COMMENTARY: The Endowment Model Is Just Active Management

Abstract

Endowed institutions and other investors, if they choose to be active rather than indexed, can benefit by considering as potential investments every asset class and strategy in the world. Such unconstrained investing is supported by finance theory, which says that constraints on active bets are always costly in terms of return, conditional on the active management in question being successful (adding alpha) in the first place. Endowment funds are free to do many things that other investors are not, making them more likely to succeed at active management than other classes of institutions or individuals. However, the performance of these funds has varied materially over time, with a recent long period of underperformance, so the success of the endowment model is not guaranteed. Part of this underperformance is due to the high costs of the alternative investments that distinguish endowment-model portfolios from more traditional portfolios, so investors adopting the endowment model should pay special attention to fund fees and other costs.

TOPICS: Portfolio theory, portfolio construction, foundations & endowments, performance measurement

Key Findings

• ▪ The endowment model of investing is just a form of active management and is not a magic formula for making (or losing) money.

• ▪ Many endowed institutions are free to make substantial bets—on alternative investments, large deviations from policy portfolios, and unconventional structures—that other institutions cannot.

• ▪ This freedom should increase the alpha earned by endowments, provided that they are capable of earning alpha in the first place.