How Vanguard’s investing approach can strengthen nonprofit endowments
This three-part series examines the challenges that colleges, universities, and private secondary schools encounter when investing with the endowment model strategy and discusses how Vanguard can help educational institutions improve performance to grow endowments.
Part II: Why the endowment model has lost its edge
In part one, I discussed the compression and flagging returns seen by educational institutions using alternative-heavy investment strategies. Now let’s look at the reasons underlying these diminishing returns—investment management skill (the abundance of), and the basic economic law of supply and demand. These key factors have led to the endowment model’s declining performance.
The number of professional investment advisors has skyrocketed
The ranks of advisors holding the Chartered Financial Analyst® certification grew 544% from 1997 to 2016¹. Add accelerating technological advances and declining barriers to entry, and it seems as if just about anybody can develop, execute, and market an investment strategy.
This surging population of financial professionals translates into an increased level of knowledge and skill in the markets. According to the Bogle Financial Markets Research Center, only 17% of investment dollars were professionally managed in the 1960s. Today that figure is up to almost 70%. In a separate analysis, Charlie Ellis estimates that institutional investors now account for 98% of all activity on the NYSE².
Recent returns suggest that the presumed risk premium associated with illiquidity has dried up, meaning investors are more dependent than ever on finding managers with talent and expertise in a highly competitive market. And with more and more dollars chasing opportunities, the line between outperformance and underperformance is thinner than ever.
It’s difficult to beat skillful, informed investment managers
Today, there is so much proficiency and talent across the investment management industry that gaining an upper hand often has more to do with luck than with any skill or distinct enduring advantage. For example, according to SEC filings, George Soros sold stake in Apple and Warren Buffett bought stake in Apple in the same quarter for two straight years. These are two of the most accomplished investors in history, and they’re on the exact opposite sides of the same stock.
While Buffett and Soros surely were not transacting directly with each other, each had his reasons, and their investors undoubtedly bought into their investment cases. Does this mean that whoever comes out on top is more talented or skillful? No. It demonstrates just how hard it is to tease out skill from performance.
A glut of private equity has driven down investment quality
As seen below in chart 1, both available private equity cash ($200 billion to $900 billion) and the number of private equity firms (2,000 to 7,500) have increased significantly since 2000. Does this mean the pool of high-quality private investments has increased four-fold? Unlikely. What it means is that more investors are bidding for the same opportunities (or lower-quality opportunities are being brought to market and snapped up). These circumstances increase prices and reduce expected returns. It’s the simple law of supply and demand.
As seen in Chart 2, the exponential growth in demand seems to corroborate the decline investors have experienced in returns.
A rapid rise in available cash and private equity firms . . .
. . . has likely contributed to a significant decline in realized returns
Sources: Vanguard calculations using data from Preqin and Cambridge Associates. Values for venture capital and private equity are internal rate of returns (IRR). Private equity includes both buyout and growth equity funds.
Even Yale feels the pinch
Given the major growth in professional management, the competition for talent, and the glut of alternative strategies—some of questionable quality—it should come as no surprise that the majority of endowments are struggling to generate returns commensurate with their expectations and costs.
In the 2016 Yale endowment report, David Swensen, chief investment officer of the Yale endowment, wrote, “In some markets, Yale has little bargaining power. Venture capital and leveraged buyouts present the greatest challenge, as the overwhelming demand for high-quality managers reduces the ability of limited partners to influence deal terms.”
Remember, this is Yale, the $27 billion endowment that gave the endowment model its name and pioneered the push for diversification into alternatives. Knowing that even one of the preeminent investors in illiquid alternatives struggles to negotiate favorable terms with general partners should give pause to even $1 billion endowments.
What’s an endowment office to do?
How can your investment team be effective stewards of the capital entrusted to you? How can you ensure you are protecting and growing your endowment? In the next and final installment of this series, I’ll introduce you to the Vanguard OCIO alpha model, an effective approach to managing a perpetuity as a fiduciary.
To learn more about Vanguard’s outsourced CIO services for nonprofits, visit our nonprofit solutions site to submit an RFI, or contact your local nonprofit solutions director at 888-888-7064 or NPOCIO@vanguard.com.
¹ CFA Institute and Bogle Financial Markets Research Center.
² Ellis, Charles D., The Index Revolution: Why Investors Should Join It Now. 2016.
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