Reasonable Returns? What College Endowments Can Show You about Investing

Princeton University
Written by J. Cannon Carr, Jr. on October 10, 2017

A look at portfolio returns of college endowments over the past ten years highlights three key principles for everyday investors to keep in mind in today’s markets.

People often believe that universities are some of the most sophisticated investors. They use a mix of investment strategies—some of which are available to everyday investors, and some of which are not—to grow their endowments while balancing spending for today. Have they achieved high performance returns? Are they able to manage spending challenges with ease?

We looked at their aggregate returns over the past 10 years to test this perception and to see what everyday investors, nonprofits and foundations can learn.

First, the Data: Returns for College Endowments

Between 2006 and 2016, average annual returns were 5.0% (where the 75th percentile was 5.6%; the 25th percentile was 4.2%), across 805 colleges and universities with endowments of all sizes, totaling a collective $515 billion[1]. By comparison, the S&P 500 and long-term bonds did better, while international stocks and a common hedge fund index did worse (Exhibit 1).

The typical allocation in 2016 (Exhibit 2) was 30% US stocks, 18% international stocks, 16% fixed income, and 29% alternatives (hedge funds, private equity, fund-of-funds, etc.).

Exhibits 1 and 2:

College Endowments Returns and Allocations 

Key Point #1: Rational and Predictable

Do those annual returns seem low? They might to some people—and they are certainly frustrating to colleges if their spending rates are high.

Historically, we would expect returns to be 7%-8% for this kind of portfolio, but international stocks and alternatives (particularly hedge funds) were a notable drag during the period, and domestic stocks were on the lower side, too—and beaten by a very strong performance from long term bonds. Also, the results of any given year can move the needle a bit either way; in fiscal 2015, for example, annual returns for the prior ten years were over 6%.

So the past decade’s institutional returns are on the low side, but not completely out of bounds for a diversified portfolio.

We aren’t encouraging anyone to accept “average” but the point is that over longer periods, returns tend to be fairly predictable within a certain range. It’s difficult to produce outlier magic, at least without taking bigger risk.

It’s a good reminder that there is no free lunch when it comes to risk-return dynamics. Balanced portfolios do not tend to produce “lights out” returns or dramatic downside—by design.

Key Point #2: Getting the Right Balance

As the S&P 500 continues to hit all-time highs this year, people get used to seeing double-digit returns. They can grow impatient. Tech stocks are up over 20% this year through September—why not reproduce some of that? Bond yields are terrible—why not get better yield from stocks instead?

The pressure compounds when spending rates require higher returns, as is the case for many institutions. On average, colleges spend 4.3% of their endowment annually—roughly on par with what retirees spend on average.

The obvious answer to “can we juice returns” is that those strategies bring potentially higher returns but also greater risk, which changes the risk profile and purpose of a balanced portfolio. Chasing returns may help near-term, but the greater volatility could put big annual spending plans at risk longer term.

These strategies—which include basic stocks like US small cap and emerging markets—aren’t  themselves good or bad; they are simply tools to include as part of an overall purpose, in the right balance.

If your risk profile has changed, then it is worth considering greater use of more offensive tools to drive returns, even as it increases portfolio volatility. But if your risk profile is conservative, you shouldn’t make a reactionary adjustment.

A Quick Side Point: Hedge Funds

Incidentally, the heavy allocation to hedge funds among college endowments has not, on average, helped boost returns or meaningfully dampen volatility during this period—and arguably, they have detracted from them. The HFRI (Hedge Fund Research, Inc.) Fund of Funds Index produced average annualized returns of 1.7%, without the benefit of less volatility when adjusted for risk-return dynamics.

These returns are net of fees, which can have a significantly negative impact on actual returns experienced by investors. Our view is that the average returns of hedge funds, net of fees, will usually lag those of more liquid, public markets.

Key Point #3: Getting It Backwards

It’s human nature to chase returns or to try to avoid losses. This is an emotional response. Unfortunately, it’s also a loser when it comes to strategy.

A look at money flows into and out of stocks and bonds over the past 15 years makes the point (Exhibits 3 and 4). Investors have consistently put money in when returns are good, and pulled money out when returns are bad. This is a destructive approach to long-term performance. You are “buying higher” and “selling lower.”

Exhibit 3:

Cash Flows into Stocks

Exhibit 4:

Money Flows into Bonds

The Bottom Line

The urge to “do something” when markets are surging or tanking exists for all investors, whether they are trustees for large universities, advisers to smaller nonprofits, or individual investors. The decisions are usually reactionary, too late, and detrimental to returns.

A diversified portfolio is designed to smooth out the volatility of the various investment strategies, with the goal of navigating uncertain periods more effectively and keeping risk return in better balance.

In any market, it’s important to stay with the plan, which includes a written policy statement for reference and consistency. That way, you don’t fall for less rational behavior in challenging times.

[1] Source: The NACUBO-Common Fund Study of Endowments (2016). Here’s a link to the summary report: Note: fiscal 2017 data won’t be available until January 2018.

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