Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

Don’t count out active managers just yet, the Yale endowment says.

As Bloomberg’s Janet Lorin reported on Sunday, Yale University’s endowment hit back at “fee bashers” in its recently released 2016 annual report. Yale gave voice to the battle cry of high-priced active managers everywhere: “The important metric is net returns, not gross fees.”

Yale’s faith in active managers has paid off handsomely over the last three decades. More than 90 percent of Yale’s endowment is “targeted for investment in assets expected to produce equity-like returns.” The endowment has beaten a passive 90/10 portfolio made up of the S&P 500 Index and the Bloomberg Barclays U.S. Aggregate Bond index by 3.3 percentage points annually over 30 years through fiscal year 2016, including dividends. Yale did even better over 20 years, beating the passive portfolio by 4.8 percentage points annually.

Pricey Portfolio
The vast majority of Yale's endowment is invested with active managers
Source: Yale

Yale’s argument assumes that high fees are the inevitable price of market-beating returns, but that’s no longer true. As I’ve pointed out, traditional styles of active management are now available as low-cost index, or smart beta, funds. Granted, those funds haven’t been around for 30 years. But because they use a quantitative approach to active investing, that approach can be back-tested to see how it would have performed historically.

It turns out that when comparing Yale’s returns to low-cost active strategies rather than a passive index like the S&P 500, Yale’s active managers don’t look so special.

More for Less
It's not clear why Yale's endowment should pay a fortune for active management
Sources: Yale, Ken French, Bloomberg
Note: 90/10 passive portfolio is S&P 500/Bloomberg Barclays U.S. Aggregate Bond Index; 90/10 active portfolio swaps an equally weighted blend of quantitative value and profitability strategies for S&P 500.

For the 90 percent of Yale’s portfolio that’s allocated to equity-like investments, I substituted an equal blend of two quantitative active strategies compiled by Dartmouth professor Ken French. The value strategy selects the cheapest 30 percent of U.S. stocks by price-to-book ratio, and the profitability strategy selects the most profitable 30 percent of U.S. stocks. The chosen stocks are then equally weighted. This 90/10 active portfolio beat Yale’s endowment by 0.4 percentage points annually over 30 years and trailed the endowment by just 0.3 percentage points annually over 20 years.     

So Yale is right that active management can add value to its endowment, but it’s no longer clear why active management has to cost a fortune.

Still, you can’t blame Yale for trying to pre-empt complaints about the fees it pays to active managers. Yale’s endowment was $25.4 billion as of fiscal year 2016. If it pays management fees of 1 percent -- and that number could very well be higher -- that’s $254 million in fees every year.

Yale may be able to keep a lid on the fee discussion if the endowment continues to beat the market. The problem is that active strategies -- whether traditional or alternative -- have struggled to keep up with the market in recent years. Those struggles are showing up in Yale’s returns. Over the last 10 years, Yale has beaten the 90/10 passive portfolio by just 0.8 percentage points annually. And Yale should feel fortunate to have done that well. The 90/10 active portfolio trailed the passive portfolio by 0.3 percentage points annually over the same period.

Now the question is whether active management’s recent malaise is cyclical or something longer lasting. Many investors aren’t hanging around to find out. A growing number of institutional investors are reducing their exposure to hedge funds. Investors have allocated a net $1.1 trillion to passively managed funds over the last three years through 2016 while withdrawing a net $320 billion from active funds, including smart beta. 

Yale’s bet on active managers is a bigger gamble today than it was 30 years ago when David Swensen took the helm at the endowment. Given the mood of investors, Yale’s stakeholders are likely more fee conscious than they used to be. They’re probably also more skeptical than ever that active managers can beat the market. If active strategies continue to disappoint, the Yale community will no doubt wonder why the endowment isn’t more passively postured. Or at least why it isn’t turning to more cost-effective forms of active management.

Yale’s endowment prides itself on pioneering portfolio management. With the popularity of low-cost investing, Yale is once again bucking the trend. Only this time everyone is watching.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net