The Endowment Model and SFOs

The Endowment Model and SFOs

Kenneth Frier and Gretchen Tai explore the Endowment Model and SFOs in Improving the “Endowment Model” Recipe

This paper offers a perspective on how the endowment model might be improved, based on our experience over the past twenty years in Chief Investment Officer roles at large corporate and endowment plans.

The “endowment model” as developed and popularized by the Yale University investment office is seen by many as the gold standard of investment management practice.

Endowment style investing relies on:

  1. Equity-like investments for nearly all the investment return
  2. Illiquid investments as a means to outperform liquid investments
  3. Creating additional return through skillful selection of external investment managers

As of June 2015, the Yale endowment portfolio has a twenty year annualized return of 13.7%, a remarkable 6.4% per year ahead of global equities. This deserves recognition as a truly outstanding investment achievement. Nonetheless, this paper will argue that Yale’s approach could be enhanced in several important ways. With those enhancements, it would be more suitable for others to emulate in the years ahead. The need for change is motivated by current market conditions, certain shortcomings in the endowment model and the sheer difficulty of reproducing in the future what has worked so well for Yale in the past.

Section 1 Preview:

The Cook and the Recipe:

It may be helpful to compare the creation of an outstanding investment portfolio to the making of a delicious stew. The two primary ways to create a stew that stands out relative to all other stews are:

Option A: Use a different recipe, with different proportions of ingredients than other stew-makers

Option B: Use superior ingredients – better potatoes, better spices, better meats, etc.

Of these two approaches, Option A has much higher potential to lead to a differentiated stew than Option B. There is always wide latitude to adjust the recipe. In contrast, differences in ingredients, for instance one type of potatoes vs another, will be more subtle.

The Chief Investment Officer (CIO) of a university endowment faces similar choices. The main levers to influence portfolio outcomes are the recipe (asset allocation) and the ingredients (manager selection). As with our stew example, the recipe has the most influence on the outcome.

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