Originally written in Spring 2010


Whatever the underlying causes, low risk-free long-term rates worldwide seem to be one factor driving investors to reach for higher returns, thereby lowering the compensation for bearing credit risk and many other financial risks over recent years. The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

Much has been written about the evolution of endowment portfolios over the last two decades to include an increased amount of alternative investments in portfolios. Pension funds, too, while slower to adapt, have also increased their investments in non-traditional areas. The first nine years of the last decade’s worth of returns indicated that this strategy was an unqualified success. But, the returns for fiscal year 2009 released in the annual NACUBO (National Association of College and University Business Officers) study compiled and produced by Commonfund confirm what anecdotally had been suspected for some time, that endowments suffered their worst fiscal year return since such statistics were measured.

Exhibit 1: Endowment Investment Returns

Endowment Mean Return-4.00%-10.50%-14.1%
Endowment Mean Return-3.50%-6.20%-9.48%
Endowment Mean Return-3.00%-18.70%-21.10%

Source: NACUBO-Commonfund Study of Endowments 2009; Cambridge Associates Analysis of College and University Endowment Pool Returns  1984. Fiscal years ending June 30. Two-year returns are cumulative.

In the years leading up to the recent bear market, larger endowments such as Harvard and Yale, and the other Ivy and Ivy-type institutions that had embraced highly diversified portfolios, did better than smaller schools. For years 2000 through 2008, these schools had enjoyed higher returns than those that employed more “traditional” allocations, but as the liquidity crisis swamped all of the markets during 2008 and early 2009, the asset class that provided the best portfolio protection was prosaic Treasury bonds.  According to Commonfund, the top-decile performing endowments in FY2009 had an average bond allocation of 33% and 11% in cash. In fact, the Barclays Aggregate Bond Index was the best performing of the major indexes for the 10-year period ending June 30, 2009.


To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged—in many cases erroneously—to offer excess rates of return. This effort is particularly evident in the pronounced growth and increasing complexity of collateralized debt obligations. Although collateralized debt obligations are a powerful tool for enhancing risk management by separating idiosyncratic risks from systematic risks, the models used to price and hedge these instruments are just beginning to be tested.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

Exhibit 2: Asset Allocations for Participating Cambridge Associates Institutions Fiscal Year 1984

 Domestic EquitiesFixed Income International Equities Alternative Strategies Short-term Securities/Cash/ Other
Equal-Weighted Average (%)

Source: Cambridge Associates Analysis of College and University Endowment Pool Returns 1984

Over the last forty years the major college endowments have undergone a shift in portfolio construction techniques, from the traditional “60/40” Blue Chip stock/Quality Bond balanced portfolio to an ever increasingly diversified and sophisticated asset allocation.  During this period, bonds lost their position as the defensive asset of choice, as endowments and their committees adopted a more active approach to management, with risk being managed at the portfolio level. Instead of maintaining a more or less permanent portion of the portfolio in “lower risk/lower return” assets, which could drag overall returns down during bull markets when their defensive qualities would be superfluous, many endowments chose to adopt portfolios that contained riskier, though presumably lower-correlated, assets. In many cases risk would be hedged with assets that had either low correlation or negative correlation to the equity market, broadly defined. These would be managed by skilled asset managers and the managers would be monitored by skilled professionals/investment committees/investment offices/consultants etc.  As of 6/30/09 the average endowment with assets over $1 billion had an average allocation to bonds of only 10%, thus many endowments had bond exposures in the single digits.  Exposure to alternative assets, whose rapid proliferation and unregulated status meant that capital markets assumptions about their performance were just that, was at 61% for the larger endowments. In fact, the success of these portfolios in the bear market of 2001-02 may have emboldened decision makers at both endowments and pension funds to seek increases in alternative investments, especially hedge funds. The market meltdown would put these portfolios to their most serious test. 

Exhibit 3: Asset Allocations for U.S. Higher Education Endowments and Affiliated Foundations for Fiscal Year 2009

Size of FundDomestic Equities (%)Fixed Income (%)International Equities (%)Alternative Strategies (%)Short-term/Cash/ Other
Over $1 Billion141012613
$501 Million to $1 Billion201417436
$101 Million to $500 Million261717337
$51 Million to $100 Million342117226
$25 Million to $50 Million372315187
Under $25 Million382713139
Dollar-weighted Average 19 13 14 51 4
Equal-weighted Average 31 21 15 25 8

Source: NACUBO-Commonfund Study of Endowments 2009; dollar-weighted averages unless otherwise noted

