Future Returns: Building an Endowment-Style Portfolio

Portfolios that model those of endowments can produce the sort of outsized returns many individual investors dream of.

The late David Swensen, Yale University’s longtime chief investment officer, is often credited with originating the “endowment model.” Imagine a diversified portfolio, with greater-than-usual exposure to alternative, less-liquid assets such as private equity to spur above-average returns. According to one study of endowments, college and university endowments produced average net returns of 30.6% in the 2020-21 fiscal year.

With some alternative investments, such as cryptocurrencies, suffering a downturn and inflation high, it’s a natural time to think about adding endowment-style alternatives to portfolios, says Dan Ziznewski of Atlanta-based wealth management firm Homrich Berg.

“As equity markets have continued to hit all-time highs, obviously separate from what’s been going on in the past few weeks or months, there’s a natural conversation,” he says. Investors don’t want to put their marginal dollar into the S&P [500] when it’s at a high, he adds, “they want to get some diversification away from that.”

Also, with interest rates expected to continue rising, an opportunity exists to “allocate away from public fixed income into something more income-oriented on the private side,” Ziznewski says. “Unlike fixed-income portfolios, private debt-side markets tend to be floating rate, meaning they may benefit from interest-rate increases.

Increased access to alternatives for the average high-net-worth individual compared to 5 to 10 years ago is available, owing to new structures like non-traded business development companies (private debt financing tools to invest in small and medium companies) or closed- end interval funds which periodically repurchase their shares. There are also technology platforms offering wealthy investors access to private equity at lower minimums.

But Ziznewski says creating an endowment-style portfolio requires a lot of careful consideration for conservative investors, because it can involve selling lower-risk assets in favor of higher-risk ones. For endowments of more than US$1 billion, the study of endowments found nearly a third of the portfolio was in private equity or private venture capital. The potential returns are attractive, but it’s necessary for investors to make sure they’re comfortable with a range of issues, from liquidity and risk tolerance, to maturity considerations and fees.

Ziznewski offered Penta the following strategies for investors wondering if incorporating endowment-model tactics in their portfolios are a good fit.

Assess Your Suitability

Ziznewski says investors need to figure out if they’re well-suited to this portfolio style, which takes a high-risk, high-return strategy, and a long-term view. “I don’t think trying to pursue an endowment style of investing, simply for the sake of it without the appropriate options is a good strategy,” he says.

It can mark a big shift for more conservative investors. Ziznewski suggests a model portfolio for an individual or family might have 15% allocated to private securities that are illiquid, meaning they can’t be bought and sold quickly, such as private equity or venture capital, plus an allocation to hedge funds in addition to investments in public stocks and bonds. Private equity and private debt funds typically require investors to commit funds for at least three to five years, if not longer.

Investors considered qualified purchasers who own US$5 million or more in investments are better able to populate an endowment-style portfolio, because their size helps them withstand risks while they have more options for alternative options investments.

In addition to having more assets under management, they’re generally more willing and able to have higher percentages of their portfolios in truly illiquid assets. “You need to be willing to take on a much higher risk return threshold than you otherwise would have to generate the types of returns that endowments seek to generate.”

Research and Consult With an Advisor

Alternative investments for an endowment-style portfolio range from hedge funds, private debt, private equity, and real estate, all with different risk return characteristics. “It’s important to understand them, and how they fit into portfolios.” Ziznewski says.

“If an investor says, ‘I really want access to private equity,’ I think that’s a very different thing to research and understand the options, vis a vis, somebody that’s saying, ‘I just want to generate some additional yield in my portfolio .’” This is where talking with an advisor can help.

He notes that filling out subscription documentations, tracking money movements and financial reporting are all difficult to do as an individual investor, unless managing your portfolio is treated like a full-time job and you have the expertise.

Clients approaching or in retirement may be more concerned with realizing income and reduced portfolio volatility, while younger clients or families may plan investments multiple generations out and seek capital appreciation. These differences in immediate needs can also be discussed with advisors.

Plan For Fee Differences

Building an endowment-style portfolio with alternatives generally comes with higher costs, says Ziznewski.

Private equity funds, for instance, often charge a 2% annual management fee. In return, the fund must eventually return all invested capital to investors and generate a return that’s typically at least 8% a year. The fund managers reap any profits above that return, typically 20%.

“They tend to be significantly higher costs when compared to a very low-cost ETF or maybe even an actively managed mutual fund,” he says. But Ziznewski adds the higher fees align to the structure, and he encourages clients to focus on the return net of fees in alternatives. “That’s what we need to understand and be comfortable with, to make sure the return is commensurate for the risk involved.”

Venture capital funds can be more expensive, as managers shoot for higher returns, and many of the best “consistently deliver them,” he says. Management fees can go above 2-2.5% with additional profit of 30% or more. Other strategies, such as private debt, can cost less—generally 1-1.5% management fees, with less upside participation.

“Frankly, there isn’t as much to participate in because they are not strategies that are trying to double or triple your money,” Ziznewski says.

Leave a Comment

Your email address will not be published.