Investment beliefs of endowments

Date01 January 2018
Published date01 January 2018
DOI: 10.1111/eufm.12149
Investment beliefs of endowments
Andrew Ang
Andrés Ayala
William N. Goetzmann
Columbia Business School, 3022
Broadway, New York, NY 10027, USA
National Bureau of Economic Research,
1050 Massachusetts Ave., Cambridge,
MA 02138, USA
Yale School of Management, Box
208200, New Haven, CT 06520-8200,
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 assetsreturns 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 %.
alternative assets, asset allocation, hedge funds, portfolio choice,
private equity
G11, G14, G23
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;24:333. © 2018 John Wiley & Sons, Ltd.
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 3.153.82% 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 investorsviews 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.
Franzoni et al. (2012), for example, show that private equity alphas net of FamaFrench and PastorStambaugh factors are
roughly 0.4% per annum. Harris et al. (2014) correct for buyout fundsexposure to small cap and value factor and estimates
of net alpha in the neighborhood of 1.52.5% 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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