Investment beliefs of endowments

• Author: William N. Goetzmann,Andrew Ang,Andrés Ayala
• Date: 01 January 2018
• Published date: 01 January 2018
• DOI: http://doi.org/10.1111/eufm.12149

DOI: 10.1111/eufm.12149

ORIGINAL ARTICLE

Investment beliefs of endowments

Andrew Ang

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Andrés Ayala

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William N. Goetzmann

2,3

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Columbia Business School, 3022

Broadway, New York, NY 10027, USA

Emails: aa610@columbia.edu;

aayala15@gsb.columbia.edu

2

National Bureau of Economic Research,

1050 Massachusetts Ave., Cambridge,

MA 02138, USA

3

Yale School of Management, Box

208200, New Haven, CT 06520-8200,

USA

Email: william.goetzmann@yale.edu

Abstract

United States university and college endowments now hold

close to one-third of their portfolios in private equity and

hedge funds.We estimate the implied beliefsof endowments

on these alternative assets’returns relative to equities and

bonds. At the end of 2012, the typical endowment believes

that its privateequity investmentswill outperform a portfolio

of conventionalassets by 3.9%per year, and hedge fundswill

outperformby 0.7% per year.Taking into accountthe implied

equity exposures in alternative asset positions, the effec tive

equity holding of endowments is approximately 60 %.

KEYWORDS

alternative assets, asset allocation, hedge funds, portfolio choice,

private equity

JEL CLASSIFICATION

G11, G14, G23

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INTRODUCTION

In recent years, important institutional investors such as university endowments, sovereign wealth

funds, and pension funds have shifted their asset allocation away from standard asset classes like stocks

and bonds into alternative investments such as private equity and hedge funds. This suggests that their

portfolio managers either believe that alternatives earn high net abnormal returns or they provide

diversification benefits.

University endowments in particular have been leaders in the recent trend towards alternative

investments. David Swensen's (2009) Pioneering Portfolio Management articulated the value

proposition of this investment style; first, accessing factor returns through non-marketable investments

We would like to thank an associate editor, Stephen Dimmock, Christopher Hrdlicka, Steven Kaplan, Ludovic Phalippou,

Guofu Zhou, and seminar participants at Columbia University and NYU for helpful comments. We also thank Commonfund

and NABUCO for making data available. Ang and Ayala acknowledge support from Netspar. All errors are our own.

Eur Financ Manag. 2018;24:3–33. wileyonlinelibrary.com/journal/eufm © 2018 John Wiley & Sons, Ltd.

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offers an additional liquidity premium to patient investors and second, inefficient asset markets offer

astute investors the chance to capture positive alpha by identifying skilled managers. A handful of

university endowment officers put these principles into practice in the 1990s and 2000s and were

highly successful. Many other institutions followed suit (Goetzmann & Oster, 2012).

With the widespread adoption of the alternative investment paradigm, a fundamental concern is

whetherthe experience of the industryfirst-movers can be successfullyimitated. By adoptinga new style

of investing,are investment managersalso expecting to realizefuture risk-adjustedreturns commensurate

with thepast performance of its mostsuccessful practitioners?In this paper, we extractthe implicit beliefs

held by universityendowments about the excessreturn they expect to capture by investingin hedge funds

and private equity. For hedge funds, we estimate their expected alphas to be somewhat lower than

industry andacademic studies based on historicaldata. For private equity, we find the expectedalphas to

be commensurate with, and by some measures, somewhat higher than industry and academic studies,

depending on definitions of excess return and the nature of the databases used for analysis.

These beliefs have changedthrough time. The nature of the returns to investment in hedgefunds and

private equity are not as fullyunderstood as investment in US stocks and bonds. Data is less accessible,

less reliable, and has been studied less thoroughly by industry and practice. Peer-reviewed academic

research on hedgefund and private equity performance is stillrelatively recent, and improvementsin the

theory and empirical analysis are ongoing. Thus, endowment managers are faced with significant

uncertainty. In our analysis,we study the evolution of beliefs over the 7-year periodending in FY 2011.

We find considerable change in beliefs during this time –particularly for private equity.

There are, however, significant cross-sectional differences around this trend. Private universities

with larger endowments have relatively higher alpha expectations compared to smaller endowments.

This may reflect an implicit assumption of increasing risk-adjusted returns to scale; Barber and Wang

(2013) document a 3.15–3.82% positive alpha earned by Ivy League schools (the early adopters of

alternative investing). This range is consistent with the expectations of the average endowment for the

alpha generated by their private equity investment alone.

This paper focuses on investors’views on the level of net abnormal returns. We assume that asset

returns follow a factor model and endowments solve a standard portfolio allocation problem. Using a

Bayesian framework, we use information on asset returns and cross-sectional asset allocations to

estimate the implied views of educational endowment managers about the net abnormal returns (which

we term alpha) regarding two major alternative asset classes: hedge funds and private equity. We use a

Markov Chain Monte Carlo (MCMC) algorithm to estimate a Bayesian specification of beliefs that

justify the observed weights on alternative investments. Our approach allows for updating of beliefs

through time. We find that expectations about private equity alpha have increased over the past 7 years

and, as of fiscal year end 2012 they represented a 3.9% annual premium. This roughly corresponds to

the illiquidity premium estimated by Franzoni, Nowak, and Phalippou (2012), the private equity return

differential over the S&P 500 reported by Harris, Jenkinson, and Kaplan (2014), and the differences in

geometric means between the widely used industry benchmark Cambridge Associates US Private

Equity Index and the S&P 500. It is higher than estimates of alpha delivered by private equity

investments for which alpha is defined as the residual component of return not explained by exposure to

a multi-factor equity benchmark that includes small cap, value, and liquidity factors.

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Franzoni et al. (2012), for example, show that private equity alphas net of Fama–French and Pastor–Stambaugh factors are

roughly 0.4% per annum. Harris et al. (2014) correct for buyout funds’exposure to small cap and value factor and estimates

of net alpha in the neighborhood of 1.5–2.5% per annum –about half the premium estimates using only the S&P 500 as a

benchmark. Phalippou and Gottschalg (2009) estimate the factor-exposure-adjusted annual premium for buyout funds to be

zero or lower using a micro-cap benchmark appropriate for buyout funds acquiring smaller companies.

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ANG ET AL.