Failure of the Endowment Model

Abstract

Large institutional investors in the United States commonly diversify their portfolios among 8 to 12 asset classes. This approach typically involves using more than 100 investment managers at a cost of 1% to 2% of asset value annually. Sometimes referred to as the endowment model, the approach has failed to provide a diversification benefit and has proven to be a serious drag on performance. The vast majority of institutional investors would be better off managing their funds passively at next to no cost in the configuration that best accords with their risk tolerance and other preferences.

TOPICS: Portfolio construction, real assets/alternative investments/private equity, mutual funds/passive investing/indexing, performance measurement

Key Findings

• ▪ Most large institutional funds in the United States embrace an unwieldy multi-asset-class diversification architecture that emphasizes expensive alternative investments well beyond their proportional representation in the funds’ natural opportunity set. The multi-asset-class architecture has afforded no diversification benefit beyond that achieved with stocks and bonds alone.

• ▪ Alternative assets, generally, have not been a source of value added over the past 12 years. In fact, they have been a consistent drag on performance.

• ▪ Large funds typically use more than 100 managers, funds, or limited partnerships and incur costs of 1% to 2% of asset value annually, the effect of which is to virtually preclude their earning a positive alpha over the long run.