Sunday, June 5, 2016

Are big endowments smarter or just willing to take on more risk?

Are bigger endowments just better managers? Everyone wants to be the Yale or Harvard endowment because we have been told that they have unlocked the secrets for big returns. The big boys are the envy of most investors, yet a closer look may surprise you.

A recent study of endowments by Tuo Chen of Columbia University shows there is a strong positive size effect between the size and returns. This is is consistent with the work of Piketty on inequality and wealth. There is a rising gap between the wealthy and not so wealthy because richer investors make higher returns. It is the reason for this success which may surprise many investors.

This higher return story makes sense if you believe that the larger endowments have an information advantage and can higher better skilled managers. However, the story is more complex. After adjusting for risk, the size advantage goes away and may actually be negative. The big endowments are better because they take on more risk. Being less risk averse allows for bigger bets that generate higher returns.

The poorer performance of smaller endowments is based on their caution. If you think the markets are not fair, caution may be warranted. Don't play a game that can work against the less sophisticated. There may be some value from an information channel, but the authors shows that risk-taking is a much  greater driver. Perhaps it makes sense for investors to better understand their willingness to take risk over trying to get an information advantage  in order to enhance performance. 

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