Can the Endowment Model of Investing Be Applied to Individuals?

While there are numerous differences between individuals and institutional endowments which impact their ability to utilize this model to its fullest, the basic tenets of the endowment investment model can still be applied to an individual’s portfolio.

The Origins of Modern Portfolio Theory and Endowment Model

Harry Markowitz first detailed Modern Portfolio Theory in the Journal of Finance in 1952. In his paper Portfolio Selection, he presented evidence illustrating an efficient frontier of optimal portfolios that maximize expected returns for a given amount of risk. Up until this point, investment returns were considered to be driven by security selection. However, Markowitz found that looking at the risk and return characteristics of each security individually was not sufficient. Alternatively, by diversifying across a set of asset classes, with different risk/return characteristics and low correlation to one another, an investor can achieve a higher risk-adjusted return. 

In the 1990’s, David Swenson, the Chief Investment Officer for Yale, used Modern Portfolio Theory as a basis for what came to be known as the endowment model. He maintained the importance of diversification across asset classes and Yale placed a heavy emphasis on investing in alternative strategies, such as hedge funds, private equity, and real assets (i.e., natural resources, real estate). As can be seen from Yale’s 2016 target allocation below, nearly 75% of the assets are allocated to alternative investments:

Have Alternative Strategies Historically Generated Outsized Returns? 

According to Cambridge Associates, U.S. Private Equity generated an annualized return of 13.5% and U.S. Venture Capital generated an annualized return of 30% for the 20-year period ending September 30, 2013. For the same period, the S&P 500 annualized return was 8.8%. 

So how have these strategies generated these types of returns? Generally speaking, the more information an investor has, the more likely they are to earn a higher risk-adjusted return.  Because there is generally less wide-spread information relating to alternative investment strategies (i.e. there is a greater abundance of information with respect to blue chip stocks than there are alternative investments), those who have that information are at an advantage. Additionally, investors are rewarded with an illiquidity premium for committing capital for long periods of time, which is typically the case with alternative investments. To tie this back to the principles of Modern Portfolio Theory, the greater risk one takes on (in this case, locking up your capital), the greater reward one should expect.   

Why Don’t Individuals Adopt the Same Strategy as These Esteemed Institutions? 

Despite the largely positive institutional track record, there are key differences between individuals and institutions that can prevent an individual or wealthy family from truly maximizing the benefits of the endowment model. 

First, an institution is theoretically expected to exist in perpetuity and therefore may have an extremely long time horizon for its investments. They are better able to hold onto illiquid investments as they typically do not need to fund shorter-term liabilities. Individuals typically have to plan for nearer-term cash flows such as retirement expenses and are reliant on their portfolio for liquidity. More often than not, managers impose gates which limit when investors can access their money. Alternative investment managers benefit from these gates, as they are not under pressure to sell a position at an inopportune time to meet liquidity requests.  

Second, institutions with endowments are usually tax-exempt organizations, not subject to the same taxes as individuals. Taxes erode the returns of an individual’s portfolio and, over the course of time the compounding effect can be very detrimental. Endowments are able to invest without consideration of tax implications, a luxury individuals do not have.

A third difference is that access to sophisticated alternative investment strategies and information relating to them is limited. These strategies often have strict investment terms and extremely high minimums that only the largest institutions are able to meet. Additionally, many of the most coveted strategies are closed to new investors. 

With the advent of liquid alternatives with lower investment minimums, more individual investors are able to gain some exposure to alternative asset classes through mutual funds, exchange-traded funds and closed-end funds. These investments do not have lock-up periods or gates, so investors are able to access money monthly or even daily. The benefit of liquidity, however, means the investor is subject to the whim of other investors, which can result in negative implications to investment returns and tax consequences. Studies have shown that return expectations should be reduced when using liquid alternatives.   

Last but certainly not least, the Achilles heel of individual investors is emotion, and institutions lack the emotional exuberance and exasperation inherent in most individual investors. Individual investors often make shortsighted decisions regarding their portfolios based on fear or greed. Institutions, however, tend to adhere to their long-term time horizons for the investments, and are not as hasty to make abrupt changes to their portfolio during extreme market volatility.    

Integration of the Endowment Model for the Individual

While there are clear barriers that prevent individuals from replicating the endowment model for their own portfolios, the pillars of the endowment model, as outlined below, can be broadly applied to individuals when constructing investment portfolios:

  • Broadly diversify the portfolio across asset classes.
  • Allocate a portion of your portfolio to alternative strategies with lower correlation to more traditional, long-only strategies.
  • Maintain a long-term perspective on the portfolio and be prepared to participate in full market cycles.
  • Ensure you have accounted for liquidity needs so you are not forced into exiting illiquid investments prematurely.

While the endowment model is certainly tailored more to institutions, it is important that individuals do not dismiss the model entirely, as they can still benefit from applying its core principles.