Carthage College Endowment Overachiever Leaves Money on the Table

(Bloomberg) -- Bill Abt, who manages money for Carthage College in Kenosha, Wisconsin, is at the top of the endowment game. Using 10 Vanguard funds — the same low-cost funds available to retail investors — his 10-year return beat 90 percent of his peers. He avoided the high costs and extra risks of more sophisticated products and the need for a large staff for due diligence and monitoring.

It's a feel-good story, for sure, but it can be misleading. Not because the message is wrong — low cost, well-diversified index funds are a sensible way to invest. But there are good reasons for sophisticated investors to look beyond them. One investor over one 10-year period is meaningless.

Let's use the same 10 funds in the same proportions, rebalanced monthly, and track returns since 1963.

Over the 55 years, the Carthage portfolio's annualized return was 8.87 percent. This is significantly better than the 5.63 percent  over the 10-year period, so I'm not being unfair in choosing the longer one.

Should an institutional investor be satisfied with this performance? I think the answer is no. For one thing, after adjusting for inflation, the 8.87 percent is only 4.79 percent. For another, there's reason to believe recent years have been unusually good for equities. A prudent assumption is perhaps a 2 percent to 3 percent inflation-adjusted return in the future.

Another problem is drawdowns. In 55 years, this portfolio had six separate drawdowns that exceeded 20 percent, three that were more than 30 percent, and two that were more than 55 percent. That's significant pain and often causes disastrous decisions to reduce risk at the bottom. Volatility has another cost. If Carthage returned a real 4.79 percent a year every year, it could afford to pay out 7 percent of initial assets, increasing with inflation, every year for 25 years. But the actual portfolio runs out of money within 10 to 20 years, depending on whether it started at a good or bad time. So even if 4.79 percent  satisfies actuarial needs, 4.79 percent with 14.45 percent standard deviation will not.

So investors have reason to consider more sophisticated strategies like leverage. Because equities have embedded leverage (the stocks represent corporations that have borrowed money), they're the only main asset class with expected returns to satisfy most investors' needs. But other asset classes can provide enhanced returns and diversification.

For instance, you could try this: For each $100 under management, use $90 to buy the 10 Vanguard funds and also buy $90 of 10-year Treasuries. You have to borrow $80 to do this and pay interest.   The annualized return jumps nearly 100 basis points — from 4.79 percent to 5.73 percent — with the same standard deviation. This is not hindsight basis. Financial theory suggests investors should earn a premium by investing in long-term bonds, and there are roughly equal periods of increasing and decreasing interest rates since 1963. The leverage will add costs and risks, but there is an argument for using leverage to include some low-risk, low-return asset classes,  thereby diversifying  risk sources.

Within equities, investors can improve their results by shorting. Even the father of efficient markets, Eugene Fama, agrees that there are long-short equity portfolios that systematically produce market-beating returns. His colleague Kenneth French graciously posts these on his website, so there's no need for expensive research to exploit the four Fama-French factor portfolios.

For each $100 under management, keep $100 in the 10 Vanguard funds, but also make $25 notional investments in each of the four Fama-French factor portfolios. Overall, this means you'll be long $200 of assets and short $100. You have the same net exposure to assets ($100), but your portfolio will be overweighted with the types of stocks that have historically outperformed (small, value, high-quality, conservative) and will not only avoid but bet against the types of stocks that have historically underperformed (large, expensive, low-quality, aggressive). This is not discretionary active management, it's smart beta, getting your exposure to stocks in systematic ways that have historically done better than being 100 percent long and 0 percent short. The results are that real return would have climbed from 4.79 percent to 8.40 percent, and the standard deviation would have fallen from 14.45 percent to 13.44 percent.

The Carthage Vanguard funds charge fees from 0.04 percent to 0.40 percent. Institutional portfolios that use leverage, shorting and other techniques to diversify away from equity risk and exploit alternative risk premia typically charge 0.60 percent to 0.80 percent for simple strategies like those described here, all the way up to 2 percent of assets and 20 percent of profits for sophisticated proprietary strategies. In my opinion, there is a lot of overcharging — 2 percent fees for worthless enhancements, 2-and-20 for simple things anyone can do for 0.60 percent. Nevertheless, I think there is a strong case for institutions to at least consider paying more than 0.11 percent (the weighted average fee for Carthage) and accepting some risks of leverage, shorting and illiquidity, among others, to reduce excessive concentration on equity risk.

To contact the author of this story: Aaron Brown at

  1. None of the actual funds have returns before but we can approximate the earlier returns using Fama -French factors. These have a better than percent correlation with the actual returns, so they're a pretty good guess about how this strategy would have worked had Vanguard offered the funds in

  2. The actual endowment returned percent; the percent is my computation of the return on the indicated portfolio of Vanguard funds rebalanced monthly. The difference presumably is due to either a different rebalancing schedule or changing allocations over the years.

  3. Public pension funds typically use assumptions that imply about a percent real return on this kind of portfolio, and most are severely underfunded even if that real return is realized. So even if the percent is reached in the future, it's still not enough.

  4. In practice, most professional investors would instead put $90 in the Vanguard funds and use the extra $10 as margin to go long $90 notional of 10-year Treasury futures, but the economic effect is the same either way.

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