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Endowment Allocations
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Harvard University sits atop the academic world with a staggering $39.4 billion endowment fund, while the Yale University endowment manages approximately $30.3 billion. As of the fiscal year ending June 30, 2019, the 10-year average annual returns are 8.6% for Harvard and 11.0% for Yale.

It is common knowledge that one of the best ways to achieve portfolio diversification is through asset allocation. For years, individuals have been managing their investments with the use of stocks, bonds and cash, often in the form of mutual funds. This conventional approach provides a limited degree of benefit, but lacks a tactical element—which is why the conventional approach is no longer used by professionals, such as those managing university endowments. Notice the allocation differences between Large (over $1 Billion), Mid ($100 to $500 Million) and Small (under $25 Million) endowments.

EndowAllocFig6.jpgSource: NCSB Study, June 30 2019

Both Harvard and Yale follow the philosophy of diversification by spreading their investments across a broad variety of asset classes. The idea, of course, is to create a portfolio that is less volatile than a standard stock and bond mix—but one that also yields better returns. Other investors have tried to duplicate these results, and many have failed. What makes the endowment mixes of Harvard and Yale so successful?

University endowments are looking for income to fund their operations indefinitely. They also want to outperform in any market. The heart of the endowment manager’s job is to allocate assets to different classes of investment. In the mid-1980s, Yale held more than 90% of its assets in a conventional asset that was dominated by domestic equities and bonds.

For Yale, this portfolio was not sufficiently diversified. Since then, Yale has migrated to a diversified, equity-oriented asset allocation that promised higher returns and lower risk. In the past three decades, the university’s endowment more than met expectations, returning greater that 12% per annum and exceeding results for traditional marketable asset classes by wide margins.

On the surface, the two endowments seem to take different approaches. Both have asset mixes beyond the traditional domestic equity and fixed income instruments. And it’s a dynamic mix, in that they expand or contract asset classes tactically when necessary. These portfolios are quite unlike traditional stock and bond portfolios which often have predetermined allocations and scheduled rebalancing regardless of the market environment.

Source: Harvard University, Fiscal Annual Reports of the Harvard Management Company, periods ending June 30.

Instead, the endowment asset allocation process is largely driven by quantitative analysis. The heart of the endowment manager’s job is to allocate assets to different classes of investments. In the 1980s, Harvard’s investing was strictly limited to U.S. stocks, bonds, and cash. This portfolio was not sufficiently diversified.

Harvard was both taking on too much risk, and missing out on opportunities in international and alternative assets. But around this time a gradual shift began, away from U.S. equities and securities and in favor of such investment classes as foreign stocks, real assets, private equity, and what are known as “absolute return” assets.

Real assets include real estate and commodities; private equity includes venture capital and buyout firms; and “absolute return” assets attempt to capitalize on market inefficiencies and special situations such as distressed businesses. These asset classes have the potential to deliver “equity-like” returns, but with low correlation to U.S. equities. So, they may cushion the portfolio against losses when the market goes through an inevitable down cycle.
The chart to the right illustrates the goal of Endowment Allocation strategies—to improve on the limitations of the traditional Efficient Frontier by reducing risk and increasing returns.EndowmentAllocations-Img2.jpg
The chart illustrates the goal of Endowment Allocation strategies—to improve on the limitations of the traditional Efficient Frontier by reducing risk and increasing returns.

While the markets have viewed Harvard and Yale’s portfolio changes as cutting edge, the endowment managers were really just putting into practice the evolving theories on asset allocation taught in their respective universities.

How diversified have endowment holdings become? Today, many large university endowments are allocating over 20% to absolute return strategies. Likewise, these endowments have also reduced their fixed income exposure. Why? Absolute return strategies are designed to respond in all market conditions. While bonds provide some support during down markets, they typically do not participate equally when the markets are strong. This may explain why Harvard and Yale maintain an exposure to alternative instruments.

In his book Unconventional Success, Yale’s David Swensen offers advice for the average investor. Swensen argues that an investor has three levers over investment performance: asset allocation, portfolio strategy and security selection.
To paraphrase Swensen’s main points:
  • Asset allocation—include six core asset classes in your portfolio: domestic equity, foreign developed equity, emerging market equity, real estate, U.S. Treasury bonds, and U.S. Treasury inflation protected securities.
  • Portfolio strategy—rebalance your portfolio annually, employing a strategy capable of making short-term bets against long-term asset allocation targets.
  • Security selection—buy low cost index funds or exchange traded funds; avoid hedge funds and corporate bonds.
History of Endowment Allocations
Past performance is not indicative of future returns. Source: Yale, calculated by Arrow.

