The best-performing college endowments have less than $1 billion — places like Abilene Christian and Spalding University, not giants like Yale. People have become disenchanted with all these exotic investment vehicles. The consultants have really pushed these things.”

November 8, 2013

Fast-Growing Endowments, Without the Ivy

By JAMES B. STEWART

Jack Rich said Abilene Christian’s investments benefited from its board members’ knowledge of the oil industry.

Move over, Yale.

This week, the National Association of College and University Business Officers unveiled its preliminary results for endowment performance for the year that ended on June 30. And Yale, the longtime titleholder, was knocked from its perch for the most recent three- and five-year periods. The long success of the Yale model underlies the conventional wisdom that a top-performing endowment has to be big (over $1 billion), heavily invested in costly alternative strategies like hedge funds and private equity, and managed by a large and sophisticated staff of internal investment professionals.But the new stars of endowment performance are standing that notion on its head. They’re emerging far from New Haven, Cambridge or Palo Alto, in surprising places like Abilene, Tex., and Louisville, Ky. And their success suggests that the much envied and copied Yale model may be showing signs of fatigue.

The association of business officers gathers its data in confidence, and doesn’t disclose the identities of top-performing universities. But I was able to identify two in the top percentile for recent performance: Abilene Christian University in Texas and Spalding University in downtown Louisville. They have outperformed Yale over the most recent five-year periods and have far surpassed the average for all endowments.

Abilene Christian’s $312 million endowment had a five-year annualized return of 9 percent. Spalding’s five-year return was 8 percent. Yale’s annualized return was just 3.1 percent, according to its 2012 report, though that was still better than the average endowment’s five-year return of just 1.1 percent.

A spokesman for Yale noted that its endowment had a strong 12.5 percent return for the most recent fiscal year, which ended on June 30. Those numbers aren’t yet included in the three- and five-year averages. The spokesman said the university wouldn’t comment beyond the report.

Abilene Christian and Spalding aren’t the only small and midsize endowments that are outperforming their billion-dollar-plus peers. The data released this week shows that small (less than $100 million) and midsize ($100 million to $1 billion) endowments — which typically have smaller allocations to alternative investments — have surged ahead of the largest endowments over the most recent three- and five-year periods.

Endowments with assets under $25 million reported the highest average three-year return, at 11 percent, while those with assets between $25 million and $50 million reported the highest average five-year return, at 5.5 percent, according to the business officers association.

The largest endowments led over 10 years and longer, and Yale still holds the 10-year crown with annualized returns of 11 percent. But that’s only because the strong performance of alternative assets in earlier years supercharged its results. It’s no secret that since the financial crisis, many alternative assets have been a drag on performance.

Hedge funds — whose owners typically charge 2 percent of assets under management and 20 percent of any gains and, in some cases, even higher — have performed dismally over the last three and five years, with annualized returns of just 3.88 percent over three years and 5.03 percent over five, according to the HFRI composite index of hedge funds. By comparison, the Standard & Poor’s 500-stock index has had annualized gains of 15.2 percent over three years and 15.34 over five.

Yale’s target allocation to alternative strategies like hedge funds and private equity is 53 percent, while its target allocation to United States stocks is just 6 percent. Many institutions slavishly copied Yale’s allocation targets.

But the disappointing results are starting to sink in. In an ominous sign for the nearly $2 trillion hedge fund industry, the business officers’ association reported that colleges and universities cut their allocation to alternative assets to an average of 47 percent of assets in 2013 from 54 percent in 2012 after years of rapid growth.

Spalding University, which has about 2,500 students, many of them first-generation college students from lower-income families, doesn’t have to worry about alternative assets because it doesn’t own any.

“We never had that luxury,” the university’s president, Tori Murden McClure, told me this week after the business officers’ results were unveiled. “We’re just itty, bitty Spalding.” Referring to her college alma mater, Smith College, where she served as a trustee, Ms. McClure said: “At Smith, we have tremendous access to folks on Wall Street. But we don’t have that here. We’ve just tried to go with a low-cost, plain-vanilla approach and grow the endowment as much as we can.”

