The original version of this article first appeared in The Business Times. 

Institutional endowment investing can be available to individuals

In 1985, Yale University’s Endowment appointed a young David Swensen to become the Chief Investment Officer. 

From 1985 until he passed away in 2021, Swensen took the Yale Endowment from US$1 billion to over US$40 billion despite disbursements of 5% every year and achieved an unprecedented average annual return of 13.7% over 25 years. 

The terms institutional investing or endowment investing are so closely associated with Swenson and Yale that it is sometimes even called the Yale model or the Endowment model of asset allocation and investing. 

One of the key pillars of such a successful investment strategy was not only the heavy equity bias of the portfolio over fixed income and commodities, but also what was at the time a revolutionary idea. The thesis that the Yale endowment held at its core was that liquidity was a bad thing, as you paid a heavy price in the form of lower returns to have liquidity. Cash or deposits drag on long-term returns. 

This is why the Yale model pursued a heavy allocation to asset classes such as private markets, especially private equity and venture capital early on and they harvested excess returns from its illiquidity premium. 

The idea was that by giving up liquidity, which you don’t need for your long-term savings, one can generate higher returns without necessarily taking more risk or reducing the risk in the form of volatility of returns. 

Asset allocation drives most of the return

Many studies show that up to 90% or more of long-term returns are driven by asset allocation. What that means is that it isn’t what stocks you buy that matters, but how much equities you have in your overall portfolio versus other assets such as cash, fixed income, commodities, and alternatives such as private equity, private credit, private infrastructure, and hedge funds. 

It is the systematic factors behind each asset that drive these long-term returns and assessing the risk and return of each asset class is what will determine the risk you expose yourself to and what returns you will generate in the long term. 

Exposure to alternative asset classes such as private equity and private credit has been shown to lower the level of realised volatility. 

Many people take risks that are not compensated or rewarded, by punting on stocks or trading crypto. One must always be compensated for the risk one takes in the form of returns that are consistent and realisable. It is the consistency of long-term returns in traditional and alternative assets that require them to be the core of any individual or family portfolio. 

Private equity opportunity set is much larger than the public markets 

Are there more opportunities in private equity? 

As of 2024, there are 20x more private equity-backed companies than companies listed in the public markets. Around two-thirds of all corporate revenue is generated by private companies while the remaining one-third comes from public companies, including familiar names like Apple, Nvidia, Microsoft, Amazon, and Google. 

With no exposure to private markets, you are missing out on a significant part of global corporate growth. Research from Nobel-laureate Professors Eugene Fama and Kenneth French suggests that small companies tend to generate better returns as they have a lower base from which they start, and so not investing in this category means the ability to generate excess returns is diminished.  

In addition to getting exposure to a broader investable universe by investing in a private market fund, you get exposure to more active management of the underlying portfolio companies. Unlike public companies, where the shareholders do not have much control over how the business is run, in private companies, the private shareholders can help improve or restructure the business to create value both in equity and credit. 

With the advent of open-ended, evergreen fund structures, there is no need to take the additional credit risk of a single-vintage, closed-end fund and the higher concentration risk that arises from investing in a narrow pool of companies. If you build these funds into a multi-manager portfolio, then it further diversifies risks. 

So why include private markets in your portfolio?

The three main reasons for investors to consider investing in alternatives are to achieve greater diversification through uncorrelated returns; to bear lower volatility and risk, and to improve systemic returns by, for example, harvesting the illiquidity premium.

The global public equities market has returned an average of 7% per annum over a multi-decade period. There are only a few ways to improve returns above the public equity beta over a longer-term period. These include alpha, illiquidity premium, and leverage. 

There is a higher chance of alpha generation with private opportunities that are available for a smaller pool of assets. There may also be greater flexibility in achieving alpha with the absence of benchmarks or in the case of hedge funds, the use of shorts and derivatives.  It also has an illiquidity premium as long-term capital that does not need to be withdrawn can demand higher returns from companies that need funding.

Alternative investments tend to have lower volatility as compared with the public markets, as private equity firms would value their funds (mark to market) on a less frequent basis, often based on “events” such as the pricing of the latest fundraising round of the company. As such, it would not have to go through the daily volatility that public markets go through. 

We talked about the diversification benefits of a much deeper pool of private companies that are otherwise not available for public market investments already but it is not just in numbers but also greater flexibility to include sectors that are harder to access — such as aircraft leasing, ownership of sports franchises, and intellectual property, etc.

Will private market investments be more broadly available?

On 27 March, the Monetary Authority of Singapore published a consultation paper to seek feedback on a proposed regulatory framework for retail investors to invest in private market investment (“PMI”) funds, providing them with a wider set of investment choices. We believe, if done right, this is a positive step to make private markets available to all investors regardless of their income and amount of assets and could lead to democratisation of access to Private markets. 

However, we feel it does require greater effort in educating those new to the asset class, and the importance of a trusted financial advisor becomes even more important to make sure the investment is suitable. Again, we must ensure that the appropriate risk is being taken and that investors will be rewarded with better outcomes commensurate with the risk they are taking and not taking too much risk while not being compensated for it. 

If done right, private markets open up an opportunity for individual investors to reduce volatility and protect capital, or improve returns and outcomes for their investment goals as long as the investment horizon also matches their goals and is long-term enough to reap the benefits of investing in illiquid asset classes like private equity. That would truly allow an institutional or endowment style of investing for all of us.