The Unconventional Approach
Access to the strategies used by university endowments have historically been unavailable to many individual investors and seemed to be reserved for use by hedge funds and institutions. But today’s investors finally have access to a wide array of tactical and alternative investment mutual funds and ETFs. By combining traditional investments with alternative assets, individual investors can now create tactical asset allocation strategies similar to the sophisticated approach of the investment management teams at Harvard and Yale.

Over the past three decades, Yale dramatically reduced the Endowment’s dependence on domestic marketable securities by reallocating assets to nontraditional asset classes. In 1988, 92% of the Endowment was targeted to U.S. stocks and bonds. Today, target allocations call for a heavy allocation to nontraditional asset classes, which stems from their return potential and diversifying power.

Even Yale has tactically increased and decreased its international exposure over the years. While it has 51% allocated to equity-based strategies, 31% of the exposure is now tied to the international equity market. It is coincidence that these allocations were shifting based on the overall strength of the U.S. equity market. In global equity markets, certain trends have been reliable for investors seeking positive risk-adjusted returns. Among the trends, short-term momentum for individual stocks and for markets is an important factor. Longer term, momentum tends to shift in the opposite direction. This feature of markets is known as return reversal (mean reversion). Return reversal for individual national markets (country level) has been documented in academic research. While domestic equities may continue to perform well, long-term return expectations appear modest given lofty equity valuations. As the fundamentals of the market change in the coming years, remember that “smart beta” has the ability to differentiate itself from traditional indexes and fundamental strategies. Based in a quantitative structure, smart beta focuses on specific investment factors that drive returns, like momentum, mean reversion and a quantitative assessment of quality and value. A return to wider dispersion across sectors and countries can result in clear market leaders and market laggards.
International Component: % of Equity Portfolio
Past performance is not indicative of future returns. Source: Yale, calculated by Arrow.

Constructing a portfolio to prepare for the unknown events and beyond may require more than a static stock/bond blend (60/40 portfolio). Strategy diversification is often overlooked as an important part of diversification. Investors often fail to incorporate tactical and adaptive (alternative/absolute return) elements that have the ability to respond to changing markets. And of course, asset classes to consider should include those often referred to as alternative assets. Most investors have little to no allocation to alternatives. Yale, on the other hand, is currently allocating 26% to that asset class—an allocation that has increased during a very robust equity market.

Endowment Allocations: Then and NowEndowAllocFig5v2.jpg
Past performance is not indicative of future returns. Source: Yale, calculated by Arrow.

Investors may wish to add tactical and adaptive strategies to their traditional assets. When doing so, it is important to consider correlation in order to seek true diversification. The markets are always unknown; they go up and they go down. It is important to use a strategy that matches the individual investor’s investment objective, risk tolerance and time horizon. No investment strategy is perfect or can guarantee positive returns in every environment. Being too defensive against a downturn can lead to missed opportunities in the way of upside potential. But taking on too much risk can lead to excessive losses and cause irrational reactions. The strategies discussed here are not without their own risks. Each one has defensive elements, but can also provide upside potential. It is not necessarily a matter of preparing for a black swan drawdown event, as the markets may ultimately provide positive returns for the year. But time and the law of averages are working against traditional asset classes, so portfolios should be adapted to prepare for a less predictable outcome than we have seen in previous years.

While many individuals lack the time or experience to implement these strategies on their own, there are now mutual funds that can do it for them. With relatively lower costs compared to hedge funds, mutual funds provide the access, liquidity and professional management that investors want—providing a conventional solution for an unconventional approach.

Past performance is not indicative of future returns. Images shown are for illustration purposes only and should not be used as a predictive measure for the future return expectations of any investment. The information is subject to change (based on market fluctuation and other conditions) and should not be construed as a recommendation of any specific security or investment product, and was prepared without regard for specific circumstances and objectives of any individual investor. Traditional, nontraditional and alternative investments involve risks, including the potential for loss of principal. Nontraditional and alternative investments may involve additional risks, including, but not limited to, shorting risks, the use of leverage, the use of derivatives, futures market speculation and regulatory changes. Before investing in any financial product, always read the prospectus and/or offering memorandum for product-specific risks.

Before investing, please read the prospectus and shareholder reports to learn about the investment strategy and potential risks. Investing involves risks, including the potential for loss of principal. An investor should consider the fund’s investment objective, charges, expenses and risks carefully before investing. This and other information about the fund is contained in the fund’s prospectus, which can be obtained by calling 1-877-277-6933. Content reviewed by an affiliate, Archer Distributors, LLC.