Given that each organisation has different foundations, it follows that there is no single best strategy. The Yale Investments Office approach is great for Yale but this may not be the case for others. That said, the long-term nature of endowment capital and the requirement of endowments to remain a source of funding in perpetuity (or at least over a very long period) does mean that certain elements of investment strategy are likely to be appropriate regardless of the organisation. We suggest five:
- Focus on the Long-Term: Given the ultra-long-term nature of endowment capital and the advantages this affords, it follows that backing long-term focused strategies makes sense. This needs to be backed up by a strong investment process, culture, and governance structure to maintain the long-term behavioural advantage.
- Bias towards high-quality assets: If the focus is on the very long-term, then it should be assumed that the assets will face hard times at some unknown point (unless you back your ability to predict recessions). As such, one needs to ensure that the assets can survive the path, perhaps even become stronger as weaker competitors are impaired, and emerge with long-term value intact or even enhanced. This kind of durability exists only in high-quality companies. A strong bias in the portfolio to these kinds of assets is therefore warranted.
- Deep fundamental research: To determine long-term fundamental value and to have conviction in the investments during times of severe price movements, it is important to understand the portfolio companies at a deep fundamental level, always from first principles.
- Valuation focused: Owning assets at a discount to their fundamental value provides a 'margin of safety' for when things go wrong. This should be a core discipline regardless of the investment model adopted.
- Diversification: The world is unpredictable and even more so over longer-term horizons. As such, for an endowment to continue to flourish over the ultra-long-term, the portfolio needs to be robust to a range of different scenarios from recessions, to supply shortages, to deleveraging events, and even to world war. This requires a portfolio of assets with different long-term return drivers. This is not about simply holding uncorrelated assets as measured with short-term market prices (the topic of a future post), it is about understanding the underlying fundamental drivers of asset classes and assets over a decade or more and ensuring that there are varying exposures to these. The required level of diversification can be reached without becoming a proxy to the benchmarks. Too many assets or managers will make it impossible to undertake the required deep fundamental research.
It is common for endowment funds to have a focus on high-quality assets. However, it is often the case that the focus expressed on paper is not what is executed in practice. Sometimes it is the result of how strongly the firm believes in owning high-quality assets and sometimes it is because the firm has not taken the time to analyse and define what a high-quality company is for themselves. In this latter case, the firm becomes reliant on the external investment managers’ views of quality, which can vary a great deal.
A bias towards high-quality assets does not mean the entire portfolio must be invested in high-quality companies, although a large percentage is warranted. The inclusion of non-quality companies, like venture capital for example, may be appropriate for other reasons. When including such assets, it is just important to be clear on what you are backing if it is not quality and to develop alternative investment frameworks for these assets. The lack of quality may still be a factor that penalises the sizing of these assets.
This applies whether adopting a direct investment approach or an external investment manager approach. As outlined here, analysing the judgement of external managers and understanding the quality of the assets within the endowment firm’s own business quality framework requires the endowment firm to have its own proprietary research processes and frameworks on the underlying companies, even if not making direct investments.
In external investment manager models, it requires a deep trust in the valuation discipline of the managers and their alignment with long-term performance to both the upside and the downside. Our experience is that it is very difficult, if not impossible, for external manager models to develop robust, bottoms-up views on valuation on the underlying portfolio companies. There are simply too many assets to track in the required detail without defaulting to index-level approaches that never quite represent what is actually owned or capture true long-term intrinsic value.
To align the focus on the very long-term, valuation should be considered more of a risk mitigant than a return driver — that is, the aim should be for returns to come from the compounding of intrinsic value rather than the shorter-term timing of multiple expansion / re-rating.