Beating the S&P on a return basis is totally irrelevant. Almost any diversified portfolio will have a lower absolute return than the S&P and a higher risk-adjusted return. If a school's endowment had the same return and volatility of the S&P 500, that would be quite disturbing.
An endowment should be diversified across asset classes (metals, real estate, equities, bonds) and strategies (PE, hedge funds, VC, etc) and have a moderate but stable return stream.
A core component is usually the S&P 500, with the rest invested in assets and strategies that have low correlation to the market.
We don't know the volatility of the endowment, so maybe it is just shitty, but having a lower return than the S&P is to be expected. And if it did match the S&P, that would indicate to me that perhaps too much risk is being assumed.
Non finance people make this mistake all the time, thinking that return is something anyone cares about. Return is synthetic, in that any positive return can be trivially leveraged up to whatever number you desire. Because of this, what matters is the Sharpe ratio, because it gives you a blueprint of sorts: it tells you how your volatility and return will scale with leverage.
> An endowment should be diversified across asset classes (metals, real estate, equities, bonds) and strategies (PE, hedge funds, VC, etc) and have a moderate but stable return stream.
Over the last ten years, all the fancy-pants portfolios that Ivey League endowments used have generally under-performed a 60/40 portfolio:
Dartmouth has matched, Yale has beaten such a portfolio by 0.6%, and Princeton beaten by 1.1%.
We've had over 15 years of SPIVA keeping track of active management performance, and over such a time period most active managers can't beat market returns:
> Dahiya and Yermack found that the performance of the typical endowment fund [from 2009-2016] was so poor that it would have earned substantially higher returns if its trustees had followed a simplistic investment strategy of holding 100% Treasury bonds and taken no equity market risk whatsoever.
> > Dahiya and Yermack found that the performance of the typical endowment fund [from 2009-2016] was so poor that it would have earned substantially higher returns if its trustees had followed a simplistic investment strategy of holding 100% Treasury bonds and taken no equity market risk whatsoever.
As a non-expert this intrigued me so I found an online calculator for that period (https://dqydj.com/treasury-return-calculator/) and was confused when it showed an annualized return of 1.72%.[1]. But then I read the actual paper where they make it clear their "simplistic strategy" is investing in a "CRSP 10-Year U.S. Treasury Bond Index". (See page 10 of PDF at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3291117)
Digging further, as explained on this bond index calculator, https://portfoliocharts.com/bond-index-calculator/, a bond index fund uses mechanical rules, similar to an equities index fund, for buying and selling bonds, making money on changes in the market price, which can be greater or lesser than the nominal coupon return. IOW, such an index isn't simply buying and holding onto treasuries.
If you download the spreadsheet from the above link (the calculator is a spreadsheet) you'll see that YoY swings are huge, ranging from -4.5% in 2009 to 17.5% in 2011 for 10-year treasury index.[2] Those very good years are why a treasury bond index can achieve such amazing returns over longer periods--greater than 2x the nominal + reinvestment return, without using derivatives for leverage.
Now, I initially assumed the YoY bond index returns would be negatively correlated with equity returns. That's the point, right? But that doesn't seem to be the case; rather, it looks like a mixed bag. Here's the YoY returns of the example treasury bond index as compared to the S&P 500 (from https://ycharts.com/indicators/sp_500_total_return_annual):
On their face the years 2010, 2014, 2015, and possibly 2012 don't look negatively correlated. Maybe they are for some technical reasons, but it makes me skeptical about the degree to which such a bond index fund hedges equity risk.
As a total layman in this domain but with some experience pouring through these sorts of academic research notes, what this tells me is that the Dahiya and Yermack paper is interesting but hides some significant assumptions and, presumably, some pretty deep theoretical disputes within the academic and investor communities.
[1] 1.72% is for January 2009 to January 2017. For June 2009 to June 2017 the return shown is 2.75%. That suggests we should be a little skeptical about the effects of the starting and stopping points of any analysis.
[2] AFAICT, actual CSRP models and data are proprietary. The calculator and historical returns are based on that author's own model. (EDIT: Table A3, page 62 of the Dahiya and Yermack paper give the benchmark returns. I'm just eyeballing them, but the 10-year treasury figures seem to match up well with the returns from the portfoliocharts.com spreadsheet.)
> Most investors assume you want to own negatively correlated investments that move in opposite directions. But what you really want is assets that have a positive expected return profile with correlations that change over time depending on the market environment.
