error of return relative to benchmark of 2.7%. If an endowment
fund with that degree of diversification incurs costs of 1.5% annually, the likelihood of it

12
See McKinsey & Co. (2017) and Phalippou and Gottschalg (2009).
13
See our previous work for a detailed discussion of the cost-estimation procedure.

14

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underperforming the benchmark over a decade is 96%.14 Here lies the crux of the problem of
running high-cost diversified portfolios: The math simply doesn’t work.

CONCLUSION

Notwithstanding the existence of a handful of arguably skillful endowment fund managers in the
realm of alternative investments, the vast majority of endowment funds incur costs that
overwhelm the limited opportunity to exploit mispricing. The alt-heavy approach to investing
has failed to provide a diversification benefit and has significantly underperformed simpler
approaches employing stocks and bonds alone. Absent a change in strategy, the great majority of
endowment funds, large and small, are likely to underperform by a significant margin in the
years ahead. Those confident of their ability to identify truly profitable alternative investments
consistently should concentrate those investments to a greater extent, just as they should do with
traditional active portfolios. Absent such confidence, they should shift assets to passive
investments.

REFERENCES

Ennis, Richard M. 2020. “Institutional Investment Strategy and Manager Choice: A Critique.”
Journal of Portfolio Management (Fund Manager Selection Issue): 104-117.

Hammond, Dennis. 2020. “A Better Approach to Systematic Outperformance? 58 Years of

Endowment Performance.” The Journal of Investing August 2020.

McKinsey & Co. “Equity Investments in Unlisted Companies: Report for the Norwegian
Ministry of Finance.” November 2017.

Phalippou, L., and O. Gottschalg. 2009. “The Performance of Private Equity Funds.” The Review
of Financial Studies 22 (4): 1747–1776.

Sharpe, W. F. 1988. “Determining a Fund’s Effective Asset Mix.” Investment Management

Review (September/October): 16–29.

14
The probability reflects the area under a normal distribution curve with a tracking error of
2.7% and incorporating a cost of 1.5% per year.

15

Electronic copy available at: https://ssrn.com/abstract=3614875