University endowments have been earning returns that have well underperformed stocks, due mostly with their fascination with private equity. They happily fail though.
University endowments manage a total of $840 billion in funds these days, and coming in with returns that have averaged 6.3% less than the S&P 500 over the last 10 years should be met with much disappointment and embarrassment. When we multiply 6.3 by 10, we get 63, and 63% of 840 is 529, meaning that the cost of this underperformance adds up to a whopping $529 billion.
Instead of just having $840 billion in their accounts, these endowments could have very easily had $1.369 trillion instead, and even though they may or may not have a use for all this extra money, those in charge of these funds are supposed to be striving to build their endowments you would think.
If this actually is their goal, you wouldn’t know it by talking to the people that are running these endowments, who actually tell us that they are quite pleased to see their funds do so poorly relative to the market. They have beaten their self-professed goal of 7% return over the last 10 years, and this is enough to put a smile on their face.
What is most noteworthy about this situation is that these disappointing results have not been by their seeking overly conservative approaches, it has been by way of their being willing to take on even more risk to shoot for what they have believed to be higher returns, and when you shoot for higher returns and get much lower ones, that’s certainly not working very well.
We might think that heads would be rolling in the aftermath of such a fiasco, and normally they would, where we would have reached the threshold of failure quite some time ago, with theses failed fund managers and their failed ideas being tossed out in favor of someone who at least isn’t so terrible.
Instead, we continue to see pats on the back all around, and in the strange world of university endowment funds, no one seems to even recognize that any of this is a problem. If terrible returns are not recognized as even lacking by anyone, and funds just keep on using very broken strategies year after year, there is not even a force out there that will inspire them to even shoot for better.
There is nothing that compares to the returns of the stock market, and if the S&P 500 index is too tame for you and you can take on more risk like perpetual funds can and actually get better returns. Just matching the returns of this index should not even be good enough, and stock index performance is at the level of letting chimps manage your money, where the monkeys just sit at their desk and eat bananas all day and do nothing and get these results.
When the chimps trounce you though, and it is because your people are so bad at managing money, this should be a real time of reckoning, and the fact that no reckoning is going on at all is the worst part of all this.
It is one thing to be sold a pig in a poke, the ones that big institutional funds have bought from the private equity salespeople, but only the dumbest continue to look out their windows at this pig year after year without their smiles even dimming.
You Can’t Solve a Problem if You Can’t Identify It
Without any motivation to improve, it’s simply not going to happen by itself, with nothing to jar them awake from their delusions. If missing over half a trillion dollars of missed profits, or quite a bit more if they actually wished to be more ambitious, isn’t enough to wake you up, there’s no hope for you.
Maybe the only thing that they can understand is red ink, and red ink always shows its face now and again, but if you are worried about such a thing, having this extra $529 billion covers a lot of potential red.
This appears to be a more advanced concept than they can understand though, but the biggest benefit of extra returns to this sort of fund is how it covers off future risk. This allows you to not only absorb the blows that come along much better, it also allows you to be more aggressive with your investing approach and actually take on more risk to get better returns, what they are allegedly supposed to be doing with their plan.
We don’t expect these people to be able to trade very well, and managing endowments of this size doesn’t really permit too much, where you may for instance wish to cut back your position in tough times like we’re in now but you can’t just click in and out like individuals can. This comparison is just assuming they hold stock positions though, going through both the good and bad and ending up where stocks do, considerably higher over the longer-term.
This idea of diminishing risk by way of better returns is actually pretty elementary, although for reasons not very clear, it’s not very well understood at all within the investment community. For example, if we see the value of our portfolios drop by 20%, people don’t get past the point where they see this as 20% loss. They may look at a different strategy that has just given back 30% instead, and are happy they didn’t “lose” this much, but miss the fact that they could have doubled their money they would otherwise have in the years leading up to the downturn and gain 100% more while only having to give up an extra 10% during the lean times.
This is the ultimate undoing of overly conservative investment strategies, which these endowment funds clearly are not, and engage almost exclusively in strategies that everyday investors aren’t even allowed to engage in without being “accredited.” Whether or not all investors should be allowed to invest in these illiquid assets, they are certainly riskier than stocks overall are and the reason why this is the case isn’t so much that they go down more, but because they don’t go up enough and this leaves us with a much smaller buffer of gains to offset future losses.
The benefits of long-term stock investing are not just limited to the fact that stock prices go up over time, which is the part that everyone understands, it’s also that past gains will serve to offset risk. If you triple your returns and then take a 50% hit, you’re still up 50% overall, where if you just double them instead, the bear swats you back to even where you have nothing to show for all the time you’ve been invested.
The best defense with investing is actually a good offense, and this is like scoring a lot more points and not being worried about the other team rallying so much because you have such a big lead. This is one of the big things that conservative investors don’t understand, and even if you’ve made a pact with yourself to never sell when the bears come, and therefore bear the full measure of any drawdowns that come your way, you still need to account for the entire story and not just worry about top to bottom drawdowns.
If you are investing for 2040, this part shouldn’t even matter provided that your long-term outlook remains intact. Even though the path up the mountain that we take may involve having to backtrack, the only thing that matters is how high we have climbed in the end, when we reach our destination time wise.
Universities may not care much about whether they get 7% or 14% a year on their money in bull markets, as they aren’t going to be spending this extra money anyway, but this can never be a good excuse to take such a lackadaisical view of things, only really worrying about the size of the downhill part of the journey. If they are actually worried about that, then they need to realize that settling for poor returns does not play into this plan at all and in fact exposes them to much more risk.