The equity-bond correlations have see-sawed between +0.6 and -0.6 over the decades:
> Since 1945, the S&P 500 has been down in 16 out of 74 years, with an average loss of -11.7%. In those down years, 5-year treasuries were positive 15 out of 16 times, with an average gain of 6.2%. The last time stocks and bonds were down in the same year was 1969, when the S&P fell more than 8% while 5-year treasuries were down less than 1%.
>If a school's endowment had the same return and volatility of the S&P 500, that would be quite disturbing.
Why? I understand why this is the case for smaller investors like individuals, but for a school endowment isn't the sheer size of the endowment and the theoretically near infinite investment time horizon part of the risk management? Some years or even some decades it will be down, but they aren't investing with the intent to spend any sizable portion of that money anytime soon.
At all but the richest institutions, you need to think of the endowment more like the retirement fund of a retiree.
You can't just not pay your faculty / demand 50% more tuition / defer fixing a roof leak for a few months just because you were down in Q2, even if you expect to be back up in Q1 of the next year.
If you expect to have the money at a future date and you can secure a low interest rate, it makes much more sense to fund operating expenses with debt than lowering future returns. Certainly for the past decade a large institutional investor with significant assets like a university would have no issue securing an extremely low interest rate.
Maybe for somewhere like Harvard that has an absolutely ludicrously sized endowment, but a more normal university can't really afford to absorb losses like that.
They need to withdraw from the endowment every year to pay expenses. If the stock market plunged and then they locked in losses by selling to pay expenses, they would run a real risk of having long term losses.
I’m on the investment committee of the board of a small school with a $300M endowment, and every year 4% is budgeted to be withdrawn to go towards school expenses.
I am new, but I find it silly they pursue this very active management, diversified across tons of different (managed) funds. I feel like they should be putting everything in whatever has the highest long term return (they have access to sequoia funds and those have consistently beat the market, yet only 1-2% goes to them), regardless of illiquidity, since their time horizon is infinite. And use borrowing to handle yearly distributions.
But due to the management structure (40+ board members, 8 on the investment committee, a team of 6 professionals who manage the money), this sort of strategy would never be considered “prudent” enough to make it through all the approvals needed.
> Dahiya and Yermack found that the performance of the typical endowment fund [in 2009-2016] was so poor that it would have earned substantially higher returns if its trustees had followed a simplistic investment strategy of holding 100% Treasury bonds and taken no equity market risk whatsoever.
Harvey Mudd? 300M at a small college is actually a quite large endowment, and HMC is tiny even by small college standards.
The institution I work with has less than 100M and is on the larger side of small. If we had 300M and a faculty/facilities layout built for ~700 instead of ~3000 then life would be completely different.
I agree with you in general -- both that the active management is dumb and also the most probable reason small colleges pursue this strategy. But HMC can probably afford investment strategies that most others cannot.
Yeah, but it seems like any sort of “permanent fund” where the timeline is infinite should be doing really aggressive, long-term, illiquid stuff, right? Investing like a 22 year old. And then any liquidity needs you need for annual distributions you handle via loans.
I feel like I could make an investment product where I pay you 4% of whatever you invest, per year, forever... but you can never get your original investment back. It seems like this would be a product all endowments/permanent funds would use. And then I just put it all in the s+p 500. I guess I’d need to be the government for endowments to trust me forever though.
> I feel like I could make an investment product where I pay you 4% of whatever you invest, per year, forever...
It seems that you have heard about the "four percent rule", but probably have not needed to actually look up the details. It is from something called the Trinity study (also see Bengen and recent Wade Pfau) and there are important details about it:
> The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index* (CPI) to keep pace with the cost of living.
Further it is/was focused only on thirty-year retirement time horizons, not the infinite-horizons of perpetual institutions. It is probably not even appropriate for the 'retire early' (FIRE) movement that is somewhat popular in recent years:
Paying 4% of an initial investment would over time become a relatively worthless amount of money due to inflation. You could get about that return by just buying a ETF or mutual fund that focuses on dividends without having to give up the value of your principal (which would also grow over time).
Corporate debt often looks like what you're describing. The principle is rarely called and the loan can be extended virtually forever (unless the bank decides you're too risky).
There are certainly other ways a school could run its endowment, sure. In fact, the way things are usually done is perhaps far from optimal.
But you don't want to that guy who gets fired because you did some crazy stuff. These institutions are perversely risk adverse, and the investment through consensus model makes it hard to do anything different.
The whole point of an endowment is that it is supposed to be an ongoing investment and the percentage withdrawn every year is minimal. Over a long enough time line does "locking in losses" mean anything when averaged out with all the gains? You can look at the best and worst rolling averages for various investments here[1]. The worst 20 year span for the S&P 500 is better than the worst 20 year window for bonds.
