Built to grow: Two growth strategies specifically designed for endowments
Because of its long-term structure, an investment portfolio for an endowment has particular needs and objectives. When the focus is on maintaining an asset in perpetuity or ensuring an intergenerational wealth transfer, it is crucial to continuously grow the asset base to offset the erosion impacts of inflation and any required spending. With the investment horizon stretching out to such a long term, the risk of not meeting growth targets for several years can endanger the overall objective of the endowment. On the other hand, the long horizon also allows endowments to take advantage of a number of alternative strategies, including less liquid investments, and to harvest an illiquidity premium associated with early-stage growth companies.
Not your average FAANG stocks
While growth has been synonymous with FAANG stocks (and vice versa) for almost a decade, growth equity is a much broader concept than a few high-flying technology names or a passive style index like S&P500 Growth Index.
Typically, growth strategies target stocks with high past or forecasted earnings growth rates, with expectations that this higher growth of earnings should be awarded a premium by the market. Systematic or passive strategies, while effective in capturing the benefit of growth stocks in some environments, can exhibit higher volatility and drawdowns when the cycle turns or when the earnings growth slows and companies disappoint expectations. In many cases, these stocks also can be longer in duration given the cash flows are further in the future, meaning that they benefit from lower discount rates or interest rates. This means they can sell off disproportionally when monetary policies are tightened, such as the experience of high-growth stocks in early 2022.
For these reasons, academic research1 and our own research2 have shown that systematic growth strategies that target stocks with high past or forecasted earnings growth rates do not outperform in the long run. This is likely due to the failure of systematic strategies to impose mean reversion on growth forecasts, extrapolating the past too far into the future and ignoring the price of investments. However, active managers’ stock selection skill can provide significant opportunities to outperform a passive growth index. Active managers capture growth-oriented opportunities by taking into account industry microstructures, future shifts in supply and demand dynamics. Through specialized knowledge of the businesses, growth-oriented active managers can achieve excess returns as they pick companies that grow faster than the overall market—and can be rewarded for it. It may require patience, however, as by definition growth investing requires a perspective on future potential, and being a growth investor is very much about being a long-term investor, as we have heard from Barry Dargan at Intermede.
For the last 10 years, passive growth indices have done well. From April 30, 2012, to May 2, 2022, the S&P500 Growth Index rose from 756.34 to 2728.09. Going forward, passive growth looks more complicated. In our recent Equity Manager Report, we heard from our underlying growth managers that they are reassessing exposure to recently fallen popular names such as e-commerce, given lower valuation ceilings with rising interest rates. While tightening monetary policies may be contributing to a selloff in growth stocks in the near-term, managers have rotated out of high-growth, high-valuation stocks into less rate-sensitive names. By adjusting to market conditions, considering shifting industry dynamics and evaluating the opportunity set, active managers can adapt in a way that a passive index cannot.
Despite the near-term challenges, growth stocks can still make sense specifically for endowments, because of that long-term structure. However, we believe active management becomes a requirement for success.
Opportunities in private equity for endowments
Skilled managers in listed equity and private equity spaces will have different opportunity sets, i.e., different hunting grounds for attractive investment prospects.
Managers looking for growing public companies can certainly find opportunities that are available in the listed markets, but being able to get in, as an investor, on the ground floor before the elevator gets crowded can mean potential multiples on your invested capital. For example, Uber and Airbnb, two of the 10 largest-ever technology IPOs, were 10 and 12 years old, respectively, before going public—long after they had disrupted the industries in which they operate.3
This is where private capital—growth or venture strategies in particular—can provide an opportunity to meet the more aggressive return targets. Getting there, though, is not easy. First, early-stage companies require a longer time horizon versus their more established peers to reach their full potential. Endowments are uniquely positioned to weather the longer time needed for a start-up to become an industry leader, as it aligns well with their long-term investment horizon.
Additionally, there are practical challenges as well. Many early-stage companies fail, which is why we believe it’s important to partner with an investment manager who is both skilled in identifying the next great story and can provide access to the opportunity. Such access requires private-market-purchasing scale. Finally, the specific nature of vehicles that facilitate investment in early-stage companies makes them more suited for endowments, which do not have the same liquidity constraints as an individual investor or a pension plan—allowing them to manage the lock-up periods required.
One version of this lock-up period is the J-curve— the term commonly used to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life, particularly with primary (newly formed) fund investments. This occurs because capital commitments take several years to be called, yet fees are charged (on committed capital) prior to the realization of returns, such as distributions or the sale of portfolio company investments. And while the J-curve reverses over time as investments are made, the fund’s net asset value grows and investments are realized, investors are nonetheless exposed to negative returns in those early years. By working with a strategic partner with deep private-markets expertise, the J-curve can be flattened through tools such as secondaries and co-investments.
The necessity of a total-portfolio approach
A total-portfolio approach is key for allocating capital to areas of the most efficiency while maintaining a perspective of total exposures present and risks taken in the portfolio. After all, in order for alternative investments to provide true diversification benefits to the endowment, they need to be a truly diversified source of returns. Some of the research, including Richard Ennis’ examination of 100 large endowments, has shown that, without an examination of risks at the total-portfolio level, it is easy for a portfolio that looks diversified from an asset-class perspective to be driven by essentially public market beta.
To ensure that the allocations to alternative asset classes provide the benefits of return enhancement and risk diversification, it is crucial that their characteristics are evaluated in the context of the overall portfolio and that concentrated risks, such as common drivers across asset classes, are addressed. As described above, since private capital space can be a more fertile ground for finding long-term growth opportunities, it is likely that an endowment’s private equity allocation will have predominantly growth-style characteristics. This may mean that the listed equity part of the portfolio may need to have other style characteristics to properly diversify risks and sources of return. No one style outperforms the broader market 100% of the time, and total portfolio risk management is essential to provide consistency of returns.
The bottom line
The long-term requirement that comes with investing for an endowment is both its greatest challenge and greatest strength. We believe that endowments do best when they lean into the advantages that only come with the long-term. It may seem obvious that growth stocks and private markets are good bets for endowments. What may be less apparent is the need to take a total portfolio approach.
¹ Source: Fama and French (1992, 2000), Chan, Karceski and Lakonishok (2002, 2003), Skinner and Sloan (2002)
² Source: Growth as a Return Source (Russell Investments Beliefs, 2017)
³ Source: Hamilton Lane, "Broader Horizons: The Case for Private Markets Investing" April 2021