Benchmarks
There’s an interesting lawsuit taking place in Colorado, as a major donor to the endowment of the University of Colorado Boulder is suing the school’s foundation for underperforming the S&P 500. The suit claims the following:
“The CU Foundation has underperformed the S&P 500 fund by approximately 5.49 percent per year from 2010 to 2019,”
and
“[CU’s] abysmal investment performance, which could have been significantly improved by simply investing in broad market U.S. equity index funds and not being over weighted in actively managed investment and ‘alternative investments,’ has cost the CU Foundation, and therefore the class, approximately $1 billion in the last decade.”
This isn’t exactly the first time a lawsuit of this nature has happened, but they are virtually all the same. So-and-so underperformed the S&P 500 which cost so-and-so money. It’s always the S&P 500 by the way. Why? Because the S&P 500 is the best performing index of the last decade of course. This is yet another example of someone adopting a benchmark of whatever has performed the best, after the fact.
This is a dumb lawsuit for many reasons. First of all, Colorado Boulder’s endowment has actually outperformed its internal benchmark as well as most of its peers over the past decade. Many would be happy with this (and generally I think most are). Second, and most importantly, endowments aren’t benchmarked against an equity index for a good reason. It’s because if you invested an endowment in all equities, you would destroy the fund. Let me explain.
Foundations and endowments have a very long (in some cases infinite) time horizon. For that reason, they must at least preserve the real (inflation adjusted) value of the fund. On top of that, these institutions also fund an operating budget each year, meaning they have regular payouts. It took me two seconds to find CU’s target payout is 4% of the fund’s value each year. Assuming they need to meet a 4% payout but also preserve real value against 2% inflation, that means they need to earn at least 6% per year.
As you’re all aware, averaging 6% per year is not going to due the job. I can still drown in a lake that is 4 feet deep on average. Endowments have to be extraordinarily careful managing risks of the fund. People have the benefit of taking on significant market risk when they are young and don’t need the money. Endowments can’t, because they have a long horizon and have regular payouts.
It took me two minutes to workout what would have happened if you had a $1B endowment invested with a 4% payout invested entirely in the S&P 500 on Jan 1, 2000. The results would have been devastating. By the bottom of the Great Financial Crisis, you would have a nominal value of $441 million, and a real value of $367 million (a little more than a third of your original capital). Monthly payouts would have started the decade at $333k but dropped to $113k in real terms by the end of the decade.
That’s why this is an incredibly stupid lawsuit. There is clearly no understanding of what an endowment’s goals are and the parameters it must operate in. It also doesn’t take a scientist to realize that this lawsuit would not even have existed if the year was 2010 instead of 2020.
The same thing can happen with your every day investor. Some will be fixated on whatever has done the best recently. If we as advisors are not meeting their planning return targets or a fair benchmark that aligns with the clients goals, that’s their bad. But if someone is upset that their portfolio that includes fixed income/insurance/alternatives is underperforming the NASDAQ over the past year, then it’s the advisors job to educate them more on why that doesn’t matter.
