By LARRY SWEDROE
In our book The Incredible Shrinking Alpha, Andrew Berkin and I presented the evidence demonstrating that the hurdles to delivering alpha had increased, and would continue to increase, making it ever more difficult for active managers to add value (an updated and greatly expanded edition was released in August this year).
In his June 2020 study Endowment Performance, Richard Ennis analyzed the performance of 43 of the largest individual endowments in the United States over the 11 fiscal years ending June 30, 2019. He found that none of the 43 endowments outperformed with statistical significance, while one in four underperformed with statistical significance. He also found that alternative asset classes failed to deliver diversification benefits and had an adverse effect on endowment performance.
In his follow-up August 2020 study Three Eras of Endowment Performance Between 1974 and 2019, Ennis analysed the performance of both large and small endowments over three periods he defined as:
— The Stock and Bond Era, from 1974 to 1993
— The Golden Age of Alternative Investments, from 1994 to 2008
— The Post-GFC Era, from 2009 to 2019
He benchmarked performance against three indices: the Russell 3000 for U.S. stocks, the MSCI ACWI ex-U.S. for international stocks, and the Bloomberg Barclays Aggregate Bond (and similar indexes prior to 1976) for bonds.
Here is a summary of his findings:
Large endowment funds
— Exposure to hedge funds increased from 2 percent in 1994 to 21 percent in 2019.
— Exposure to venture capital increased from 4 percent in 1990 to 9 percent in 2019.
— Exposure to leveraged buyouts increased from 2 percent in 1990 to 14 percent in 2019.
— Exposure to natural resources increased from 1 percent in 1990 to 6 percent in 2019.
— Total exposure to alternatives (including distressed securities and “other”) increased from 4 percent in 1986 to 18 percent in 1994 to 54 percent in 2008 and to 58 percent in 2019.
Despite the dramatic increase in alternatives over the final of the three periods, the performance of large endowments in the Post-GFC period was, for all intents and purposes, explained by their exposure to publicly available stocks and bonds. “Notably, 99% of the variance of the Large endowment composite’s returns is explained by stocks and bond indexes only. Alts had ceased to have a diversification-like influence.”
Examining their performance over the three periods, Ennis found:
— Stock and Bond Era: The Large cohort composite produced an average annual excess return of -0.8%—the approximate margin of investment expense, including transaction costs, in that era. This demonstrates that the market in public securities was already highly efficient over the period 1974 through 1993.
— Golden Age of Alternatives: The Large cohort composite produced an average excess return of 4.1% a year for 15 years, primarily due to the exceptional performance of alternative investments.
— Post-GFC Era: The Large cohort composite underperformed the benchmark by the approximate margin of cost of 1.6%. Endowments were earning returns on their alternative assets commensurate with the underlying public market beta of those assets while incurring costs of 2-4% of asset value. Thus, alternatives ceased to be sources of tremendous value-added and became a deadweight drag on performance.
As discussed in the section on hedge funds in The Incredible Shrinking Alpha, the huge flood of capital into hedge funds and venture capital negatively impacted their ability to add value, wiping out their advantage — the market became more efficient (Andrew Lo’s Adaptive Market Hypothesis).
For example, over the past 20 years or so, the amount of assets under management in hedge funds has increased about tenfold, from about $300 billion to more than $3 trillion.
Small endowment funds
— Stock and Bond Era: The annual excess return was -1.6%.
— Golden Age of Alternatives: The annual excess return was -0.5%.
— Post-GFC Era: The annual excess return was -1.3%.
Since even today the Small cohort has an average of less than 10 percent in alternative investments, about half of which are hedge funds, the Small endowment fund story is largely one of the performance of their stock and bond managers.
That led Ennis to conclude: “For nearly half a century, small endowments have been contributing more than 1% of their assets annually to the investment management and brokerage industries without benefit.”
Conclusion
The bottom line is, while there was a brief window over which large endowments were able to add value through allocations to alternatives, that window has long been shut.
The only question is why these endowments continue to have such large exposures to investments that have generated negative value added. Why do they continue to pay excessive fees to asset managers who are unable to deliver value added?