The paper, “Does Active Management Benefit Endowment Returns? An Analysis of the NACUBO-Commonfund Study of Endowments (NCSE) Data,” examines the active management versus passive management debate and concludes that endowments with more active asset management see higher returns net of fees from U.S. equity allocations.

The analysis also finds that endowments with a designated chief investment officer or outsourced chief investment officer (OCIO) are better able to earn incremental positive returns from active management than those without. 

“Larger endowments are better able to earn incremental positive returns from active management than the smallest endowments, but the effect appears to diminish as endowments increase in size,” say the authors of the paper, including David Belmont, Commonfund’s chief risk officer, and Irakli Odisharia, Commonfund’s market risk director.

“Active management is broad and portfolio managers may use a variety of factors and strategies to construct their portfolios,” explain Belmont and Odisharia, based in Wilton, Connecticut. These include quantitative measures, sector investments that attempt to anticipate long-term macroeconomic trends, and purchasing the stock of companies temporarily out of favor. Other strategies include risk arbitrage, short selling and option writing. The effectiveness of an actively managed investment portfolio depends on many elements, the team writes, which include the skill of the manager and the research staff, as well as market conditions.

Another element to consider is risk, says the paper. “Active managers have risk characteristics that match well with endowment risk appetite. These risks are typically slightly higher volatility, somewhat lower liquidity, and higher portfolio concentration than passive managers,” say Belmont and Odisharia.

The paper also notes that the performance benefits of active management are more evident over the long term. “Our results suggest that during individual years, active management in U.S. equity may or may not add value but that over longer periods of time, active management does add value and outperforms passive index investing. Outperformance in active investing is a long-term effect and takes time to materialize,” say Belmont and Odisharia.

Belmont and Odisharia observe that it requires skill and ongoing diligence to identify truly active managers and ensure the endowment isn’t paying excessive fees to a “closet indexer,” or a fund manager that advertises as active but closely correlates to an index. They say it is easy to make a mistake in differentiating a truly active manager from closet indexers and that performance analysis of managers’ returns is essential if one is to capture the benefits of active management. 

The paper recommends that in order to capitalize on the benefits of active management, smaller endowments need to have access to the services of a skilled evaluator in order to discern true active managers from closet indexers. For smaller endowments, the overhead costs of an in-house chief investment officer and support staff can outweigh the benefit. However, benefits of such services can be partially or fully obtained via the use of OCIO and consulting services.

The paper can be downloaded here.