But despite the cushion provided by real assets, endowment funds will find it hard to replicate this performance in 2022.

Djâafar Aballeche and Jacques Henry, Pictet Wealth Management.

The performance of US endowment funds was very strong in the fiscal year ending June 30, 2021 (FY21), when they posted their highest average return across all endowment size cohorts since data was first compiled in 1989. According to NACUBO, the average return for all institutions in FY21 was 30.6% (in USD), ranging from 23.9% for the smallest funds (less than USD25 m in AUM) and 37.7% for the largest. By way of comparison, global 60/40 funds (60% MSCI AC World, 40% Bloomberg Barclays Global Aggregate Bonds) provided a return of 22.5% over the same period, while US 60/40 funds (60% S&P 500, 40% US 10-year Treasuries) returned 22.1%.

These results are in line with our analysis of the long-term outperformance of endowment relative to 60/40 portfolios. According to this analysis, endowments generally outperform 60/40 portfolios when small-cap stocks outperform large-cap ones and when inflation or 10-year government bond yields rise by more than 50 basis points. This is indeed what happened in FY21. Thanks to their strong FY21 performance, endowments’ average annual return over 10 years jumped from 7.5% to 8.5%.

During FY21, endowments benefited from the strong appreciation of a number of asset classes, and in particular of public equities, private equity (buyout and venture capital) and real assets. The S&P 500 index gained 40.8% while US buyouts and US venture capital returned 52.6% and 96.9% respectively in the 12 months to 30 June 2021.

There was a slight change in endowments’ asset allocation in FY21. Public equities declined from 33.4% of assets to 32.5%. But the share of private equity assets increased by 1.9% and venture capital by 2.5% and they now account for 15.4% and 11.8%, respectively, of US endowments’ portfolios. In contrast, ‘marketable alternatives’ (hedge funds) fell by 3%, according to NACUBO figures, while fixed income fell by 1.2% and real assets by 1.6%.

In general, endowments have an historical average annual nominal target return of between 7% and 7.8% over 10 years. This year, however, due to rising inflation expectations, the target nominal return has increased to 7.94%. Endowment fund managers will therefore find it harder to meet long-term targets in the coming years. We also expect some changes in endowments’ asset allocation, with a tilt towards more real assets to hedge against rising long-term inflation expectations.

The fiscal year ending 30 June 2022 is challenging endowments’ ability to achieve a decent performance given the fallout from the war in Ukraine and the tightening of monetary policy, particularly in the US. Assuming markets remain unchanged from time of writing (beginning of March) to end-June 2022, our estimates are for an annual return of around 1% for US endowment funds in FY22. However, if markets continue to be driven down by the Russia-Ukraine war, endowment funds’ investment returns will likely dip into negative territory.

The historical beta of endowments relative to the S&P 500 during bear markets is around 0.50, suggesting that endowments will probably fall 50% less than equities in the case of a stock market decline. Real assets, particularly commodities, could do well in the context of rising inflation and heightened geopolitical stress and partially offset the loss from equities as real assets account for approximately 10% of US endowments’ portfolios.