Implications for advisors
An obvious implication of the Oxford studies is that anyone using – or contemplating using – a consultant should insist on a fully transparent record of their recommendations and an analysis of whether those recommendations resulted in risk-adjusted outperformance.
But the larger question is whether advisors embracing the endowment model are acting in their clients’ best interests, or whether they will fail to produce alpha by allocating to alternative asset classes, like hedge funds and private equity.
I spoke last week with Barber, who has been in the position of advising universities on how to manage their endowments. His recommendation, typical of academics, is to rely on a passive, index-based approach. Reducing the cost of investments leaves more for the investor.
“The vast majority of endowments choose to play the loser’s game, with mixed results,” Barber and Wang wrote in their paper. “The average endowment allocates 73% of its domestic public equity portfolio and 66% of fixed income assets to active management – markets in which it is notoriously difficult to beat public indexes.”
For advisors, Barber recommended starting with a simple asset allocation using index funds with low fees and avoiding private equity, hedge funds and active management. He said advisors should focus on estate planning, insurance and “making sure clients meet their life goals.”
“I see so many people trying to do the investment-picking thing in the advisor arena,” he said, “and that’s not where the value is added. It is hard to argue for advisors using actively managed public-equity funds.”
Barber said that an argument could be made for endowments to have a small allocation to private equity, because of their long investment horizons and ability to bear liquidity risk. But that should be a “small slice,” he said, for two reasons. First, investors should try to replicate the broad market portfolio, and private equity is relatively small compared to public stocks. Second, substantial capital has flowed into private equity over the last two decades, and there is little reason to believe the strong returns over that period – whether or not they represent alpha – will continue in the future.
He said the case is weaker for hedge funds, which represent a “side bet on alpha for which house takes a big cut.”
Barber’s recommendations and the findings of these studies will not be surprising to readers of this publication, who have been warned before, by academics and others, about the inapplicability of the endowment model to client portfolios. But the key findings – that the average endowment fails to deliver alpha and that the average consultant does not add value – reinforce the message that the odds against successfully adopting the endowment model are very steep.
These findings also have public-policy implications. Many of the investors in these studies are public institutions, such as the endowments of state schools. Those institutions are placing risky bets on private equity and similar funds, to some degree at the taxpayer’s expense. They are relying on consultants who, on average, add no value and no prospect of delivering alpha. These studies document the futility of those efforts. Taxpayers would be better served if public institutions adopted a low-cost index-based approach to endowment management.