The importance of the endowment model investing for families

Preserving and growing wealth over time has always been a challenge for investors, including families.

A key driver of preserving and growing wealth is diversification. Diversification is a powerful risk mitigation strategy that reduces the concentration risk in the core family business and generates new streams of income and capital independent of the core family business. In our experience, the most successful method to achieve diversification away from the core family business is the creation of a family investment portfolio. But what investment strategy should a family choose? What investments will comprise the portfolio? What asset classes should be chosen?

By emulating the investment model and principles used by successful institutional investors such as Harvard University and Australia’s own Future Fund, families can adopt an endowment model of investing approach that generates consistent long-term, diversified returns that preserves the capital invested even during market crises such as the GFC and COVID-19.

What is the Endowment Model?

The US University Endowment Funds (US Endowment Funds), led by Harvard and Yale Universities, have been leaders in diversified multi-asset class investing for over 30 years (Endowment Model). Through this investment model, US Endowment Funds have consistently achieved attractive risk-adjusted annual returns with much lower volatility and lower correlation to markets [1]. More recently, the Future Fund has also adopted the Endowment Model, which has produced a 10-year return of 10.1% per annum against a 10-year benchmark target of 6.1% per annum [2]. The basis for investing across multiple asset classes is supported by the Modern Portfolio Theory (MPT). MPT is an investment theory that allows investors to assemble an asset portfolio that maximises expected return for a given level of risk – i.e. for a given level of expected return, investors will always prefer the less risky portfolio [3]. The core tenet of MPT is diversification, which in practical terms means owning a portfolio of different asset classes is less risky than holding a portfolio of similar assets. MPT is the driver of the investment philosophy employed by most US Endowment Funds (and our Future Fund), and is the foundation upon which their portfolios are constructed.

The basic principle of the Endowment Model is the preservation and growth of capital at a rate that outpaces inflation [4]. This is achieved through a diversified portfolio of varied correlations (i.e. the degree to which two securities move in relation to each other) that has a lower allocation to Fixed Income securities and significantly higher to Alternative investments, including private equity, venture capital, real assets, infrastructure and commodities. Increasingly, more unique low-correlated Alternative investments have been allocated to portfolios by endowments, including litigation funding, life settlements, music and other royalty streams.

The target benchmark applied to the Endowment Model is inflation plus 5% per annum.

Unique Characteristics of the Endowment Model

The late David Swensen, Chief Investment Officer of Yale University, pioneered the Endowment Model (also known as the “Yale Model”). Yale University has been the best performing US Endowment Fund returning 11.8% per annum over the past 20 years [5]. To benchmark this performance, the Yale Endowment Fund significantly outperformed Warren Buffett’s Berkshire Hathaway (8.7% per annum) over the same period [6]. In building the portfolio of the best performing US Endowment Fund, Swensen employed these key tenets in his portfolio construction [7]:

• Higher allocation to illiquid, longer duration assets, especially Alternative Investments.

• Focus on diversification as a means of mitigating risk.

• Lower allocations to core Fixed Income.

• Long term investment horizon versus market timing.

• Superior manager due diligence and selection.

• Focus on higher returning private assets (i.e. venture capital)

• Select new managers who are in the emerging or growth phase of the manager lifecycle (< 5 years).

• Access to best of breed global investment opportunities to generate alpha.

• Global investment mandate with reduction of “home bias” within the portfolio.

Importance of the Endowment Model for Family Investment Portfolios

While most US Endowment Funds manage billions of dollars in assets, the Endowment Model can, and should, be employed for smaller investors, such as families. The greatest strength of a family is its long-term, multigenerational focus. Additionally, a well-defined investment strategy and processes, a robust and appropriate governance structure and the establishment of an investment committee can also be adopted by families to ensure the family remains substantially invested throughout all market cycles, minimises market volatility and generates consistent returns to meet their objectives, much like a US Endowment Fund. To achieve this outcome, we recommend families adopt the following tenets from the Endowment Model:

• Maintain a long-term focus and consistent investment approach.

• A focus on growth is imperative.

• Employ a multifaceted asset allocation structure in the portfolio.

• Take advantage of the “Illiquidity Premium.”

• Employ Dynamic Asset Allocation to adjust the portfolio based on macro trends.

• Remain disciplined during periods of market crisis

• Avoid market timing or impulsive investing.

• Avoid “home bias.”

Summary

Diversification to the core family business is a key to preserving and growing the wealth of a family over multiple generations. The most effective way to achieve this goal is to create a family investment portfolio that uses the Endowment Model. Through the adoption of similar asset allocation and investment principles employed by US Endowment Funds, it is possible for families to obtain high levels of risk-adjusted returns for their own portfolios, superior to that of the traditional 60/40 equity/ bond portfolio and balanced investment funds.

John Quinlan, Chief Investment Officer

EWM Group

About EWM Group

EWM Group has been created by and designed for entrepreneurial individuals and families who have already achieved many of their financial goals and is proud to continue our association with Family Business New Zealand as National Gold Partner and specialist in the areas of Family Office advice, Wealth management, Family Governance and Philanthropy.

EWM Group was the 1st Independent Multi Family Office in Australia, headquartered in Brisbane with a presence throughout Australia and New Zealand. Over that time, EWM Group has grown to be recognised as one of the global leaders in Australasia with an international client base.

Their clients are entrepreneurial individuals, multi-generational families, and families in business, all of whom have been highly successful in what they do. These include current family business owners, former business owners who have had a full or partial liquidity event, inheritors of wealth, single family offices, Philanthropists, Sporting and Entertainment individuals, not for profit organisations and Traditional Owners.​ As an independent organisation, EWM Group sits on our clients side of the table, working in unison with your existing advisory team.

For further information: www.ewmgroup.com.au or contact jquinlan@ewmgroup.com.au or bscott@ewmgroup.com.au

Disclaimer

The views expressed in this content are those of the author, who is also responsible for any errors and omissions. Family Business Association provides this article for your information only. The content of the article should not be taken as advice. If you wish to explore this topic, please consult an advisor who you consider to have the expertise to provide specific advice in relation to your family business.

Footnotes

[3] Corporate Finance Institute, What is Modern Portfolio Theory? (2021).

[4] David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (2000).

[5] Yale Investment Office, Annual Report, 2020-2021.

[6] Bloomberg Business Week, How David Swensen Made Yale Fabulously Rich, September 2019.