Ms. McClure was modest about the university’s accomplishment, but clearly has a competitive streak: She was the first woman to row unassisted across the Atlantic, and she

skied 750 miles across Antarctica to the South Pole.

While small, Spalding’s endowment has more than doubled to $14.6 million since 2006. By “plain vanilla,” Ms. McClure means a target allocation of 70 percent stocks and 30 percent fixed income, according to the university’s chief financial officer, Mark Hohmann. “We don’t have the capacity to pay consultants to manage those high-cost alternative asset classes.”

Stock Yards Bank in Louisville, with $2.2 billion under management, manages Spalding’s endowment.

“We don’t use alternatives much,” said Mark Holloway, the bank’s chief investment officer. “I have a problem with their high fee structure, especially with hedge funds and private equity. Plus, we don’t have a lot of expertise in those areas. But we’re good stock pickers.”

Among the criteria he looks for are companies that he deems good corporate citizens.

“I learned late in life that companies that reduce their carbon footprint, have disciplined compensation, have moral principles and guidelines they adhere to, and that give back to their communities tend to do better,” he said.

This approach especially appeals to Spalding, which was founded by the Sisters of Charity of Nazareth and stresses its commitment to community service.

“We also like underfollowed stocks,” Mr. Holloway said. “I can’t add much on an IBM, but maybe I can find the hidden gem.”

Some of his best performing stocks, he said, have been the biotechnology company Celgene, the three-dimensional printer manufacturer 3D Systems and Starbucks.

Unlike Spalding, Abilene Christian set out to replicate the Yale model. But in part thanks to its location in the heart of Texas oil country, it added a 20 percent allocation to energy — all of it oil and gas infrastructure, exploration and production.

“The icing on our cake is the energy exposure,” said Jack Rich, the university’s chief investment officer, who has overseen the endowment for more than 20 years. “We don’t have any other commodities. We have energy people on our board and the investment committee and that helps us make decisions that other endowments aren’t comfortable with. Oil has been good for us even as other resources went down.”

Like Yale, Abilene Christian has a high target allocation to alternative assets — 30 percent in hedge funds and 20 percent in private equity.

The university has had a close relationship with a consultant, LCG Associates, based in Atlanta, during Mr. Rich’s tenure, which has helped select outside managers. Abilene Christian has had 10-year annualized returns of close to 11 percent, which nearly match Yale’s.

“We’ve had mixed results with hedge funds, and recently they have been a drag on our performance,” Mr. Rich said. But he said the investment committee didn’t change the allocation at its meeting this week. “By design, they’ll underperform a strong stock market,” he said. “Our committee takes that in stride. “

Daniel Wallick, a principal in Vanguard’s investment strategy group who specializes in endowments, said Vanguard did a study that showed a low-cost, actively managed “balanced” fund, meaning a mix of fixed-income investments and stocks, produced returns that surpassed the average small endowments by 47 percent and the average midsize endowment by over 14 percent over the last 25 years. It didn’t outperform the average billion-plus endowment.

“This has really resonated with the smaller endowments,” Mr. Wallick said. “What Yale has been good at is finding great managers. But for an entity that doesn’t have the resources to replicate that, alternative assets have really hurt. Smaller institutions are starting to see this.”

He added, “Returns in the alternative space are trending down because more and more dollars are squeezing away the market anomalies” that led to big gains. “Hedge funds have really disappointed. They were originally pitched as a yielding a higher return, and then when that didn’t happen, they were supposed to be a diversifying asset. But they’re a very expensive way to diversify.”

Stock Yard’s Mr. Holloway agreed. “We’re seeing a lot of institutional new business,” he said. “Much of it is because people have become disenchanted with all these exotic investment vehicles. The consultants have really pushed these things. But when they do well, the fees are very high, and when they don’t do well, they really penalize performance.”