College endowments are a critical source of funding for higher education institutions. These funds are invested to generate returns that can support various initiatives, including scholarships, faculty research, and infrastructure development. The funds are managed professionally by experienced and knowledgeable investors. Many of those professionals use an aggressive strategy that should lead to higher long-term returns. In this blog post, we will explore this aggressive investment philosophy and whether it is appropriate for an individual investor.
First, let’s define what we mean by an aggressive investment strategy. This refers to a strategy that prioritizes higher returns over liquidity and volatility. Aggressive investors tend to allocate a larger portion of their portfolio to high-risk assets such as stocks, real estate, hedge funds, timber, and other alternative investments. The idea behind this approach is that these assets have the potential to generate higher returns in the long run, but they can be more volatile, less liquid, and experience significant price swings in the short term.
College endowments have been known to pursue an aggressive investment strategy. According to a 2020 report by the National Association of College and University Business Officers (NACUBO), the average allocation to alternative investments, such as hedge funds, private equity, and real estate, for college endowments with more than $1 billion in assets, was 55%. This is significantly higher than the average allocation for other institutional investors, such as pension funds and sovereign wealth funds, not to mention individual investors.
For example, Williams College, a small, elite private institution in Massachusetts, has a $3.5 billion endowment. The purpose of the endowment is to contribute financial support to both the present and future needs of the college as well as to provide sufficient liquidity to meet near-term needs on a timely basis. Based on the 2022 annual report, except for its 2% cash allocation, the fund is exclusively invested in aggressive assets. The eight percent allocation to fixed income is “non-investment grade” which is commonly called junk bonds, pushing the fixed income allocation into the aggressive space. The remaining 90% is either equity, hedge funds or real assets.
The main reason why college endowments can invest aggressively, and theoretically generate high returns, is their long-term investment horizon. College endowments are intended to support the institution in perpetuity, and as such, they can afford to take a long-term view of their investments. This allows them to allocate a higher percentage of their portfolios to assets that may have a longer time horizon, such as a venture capital fund.
This long-term investment horizon also means college endowments can handle the illiquidity that comes with alternative investments. Many alternative investments, such as private equity and real estate, are not traded on public markets and can be difficult to sell. Others, such as hedge funds, can restrict redemptions preventing the owner from liquidating their ownership.
As mentioned, college endowments are managed professionally by experienced investors. And if these investors are willing to take the risk inherent in this aggressive strategy, shouldn’t individuals follow the lead and chase higher returns?
The short answer is no. Individual investors can have a long-term investment horizon, for example, a 25-year-old has about a 50-year time horizon for his IRA (when required distributions start). Fifty years is a long time but not nearly as long as perpetuity. An endowment can always wait out a downturn in the market while an individual may not be able to do so. And liquidity is always a concern for an individual investor. Whereas a college could put off a capital project, or seek outside donors when cash is needed, an individual does not have that luxury. When an individual unexpectedly needs cash, they need to be able to liquidate their investment. Having funds tied up in alternative investments does not allow an individual ready access to their capital.
The difference in individual versus college endowment time horizons is a foundational reason Eagle Ridge does not follow the college endowment approach to asset selection and portfolio diversification. In addition, many of the illiquid investments referred to such as hedge funds, venture capital funds and real estate have other complexities – such as high minimums and high fees, and non-standard tax reporting that can result in fees and delays. In summary, college endowments and individuals typically have very different investment profiles, including but not limited to their time horizons and liquidity requirements. Their portfolio strategy and investment selection should appropriately reflect these.