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If investment skill means outperforming a benchmark, then college endowments show little skill. The authors of a recent study on the long-term performance of university endowments found no evidence that manager selection, market timing, and tactical asset allocation generated a higher return than the overall stock and bond markets. Elite institutions did outperform all other colleges but only because they put a higher allocation to illiquid alternative investments.

Brad M. Barber, a professor at the University of California, Davis, and Guojun Wang, a PhD student at the same school, recently published a working paper titled Do (Some) University Endowments Earn Alpha. It is an in-depth analysis of the performance of 279 endowment funds over 21 years, from 1991 to 2011. The authors were seeking to answer three questions: (1) Does the average endowment earn an abnormal return (alpha) relative to standard benchmarks?; (2) Do elite institutions earn alpha?; (3) Is there evidence of performance persistence in endowment returns?

The database was assembled from two sources, the National Association of College and University Business Officers (NACUBO) Endowment Study and the NACUBO-Commonfund Study of Endowments (NCSE). Three breakout groups were created from this data: Ivy League schools (Brown, Columbia, Cornell, Dartmouth, Harvard, Princeton, Penn, and Yale); top-SAT schools outside the Ivy League (75th percentile of math SAT scores for incoming freshman); and all others.

On average, the 279 colleges performed in line with a portfolio consisting of 59% in U.S. stocks (as measured by the S&P 500) and 41% in bonds (as measured by the Barclays Aggregate Bond Market index). This allocation was close to the average stock and bond allocation for all funds. This suggests that the endowments were at least able to earn back the fees they spent on active management.

Adding more benchmarks to the asset class mix reduced the results. The average fund underperformed by 0.68% per year when regressed to a benchmark consisting of 36% U.S stocks, 31% U.S. bonds, 13% non-U.S. stocks, 11% in a hedge fund index, and 8% in a private equity index (see the study for information on these benchmarks).

The Ivy League schools faired the best by outperforming 0.46% alpha-regressed against the five benchmarks. The top-SAT schools (excluding Ivy League) lost 0.99% on average (negative alpha). The remaining institutions lost 0.68% on average.

Persistence of returns was evident in the top performing schools and the bottom performing schools. The Ivy League institutions and other top performing endowments consistently outperformed the bottom schools. However, the persistence of performance was indistinguishable from zero when the higher allocations to alternative investments were accounted for using five benchmarks.

In summary, the average endowment did not earn an abnormal return (alpha) relative to standard benchmarks. The elite institutions earned alpha, however, this was only due to a higher allocation to alternative investments (which are illiquid and can be considered more risky). There is evidence of performance persistence in endowment returns, however this can be attributed entirely to a higher allocation to alternative investments and not market timing, manager selection or tactical asset allocation.

I suggest reading this well written report. The authors took pains to ensure it flows smoothly from point to point and isn’t full of complex formulas that only a PhD can understand. The article tells a story we know too well; in the aggregate, it’s not possible for a large group of intelligent investors to beat the markets, because they ARE the markets.

If the country’s top schools cannot outperform, how are we humble citizens supposed to? I would rather be certain of a market return than hopeful of a superior one. I believe the best solution for most investors (including most endowment funds) is a portfolio with a sensible allocation to low-cost market tracking index funds that is rebalanced occasionally.