It’s not exactly breaking news that college tuitions are expensive. Over the last decade, tuitions and fees of four-year public universities have increased 3.5% annually, almost double the current rate of inflation.1
But even with the hefty tuition payments coming in, it’s a financial challenge to operate a university. As such, the investment performance of endowments is very important for meeting the operating budgets for many private institutions.
University expenditures include salaries for employees such as professors, administrators, food service, security and maintenance personnel. There’s also construction and renovations on campus buildings and stadiums and associated insurance. And of course, recreational perks for students like swimming pools, on campus coffee shops and health centers.
Endowments also fund scholarships to support financial need students. As long as the endowment returns are good, universities and their students will continue to thrive. But managing endowments is not easy and there’s a lot riding on the outcomes.
Basics: What is an Endowment?
An endowment is an investment fund basically a pool of retained capital given from wealthy alumni and grown over the years. The ultimate goal of an endowment is to grow the fund’s buying power over time.2 This means achieving returns that cover outflows plus keeping up with inflation.
An interview by the University of Cincinnati’s endowment fund Chief Investment Officer Karl Scheer reveals how tough this can be. He ran through some of their expenditures in an interview with ETF.com.3 Mr. Scheer notes that the fund pays 4.5% in spending policy distributions to the university. This is earmarked for the aforementioned operating items. There is also an additional 2% outflow to the UC Fund’s fundraising efforts to keep the alumni donations coming in. Then there is a 20 basis point (0.2%) for managing some parts of the investment program. This totals 6.7% but still hasn’t addressed inflation, historically pegged at 3%. So that’s a nearly 10% required rate of return on a real (inflation-adjusted) basis.4 With many interest rates near zero, this is a daunting challenge to say the least.
Every Penny Counts
Facing these lofty expenditure hurdles, college endowments are starting to pay closer attention to the costs of running their endowment funds. The average actively managed stock mutual fund has an expense ratio of 1.19%.5 Certain investment vehicles like hedge funds and private equity funds charge even more, often 2% or more with performance fees.
But there are less expensive investments available that track market indexes. This is known as passive management.
These cheaper products, often exchange traded funds, ETFs, are gaining in popularity, especially among retail investors. The Vanguard S&P 500 ETF, VOO, has an expense ratio of just 17 basis points or 0.17%, a full percentage point cheaper than a comparable equity mutual fund.6 That presents an opportunity to increase performance by 1% just through cost reduction.
Endowment managers and other institutional investors have been slower to adopt this new passive investing model than retail investors. That means there’s room for increased adoption of this model since typical institutional investor has just 27% invested in passive investments.7
Consider, endowment assets under management in the U.S. are roughly $516 billion according to an NACUBO study.8 So, a back of the envelope calculation indicates that if the remaining 73% of institutional money went passive and saved 1% in costs annually, it could amount to an estimated savings of $3.76 billion per year (($516*.73) x .01). But would performance fall off with the switch? Empirical evidence says no.
Active Management’s Under Performance
The problem is, these funds tend to do a poor job of “beating the market” over time. A proxy for the overall stock market is the Standard & Poor’s 500 Index. This index consists of 500 of the largest stocks, most iconic stocks in America including names such as Amazon, Coca-Cola and Honeywell. Just 1 out of 3 active investment managers actual beat the S&P 500 last year.9 As dismal as that example is, a longer-term review is even more sobering.
Over the last ten years, 82% of large-cap funds failed to beat the S&P 500.10
And it’s not just for large cap managers, as small and mid-cap funds underperformed in 2015 by 72% and 57%, respectively.12 So the fact that 1- the fees are higher and 2- the performance is lower makes a very compelling case to switch over to the passive side. So why aren’t more funds making the switch?
A few universities have made the switch over to passive management. Rockefeller University has been utilizing the ETF model for their $1.9 billion endowment fund in an effort to reduce costs as well as boost long-term performance.
In addition to cost and performance, Rockefeller uses ETFs to quickly gain exposure to a market sector that they either don’t have expertise in or where obtaining research is prohibitively expensive.13 Often, this sector is international investments, often emerging market debt and equity.
According to Rockefeller’s Chief Investment Officer Amy Falls, it can take a full year and a half to vet an active manager they want to use for that sector.14
In that time, the opportunity would probably have been gone. The university has been very successful with their methodology. So much so, Amy Falls was recently recruited to help run the nation’s largest endowment at Harvard University.15
What Will the Future Hold?
It is very easy to see the trend towards passive management and dismiss active management as a dying model. But these two investment strategies go in and out of style depending on the moves of various markets including stocks, bonds commodities, real estate and currencies.
But be careful, perhaps the reason that passive management is so popular is because it has worked for so long. This is similar to the performance chase mindset.
In other words, the fact that it’s taken these large institutional managers this long to adopt this strategy change could mean that they have missed the majority of the change’s benefit. They could be switching just as actively managed funds could become in demand.
This is partly due to the structural makeup of these institutions that have investment committees they need to submit ideas through for approval. Many institutional investors also utilize the services of investment consultants, also adding to the confusion of which direction to take their portfolio. They are much less nimble than other buy side investors such as hedge funds.
But is this trend towards increasing indexed and passive investments the right choice? While active management strategies are typically more expensive, these funds should perform better during bear market periods.
There is no telling where the stock markets will go, but the current bull market is getting quite long in the teeth. As measured from the 2009 lows during the Financial Crisis, this is the second longest bull market on record, trailing only the 1987-2000 period. Something to think about…