Depends on whether you measure the profit and loss on a first in-first out basis, which is the norm, or not. If you measure it as FIFO then it's very unlikely that you are locking in any losses and are just cashing out earlier gains.
Thank you. The fund manager's comments suggesting that the index funds are unnecessarily risky make sense now.
The original article kind of made it sound like the fund invested in stocks and still managed to underperform the stock market. If you draw that assumption, it makes this sound like an open-and-shut case of negligence.
Isn't sharpe invariant to leverage? If I lever up a position 2x my return doubles as does the volatility (StdDev) of the position. Metrics like alpha are better able to tease out if a portfolio is simply levered to a market factor.
You can’t calculate sharpe for a portfolio that includes private investments (PE or VC). Even if you trust the marks - big if - the returns are reported quarterly or at best monthly, and the marks are often unchanged creating a fake effect of a “zero vol” investment
Sharpe is mostly considered invariant to leverage, but it's not strictly true. Volatility drag starts to eat more and more into your returns as you lever up.
> Non finance people make this mistake all the time, thinking that return is something anyone cares about.
No, return is the whole point of investing. If it wasn’t something anyone cared about, you’d be better off holding a stack of federal reserve notes instead and spending some on your favorite desert because no one cares about the return including the people suing the university endowment. Finance people have such a funny way of using theoretical calculations to confuse themselves out of profits.
The reason for investing is to produce the highest returns within a predefined period of time.
Over 30 years, an endowment that makes 2% higher returns than another endowment will have roughly TWICE as much money as them. That 2% is huge!
You don’t need to be a Katherine Wood to do this. One way to consistently outperform is to pick high performance stocks and avoid (or short/buy puts on) low performance stocks. Try for a moment picking which of these are the better to invest in? Amazon Vs. EBay, SalesForce vs. Oracle, NVidia or AMD vs Intel, Tesla vs Toyota, IBM vs any modern tech company. As a stock picker, you only need to be right 51% of the time to beat the market so if you got 3/5 of the above right, congrats you might be smarter than a university endowment manager. You don’t need to read a 10K or take a finance exam to know that Amazon is going to crush EBay, Salesforce is going to skip along past Oracle, Tesla is going to blow past Toyota, and IBM is going to underperform against any tech index. It’s been that way in the past and barring an act of God or congress, it’s going to continue being that way. Again, you only need to be right 51% of the time to beat an index.
Maybe you don’t have a tech background. Maybe you have a medical background and can pick biotechs. Or maybe you have a grandson or granddaughter. They should be able to pick 2 out of 3 of these out easily:
Snapchat vs Instagram (Facebook), Chipotle vs McDonald’s, Netflix Vs. Redbox. Have I made my point yet that making a high return isn’t as complex as finance people want non-finance people to think it is?
Okay but what if your stock picking stills suck? Or after 5 years of stockpicking, you lose your edge but still want to keep your cozy job. What can you do? If you know how to wield options, you can create a synthetic position on a commonly traded index like SPY(S&P500) or QQQ(NASDAQ 100). Hopefully you picked QQQ instead because it has more tech companies and Tesla while SPY has more COVID-impacted companies and will have to purchase Tesla soon. That would’ve earned you a full 32 basis points (32%) more and will continue in the near term to earn you more —- but maybe you didn’t pick it. You can create a synthetic position on your favorite index benchmark with 2year ITM LEAPs by selling a put and buying a call at the same strike. Doing this only deploys 15% of your capital while having the same effect as deploying 100% of your capital on that index. This means you can use all that extra cash sloshing around in your account to buy something that is highly liquid, is low risk, and appreciates or pays a dividend. Bond ETFs such as the ones by Vanguard fit the bill here nicely. And boom, you’re out performing the benchmark by 1%, 2%, or 3%, depending on the bond duration. Also you can sell your usefulness to the university by letting them know that their portfolio has a lower volatility than the index due to the bonds going up if the stock index options go down which steadies the ship.
An endowment should be diversified across asset classes (metals, real estate, equities, bonds) and strategies (PE, hedge funds, VC, etc) and have a moderate but stable return stream.
A core component is usually the S&P 500, with the rest invested in assets and strategies that have low correlation to the market.
We don't know the volatility of the endowment, so maybe it is just shitty, but having a lower return than the S&P is to be expected. And if it did match the S&P, that would indicate to me that perhaps too much risk is being assumed.
Non finance people make this mistake all the time, thinking that return is something anyone cares about. Return is synthetic, in that any positive return can be trivially leveraged up to whatever number you desire. Because of this, what matters is the Sharpe ratio, because it gives you a blueprint of sorts: it tells you how your volatility and return will scale with leverage.