Why Not Just Index?

Winter 2013

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Ben Stewart

Ben Stewart

Most university endowments generated very strong investment returns in the fiscal year that ended June 30, 2011, but the ensuing 12 months weren’t so kind. The majority of endowments have reported fiscal year 2012 results that range from modestly negative to small single-digit gains. The lackluster figures incited James B. Stewart to pen an article entitled “University Endowments Face a Hard Landing” in the October 12 edition of The New York Times. There are at least four critical misrepresentations in Mr. Stewart’s article.

First, beating a passive benchmark in a single year, or a handful of years for that matter, is not a university endowment’s goal. Second, his assumption that a portfolio of 60% equity and 40% fixed income is sufficient to meet a university’s needs is outdated. Third, and perhaps most importantly, he totally ignores the ever-important topic of risk or volatility of returns. And finally, Mr. Stewart’s assertion assumes that history will repeat itself, that the future will look like the immediate past.

In his article, Mr. Stewart points out that a simple, passive portfolio invested in 60% equity and 40% bonds would have performed better in fiscal year 2012 and other periods. Mr. Stewart and indexing proponents in general have missed the point. Beating the market in a single year is not the goal. You can’t get an accurate picture of an investment strategy by focusing on returns over a brief period of time, which in our opinion, is what fiscal year 2012 represents. A single year’s performance shouldn’t rattle endowment managers into making changes to a process that is proven to be successful over the longterm.

When you look at performance through a larger lens, you see a much different picture than the one Mr. Stewart describes. Active management can actually add significant value when a thoughtful and well-resourced approach is used to select managers with a demonstrated track record of exceeding the benchmark. In fact, over the trailing three years ended June 30, active management in the University of Oklahoma Foundation’s global equity portfolio resulted in an annualized return that was 1.8% better than the passive benchmark. This was true even if you isolated the domestic equity portion where the Foundation’s managers collectively bested the S&P 500 by 1.6% per year. Active management, combined with informed asset allocation decisions, works much better than allowing a machine to operate a 60/40 portfolio blindly through any environment. Here is where a longer period of time is helpful to gain this perspective. A portfolio like the University of Oklahoma Foundation’s current asset allocation would have generated a 6.6% annualized return over the ten years ended June 30 whereas a 60/40 portfolio of the S&P 500 and Barclay’s Capital Aggregate bond index yielded a return of only 5.8% per year.

In addition, the implication that a portfolio with an allocation of 60% US equities and 40% US fixed income could or should be the standard for university endowment portfolios reveals an outdated perspective. Over a decade ago, as fixed income yields continued their slide that began in the 1980s, the basic math on that allocation proved inadequate to meet university needs. Does anyone today believe that allocating 40% of one’s portfolio to an asset class that has a yield to maturity of 1.7% makes sense? This decline in fixed income yield is what put spending policies under pressure. Those in charge of investing endowment portfolios realized that a high equity allocation is the only way to generate a total rate of return that allows for a 4-5% spending policy, the norm among endowments. As a result, a 70/30 asset mix with global diversification is a much more relevant asset allocation for endowments. Where the investment professionals at endowments demonstrated their value was by finding ways to have a global, 70/30 portfolio without dramatically increasing the volatility of returns.

One of the most important considerations not accounted for in Mr. Stewart’s article is risk, which often times is described as volatility of investment returns in the investment world. The kind of endowment portfolios that Mr. Stewart disparages are designed to produce very good returns over time, but to do so with much lower volatility than a simple passive investment. For example, over the trailing five years ended June 30, the University of Oklahoma Foundation’s portfolio return (net of investment manager fees) matched the return of a global, passive 70/30 asset mix, and did so with 14% less volatility. And that was achieved without the benefit of a mature private equity portfolio, which, when fully developed, is expected to add a significant boost in returns. Taking less risk to generate long-term returns that match or exceed the index is the best way we know to provide a more predictable source of income for the institutions we support. More consistent income with a principal amount that compounds at a greater rate over the long run is how we best execute our mission.

A quality institutional investment process is designed to generate consistent, long-term results that achieve an institution’s goals over generations. Of course there are times when the macro environment does not reward fundamental processes, but those cycles are short-lived in comparison to an endowment’s investment time horizon. Just because an index briefly outperforms a carefully constructed, diversified portfolio is no reason to scrap the plan.

Editor’s note: The following is a response from Ben Stewart, director of investments at the OU Foundation, to an editorial by James B. Stewart that appeared in the New York Times.