Diminished role of bonds

I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

A Cambridge Associates Endowment Pool Study for the fiscal year ended 1984, twenty five years prior to the most recent NACUBO Study, showed that the average large endowment had approximately 25% in bonds and 6.5% in alternative investments, primarily real estate and venture capital. At that time, the schools were at the cutting edge of trying to move away from the conservative investments that had been a hallmark of endowment portfolios prior to that time. The guiding force behind this shift in strategic thinking was the Ford Foundation Report published in 1969. It encouraged endowments to shift from risk aversion and income generation toward risk-seeking and capital appreciation.  Historically, endowments had shied away from putting principal at risk and had spent primarily from the income generated by the portfolio.  This type of risk-averse strategy, especially in the high inflation environment of the sixties and seventies, seriously impacted the long-term viability of endowments, especially as it relates to maintaining their purchasing power. The Ford Foundation study validated the notion of spending from principal, thus encouraging capital appreciation-oriented strategies. Despite the issuance of this report in 1969, from July of that year, the average college endowment would lose close to 50% of its purchasing power through market depreciation, inflation, and spending by the end of fiscal year 1984. (Source: Cambridge Associates Analysis of College and University Endowment Pool Returns 1984)

At the core of the Ford Foundation study is the idea that endowments are meant to last in perpetuity. As a result, an endowment’s investment time horizon should be extremely long and should be willing to endure short term catastrophic events. The biggest dangers to endowments on a long-term scale were two things, inflation and deflation. If left unchecked, each had the ability to damage the purchasing power of an endowment for a generation or more. In order to protect against inflation a certain portion of the endowment should include an inflation-hedge. While stocks, to a certain extent, provide some inflation-hedging ability, hard assets such as real estate, timberland, gold and other commodities, and inflation-linked bonds are typical inflation hedges.

Deflation can be much more insidious, complicated by the fact that once it has begun and is universally recognized, it is typically too late to adjust one’s portfolio. One consulting firm’s solution to deflation was to hedge the capital appreciation portion of the portfolio with high quality longer-term, positively convex bonds. The best deflation hedge are Long-term Treasury bonds, but most endowments opted for a portfolio of high-quality bonds with a long/intermediate duration. The classic deflation scenario was (and hopefully remains), of course, the Great Depression where an economic shock caused the stock market to crash, with the prices of other assets following. The Federal Reserve would attempt to stimulate the economy, but to no effect. Traditional sources of cash would soon dry up, forcing people or institutions to have to sell assets at a discount in order to raise cash. The need for cash drives asset prices down further, spurring even lower rates in an attempt to reflate the economy but the downward spiral of declining asset values continues. As witnessed recently in Japan, this can happen in very slow motion over many years.

What an endowment (or anyone for that matter) wanted to avoid above all else was having to sell depreciated assets at the bottom of a market. Long-term Treasuries provide a good hedge in this environment as they both appreciate in a declining interest rate environment and provide a steady form of cash-flow because the U.S. Government has not (yet) defaulted on its bonds. If it was necessary to raise more cash, Treasury bonds could be sold at the “top” of the market.

Conversely, bonds are particularly susceptible to the effects of inflation so as a result, endowments that had a significant exposure to bonds in the late 70s, either for historical or strategic reasons due to the horrendous equity market environment of the early 70s, saw losses in a portion of the portfolio that was supposed to be a safe haven. 


But continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

Throughout the course of the 1980s, endowments adopted the philosophy of decreasing overall portfolio risk by diversifying their portfolios and increasing their exposure to riskier and presumably lower-correlated assets. The first wave of diversification was the classification of equity managers into different style such as growth and value.  Next, “alternative” assets, now commonplace, included small-cap stocks (soon separated into growth and value categories), international equity, emerging markets, and high yield bonds. As these assets became popular and no longer generated the kind of alpha desired, portfolios expanded in the 1990s to include hedge funds (in all their various permutations), private equity, oil and gas partnerships, and real estate.  By the end of the 1990s and into the 2000s the leading endowments had completed the transformation from the 60/40 stock/bond portfolio to the cutting-edge absolute return oriented pioneered by bellwethers such as Harvard and Yale and other Ivy-type institutions.

The move into such a high percentage of alternative assets was driven by a number of factors. Seeking diversification was certainly a part of it; the potential for higher returns, as well. The belief that risk could be managed at the portfolio level, even as riskier assets were brought into the portfolio was another. Both the secular bull market starting in 1982 and the cyclical bull market started in 1991 also helped, if nothing else, by encouraging Wall Street to roll out new product that found their audience with alpha seeking endowments.  Also, we’ll never know to what extent endowments were influenced by board members who themselves were successful investors and believers in sophisticated investments. After all, that was how many of them quite successfully made their living. Endowments sought to create absolute return-oriented portfolios that could alleviate some of the market volatility that vexed the spending policies of institutions that relied heavily on its endowment for funding; principally, spending policies that were tied to fluctuations in the value of the endowment. If these could be smoothed out, then budget planning would be easier.