It is Very Important Not to Miss Out on Bull Markets
We need to make hay when the sun shines as they say, for no other reason than to tide us over during rainy seasons. Perpetual funds like university endowment funds don’t really need to worry about drawdown risk like individual investors do, as there is no time horizon in play at all and they can effortlessly ride out anything that comes their way. They can just stay the course and just focus on the very long term because drawdowns don’t even have any practical implications.
Stocks clearly win the investment race by a mile, and no one has a greater capacity to bear the risk involved in holding them long term than perpetual funds do. If they want to take this a step further and actively manage their stock positions, this can provide even greater benefits, both in terms of making more money for their funds and building bigger buffers against risk, but they at least should be keeping up with the chimp fund managers.
Up until this temporary setback happened, you don’t get much better weather than what we have seen in the stock market over the last decade, and there perhaps has been no better time to be in stocks, but when you have gone through this period and only held a small portion of your portfolio in stocks, as endowment funds have over this time, and have woefully underperformed stocks, you should have a slap on the face coming.
If no one is even interested in slapping you though, if everyone is happy enough with your terrible performance, including yourself, there simply isn’t an incentive to do better, and you are destined to continue to roll around in the muck with the pig that you were sold and have placed your hopes on.
Pension funds are buying the same pig in a poke though, and these funds do not have the same luxury of just not caring about results like endowment funds do. Pension funds are on the opposite scale of this, where they need to worry a great deal about their rates of return because they have to use these returns to pay their pensioners and cannot afford to see their principal run into the ground.
We don’t even have to visit the scene of the crime, how their preferring things like private equity investing over public equity has harmed them, because the harm should be evident enough just by taking stock of what has happened and continues to happen. If the goal actually was to improve returns and be willing to take on more risk to do it, this has failed miserably, and that should mean something.
The problem with private equity is that it does increase risk but does so by significantly diminishing returns, so you end up with both more risk and smaller profits. You would have to be an idiot to choose this with your eyes open, but it’s a lot easier to stick with this if they remain closed.
The main reason why private equity lags so much is that their success does not get multiplied by the market anything like the public multiplies success with public companies.
Both private and public equities capture present value, but only public equity captures future value, the amount that people are willing to bid up share prices based upon future expectations. We’ve bid up stock prices a lot over the last 10 years, while private equity has to get by much more hand-to-mouth.
The best way to understand this is that private equity investors are stuck with just their dividends, where with public equity investing, these dividends are only a small portion of the overall return, with most of it coming from adding in future value, the part that private equity cannot capture.
This one thing is why investing in public companies is and always will be the king of the hill, and you cannot even approach returns like this just trying to live off of earnings, in the way that we do with bonds for instance. This is also the reason why stocks outperform bonds by so much.
It turns out that just going with stocks somehow scares the pants off of these fund managers, and not surprisingly, this fear results from confusion. They miss the benefits of this by just looking at part of the story, drawdown risk, and fail to account for the bigger story, and the only one that matters, where we end up with various approaches.
Kevin O’Leary, the CEO of endowments at TIFF, reveals the thinking behind the wishy-washy approach that these funds take. “Our goal is not to beat the equity market, but to provide longer term growth with manageable volatility, to over time keep pace with spending needs on an inflation-adjusted basis.”
That’s quite a mouthful, but the key term here is “manageable volatility,” where we need to ask why this would be so important or even matter at all to an endowment fund. There are some people who need to manage volatility pretty closely, someone about to retire for instance, but endowment funds are on the far end of this scale, the end where this should not even matter.
Since stocks do leverage the future, they both provide higher returns and are more volatile than other investments, beyond question. Choosing poorer performing investments can reduce this volatility, but there simply isn’t a need for this with endowment funds.
Volatility and risk aren’t the same thing at all though, and volatility will matter a lot to a trader whose ability to handle drawdown is much more limited due to it being leveraged, but the risk with longer-term investing isn’t drawdowns, it’s ending up in a worse place over time. If the market pulls back by 20% but you know it will get back to where it was and keep moving forward, and you were looking to ride things out regardless, taking a position that may have been less volatile but will end up far behind in the end offers no real benefit but comes at a very high cost.
“Keeping pace with spending needs” is another comment that reveals a lot, and while that’s a plus, the spending needs of endowment funds are very modest and do not materially affect the strategy of the funds, even with ones executed as badly as theirs have. The fact that he is worried about volatility does tell us that risk is indeed a concern, but once again, we can’t just look at differences in the amount of red on a chart without looking at the whole chart and compare it to the green if we want to understand things at all.
You would think that with over $800 billion’ of assets under management, they could buy a lot better advice than this. The disease that causes them not to bother is one we see pretty rampant in the investment industry, where ideas become so ingrained in our brains that our brains just harden to the point where even the most obvious fails to penetrate them.
If O’Leary and his kind are so concerned about volatility, they could actually seek to help themselves by seeking to manage it instead of just running scared. If the monsters under the bed do actually poke their heads out, then we might want to run, but running because you feel that you would have to stand there helpless and willingly be attacked if and when this happens is simply irrational, because if you can run from imaginary monsters, we would think that you could do the same if real ones appear.
We don’t want to even set the bar this high though, asking people to actually pay attention to how risk evolves and adapt, as that is far too ambitious a plan to expect anyone this confused to consider, but it doesn’t matter. The reality is that they can take whatever punishment that the market can dish out and still be much better off than running, and when you are much worse off under any scenario, this should not delight you so much.
As they say though, it’s their funeral, but this ends up hurting us all in turn. Hardly anyone cares about how endowment funds do, although putting more of this money to work would benefit the stock market to be sure, and all of us that are invested in it in turn. If institutions like endowments and pension funds really wished to succeed, we’d all be better off, including them, but you have to want it first.