make up the largest percentage of HEPI at 45.8 %; clerical and service employee salaries are weighted at 26.6 %; fringe benefits make up 13.1 %; and services, supplies, and utilities make up approximately 14.6 %. The rate of inflation as measured by HEPI is typically higher than that measured by CPI.
In order to maintain the real value of assets into perpetuity, as well as to meet a payout ratio, a foundation needs to achieve a return target. A return target is a level of performance deemed necessary to satisfy the goals of the owners or beneficiaries of the associated assets. A foundation that has a spending rate of 5 %, does not have any regular gift income, and wishes to preserve the real value of its assets has an aggressive return target: the rate of inflation plus 5 %, or even higher when the foundation's spending rate exceeds 5 %. When measured relative to CPI inflation over the prior 10 years, this return target is 7.3 %, a rate higher than the returns to a blended stock and bond portfolio over the same period. Return targets are even higher when the institution faces a higher inflation rate, such as HEPI, but lower when there is a substantial and regular flow of donations to the organization. For institutions without substantial gifts, endowment values likely declined in real terms over the previous decade due to investment returns that fell short of the targeted return of inflation plus 5 %.
David Swensen, the chief investment officer of Yale University and author of Pioneering Portfolio Management (2009), challenges endowment managers to resist the temptation to increase spending rates after periods of extremely high returns. He argues that limiting spending will allow an endowment to better survive cyclical drawdowns and better compound wealth in perpetuity.
3.3 The Endowment Model
Aggressive return targets, as well as the perpetual life of many endowments and foundations, have led to an equally aggressive asset allocation. The asset allocation of major endowments and foundations, which typically includes substantial allocations to alternative investments, has been called the endowment model.
Universities with large endowments have been early adopters of alternative investments, well known as sophisticated investors across all areas of alternative investments. The financial success of these investors has been much discussed, even spawning a subset of investors who seek to earn higher returns by following similar investment strategies. Many credit the endowment model, or at least the most articulate description of the endowment model, to David Swensen. Most of the U.S. colleges and universities with endowment assets in excess of $1 billion tend to invest large portions of their endowment portfolios in alternative investments, following the example of Yale University.
The six largest endowment funds, as shown in Exhibit 3.1, suffered substantial drawdowns and liquidity issues in 2008 and 2009, as assets declined from $119.2 billion in June 2008 to $95.0 billion in June 2010. After a $31.8 billion (–26.7 %) loss in value in the year ending June 2009, including spending and gifts, the endowment model attracted some criticism. However, Exhibit 3.4 shows that in the 10 years ending June 2014, endowments with assets exceeding $1 billion earned returns of 8.2 %, far surpassing the returns to domestic equity markets or a 60 % domestic equity/40 % domestic fixed-income allocation, which is the traditional benchmark for institutional investors. Ten-year annualized returns of 8.2 % refute the idea of a lost decade, rendering the three-year drawdown of an annualized –3.5 % from 2008 to 2010 relatively benign, at least when viewed in hindsight.
According to the 2014 NACUBO-Commonfund Study of Endowments, the world's largest college endowments continue to increase their allocations to alternative investments. Year after year, allocations to domestic equities decline while allocations to alternative investments and international equities increase. As of June 30, 2014, the latest time period available, these endowments held 13 % in U.S. equities, 18 % in international equities, 12 % in fixed income and cash, and 57 % in alternative investments. As shown in Exhibit 3.5, alternative asset allocations have exploded since 2004: hedge fund allocations grew to 21 %; private equity and venture capital allocations increased to 17 %; and natural resources and real estate experienced dramatic increases, to 14 % of endowment portfolio holdings. These highly successful investors now allocate more to international equities than to U.S. equities, more to hedge funds than to fixed income, and more to private equity and venture capital than to domestic public equities. The largest endowments have increased their allocations to alternative investments from 32.5 % in 2002 to 57 % in 2014.
EXHIBIT 3.5 Exposure to Alternative Investments within Large Endowment Funds
Source: NACUBO, 2014.
Swensen believes strongly in an equity orientation, seeking to participate in the ownership of both public and private equity securities and real assets. The role of fixed income is to provide liquidity and a tail hedge that serves to reduce potential losses in the portfolio. Yale University chooses not to invest in either investment-grade or high-yield bonds due to the inherent principal–agent conflict. As Swensen explains the conflict, corporate management explicitly works for stockholders and may choose to make decisions that benefit stockholders, even when those decisions are to the detriment of bondholders. Given this conflict and the fact that the total returns to corporate bonds are less than 1 % above government bonds on a long-term, net-of-defaults basis, the incremental return to corporate bonds may not warrant inclusion in the endowment portfolio. While sovereign bonds provide liquidity and a tail hedge in a time of crisis, corporate bonds can experience a reduction in liquidity and a disastrous loss of value during extreme market events, producing the opposite effect to what fixed income should have on a portfolio. Similarly, foreign bonds are not held in the Yale University portfolio because, while the return may be similar to that of domestic sovereign bonds, the addition of currency risk and unknown performance during times of financial crisis is not consistent with Swensen's goals for the fixed-income portfolio.
Not all endowments have a similar affinity toward alternative investments. Exhibit 3.6 shows the asset allocation of the equally weighted endowment, which averages asset allocation across all 832 endowments surveyed by NACUBO, ranging from those with assets below $25 million to those over $1 billion. While the average endowment has a smaller allocation to alternatives than the largest endowments, the equal-weighted average allocation to alternative investments more than doubled (from 11.8 % to 28 %) between 2002 and 2014. In fact, the allocation to alternative investments at college and university endowments increases monotonically with asset size: endowments between $25 million and $50 million have a larger allocation than those below $25 million, while those with $100 million to $500 million in assets have larger allocations than endowments with assets between $50 million and $100 million. Returns over the past 10 years reflect the same patterns: the largest endowments have both the highest returns as well as the largest allocations to alternative assets.
EXHIBIT 3.6 Asset Allocation of Large versus Average College and University Endowments
Source: NACUBO, 2014.
3.4 Why Might Large Endowments Outperform?
Investors worldwide, from pensions, endowments, and foundations to individual investors, have become attracted to the endowment model, seeking to emulate the returns earned by the largest endowments over the past 20 years. However, evidence shows that not all aggressive allocations toward alternative investments necessarily earn similar returns. This may be due to key advantages particular to large endowments. The literature discusses