Investment results from the early 2000s validated this investment strategy. In fiscal years 2001 and 2002, the average endowment was down less than 10% while the Russell 3000 was down over 30%. The market downturn starting in 2007 and lasting through the early part of 2009 was more difficult for the average endowment to weather. While achieving strong relative results in fiscal year 2008, -3.0% vs. Russell 3000 of -12.69, in FY 2009 the average endowment was down was down 18.7%, while the Russell 3000 was down 26.56%.


Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy. But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

Some of the trouble that the major endowments experienced over the last few years have been chronicled in the mainstream press.  Harvard, it was reported, tried to offload some of its illiquid private equity investments, partly due to the fact that some of its operating cash was managed in the same pool as the endowment fund, which was not a problem during the good years. They were thus caught having to do exactly the wrong thing from a timing perspective, that is, trying to sell assets at the bottom of the market to raise cash. In another operating fund quandary, college endowments that had their short-term “cash” investments with the Commonfund saw their assets frozen in September of 2008, as Wachovia Bank resigned suddenly as a trustee for the Short-Term Investment Fund as it was negotiating its own financial crisis. This sent college officers looking for other sources of cash.

It will take years to determine the ultimate fallout from this crisis and many stories will never get told. And while trying to determine what happened with other endowments may only be speculation, it is not hard to imagine that other institutions had problems similar to Harvard’s. A recent Wall Street Journal article reported that the new president of Dartmouth had to make dramatic budget adjustments to account for a roughly $50mm shortfall as a result of a -23% performance of the endowment for FY2009; and these are the wealthy institutions.

What’s Next for Endowments?

I trust such an episode would not induce us to lose sight of the very important contributions hedge funds and new financial products have made to financial stability by increasing market liquidity and spreading financial risk, and thereby enhancing economic flexibility and resilience.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

The endowment investment story is incomplete, unfortunately, as the NACUBO report only provides us with a snapshot.  We have seen a strong rebound in the markets over the last year, and hedge funds reported strong returns during calendar year 2009, but we won’t know for a while how some of these endowment portfolios performed coming out of the market bottom. Were investment committees able to hold the line, or better yet, nimble enough to make strategic investments in temporarily undervalued assets? Will alternative assets still hold the same allure as they did four or five years ago?  If they don’t, will that benefit investors who stay the course, allowing managers to maintain their flexibility to invest with fewer capacity constraints? If we are entering a lower-return environment, will endowments be able to hold the line on spending and not erode the long-term purchasing power of endowments?  The press release accompanying the release of the NACUBO report included the following comment from Commonfund Institute Executive Director John S. Griswold: “Many educational institutions have taken steps to adapt to the realities imposed by endowments that have been buffeted by losses averaging nearly 20 percent. Future NCSE reports may well reflect fairly significant changes in investment management, spending, debt practices and governance policies.”

Endowment values should return if they do not penalize themselves in the extreme and keep their long-term focus. After all, in the 10 years ending in 2009, investment returns were better than what a static 60/40 portfolio could have offered and endowments should be able to withstand short-term shocks, no matter how painful they appear.


The economic and financial world is changing in ways that we still do not fully comprehend. Policymakers accordingly cannot always count on an ability to anticipate potentially adverse developments sufficiently in advance to effectively address them. Thus our economies require, in my judgment, as high a degree of flexibility and resilience to unanticipated shocks as is feasible to achieve. Policymakers need to be able to rely more on the markets’ self-adjusting process and less on officials’ uncertain forecasting capabilities.

– Alan Greenspan, Central Bank panel discussion, to the International Monetary Conference, Beijing, People’s Republic of China, June 6, 2005

The question lingers though—was one terrible year of performance the penalty for nine strong years?  And was it worth it?  It will be interesting to watch going forward whether endowments maintain or increase investments in alternatives, or if the lack of liquidity inherent in these investments will create pressure within the institution, causing them to rethink their policy. From a pure long-term investment standpoint, it may very well be that the inclusion of alternative investments in endowment portfolios has indeed been the correct move, but from a practical standpoint where spending decisions are made from the endowment, and liquidity is a concern, can institutions recover from a onetime hit of 20% without losing focus on the long-term goals of the endowment?

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