A Free Yale Education: Fisher Investments on the Recent ‘Endowment Model’ Troubles

Once upon a time, the endowment fund at Yale University was the world’s envy, boasting high returns and steady growth thanks to managers’ decision to add private equity to the mix. Imitators aplenty arose, and it became conventional wisdom that private equity and other illiquid investments were vital tools for institutions with infinite time horizons. Retail investors sought to get in on the party, trying to mimic the “Endowment Model.” But lately, the shine has come off, making private equity’s drawbacks plain for all to see. We aren’t here to throw stones or poke fun at Ivy League institutions, and Fisher Investments isn’t inherently against private equity. But investors need to cut through hype and focus on the basics before even considering whether these assets can help you reach your goals.

Our jumping-off point today is a fascinating Bloomberg article contrasting the Endowment Model with the public school kids at Ye Olde University of California, whose managers opted for a simple mix of stock and bond index funds—pick an asset allocation, diversify within that asset allocation, wrap it in low fees.^[i] The UC System’s young endowment is now cruising along: The article notes that, in the three years ended in June, it handily outperformed several major universities employing the endowment model.

Now, we should note this three-year period is conveniently close to when twin stock and bond bear markets ended … and when private equity’s well-known troubles started to snowball. Everything has its day in the sun and the rain, and stocks and bonds won’t always perform like this. But still, the contrast is noteworthy and the article goes on to point out private equity hasn’t offered much edge over the trailing decade either.

For university endowments, periods of weak returns from illiquid assets theoretically shouldn’t be a problem because their time horizons theoretically stretch if not to infinity, then to the end of higher education as we know it. But sometimes endowments have near-term cash flow needs, and this is one of those times, with new endowment taxes looming and research funding cuts pinching some universities. So several are liquidating holdings and finding it rather tough to do so. “Higher interest rates have made it difficult for investors to exit private equity—or leveraged buyout funds [LBOs]—through public offerings. Last year, Yale unloaded about $2.5 billion in LBO funds at a discount. Because the university is such an influential investor, the fund sales, its first in the secondary markets, underscored the broader struggles of leveraged buyouts.”^[ii]

Now, for individual investors, there have always been major drawbacks to trying to mirror the Endowment Model—people generally don’t have unlimited time horizons, and many have more routine cash flow needs than universities historically have. And Fisher Investments has long taught that it is a myth that private assets aren’t volatile—there are just fewer pricing points. That is illiquidity, which is a bug, not a feature. Read the preceding paragraph again: In order to sell the funds it needed to offload, Yale had to accept a price below whatever the fund’s official valuation was. That is what “at a discount” means. An illiquid investment is one that trades so thinly that you can’t sell it right when you want it for the price you want. Official valuations are shiny and nice, but any investment is worth only what the market will pay for it.

But when you read this article, the motivation for the private investment industry’s recent push to open 401(k)s to private investments and ease restrictions on individual investor participation becomes pretty apparent, in Fisher Investments’ view: They need cash. The traditional sources aren’t as eager to fund them, so they are looking elsewhere. This isn’t a call we think most individual investors should answer under any circumstances, but that is doubly true given the current backdrop.

Always, always, always consider why you are investing: to reach a specific set of goals. Generally, Fisher Investments finds retail investors’ goals boil down to long-term growth, cash flow or some combination of the two. Your asset allocation should be the mix of stocks, bonds and other securities that carries the highest likelihood of reaching your goals over your investment time horizon (the length of time your money must work for you). If you have the faintest whiff of near-term cash flow needs, we reckon illiquid private investments likely have little to no place in that asset allocation. If you need cash in a hurry, you risk having to sell at a discount or having to sell more liquid assets that are more tailored to your needs. Forced discounts and forced selling are big unforced errors, in Fisher Investments’ view.

Nor is private equity “diversification.” Echoing what we wrote about gold earlier this week, diversifying doesn’t mean spreading your money around different asset classes—that confuses diversification with asset allocation. Diversification means spreading your exposure within stocks and bonds. Private equity can make this difficult, as the funds’ holdings can be scattershot or concentrated … and totally out of your control. LBO funds add wrinkles by shifting the titular leverage from the fund’s balance sheet to the portfolio companies, which puts them in jeopardy as rates rise and that debt becomes harder to refinance. Even if they don’t all endure bankruptcy like retailers Saks and Joann, the debt burden can make the portfolio companies harder for the fund to sell or return to the public market, which is a big reason a lot of these funds are crying for cash now. Said more simply, some of these funds may own companies you wouldn’t touch with a 10-foot pole if you were diversifying your own portfolio.

And lastly, we would be remiss not to talk about the fees, which are higher than your typical managed fund and a lot higher than your typical index fund. Now, we aren’t anti-fee, but it is all about value and what you are paying for. With private equity funds, you risk paying through the nose for illiquid investments that aren’t a fit for your goals and needs, which can add extra ugh to a spell of disappointing returns. And in the massive push to get private equity into 401(k) funds, we haven’t noticed a corresponding push to lower fees for plan participants. Indeed, high fees seem to be making a lot of plan administrators rather leery of adding them.

Again, we aren’t inherently against private equity as an investment. But what is right for any investor should come down to their goals and time horizons. And if institutional investors with theoretically infinite time horizons are finding currently that private equity isn’t so great a match for now, there is a high likelihood that mortal humans find the same.