Tuesday, September 4, 2012

Strategic Asset Allocation: Endowment Model

This is a first in a series of posts covering different competing philosophies of strategic asset allocation*, and how one could replicate these philosophies. This post focuses on endowments.

Endowments (of colleges and universities) are basically funds of funds with two important differences: there's only one client and the time horizon for investments is extremely long term. This gives endowments a few advantages over other investors: they don't have to deal with marketability or PR, and they can allocate to non-public illiquid securities (which can take years or decades to realize their alpha).

Thus, a significant amount of the new thought in strategic asset allocation* is contributed by endowments and their managers.  The traditional strategic asset allocation standard has been the Modern Portfolio Theory-influenced 60/40 stocks/bonds portfolio that financial advisers love to reference (even now, I'd wager that most 401k's look like this). However, there is nothing "modern" about MPT or these portfolios - it's a sixty year old model. For the post-MPT world, there are a few competing philosophies when it comes to asset allocation:
  1. the endowment model (most commonly represented by Yale and Harvard)
  2. the Norway model (a sovereign wealth fund)
  3. Risk Parity (most famously espoused by Ray Dalio of Bridgewater)
Here is a good summary by one of my favorite bloggers of what exactly the endowment model entails:

DIVERSIFIED:  Broad diversification is embraced.  
HIGH-RETURN ORIENTED:  Equities and high-return alternatives are favored.  Other than as a safe-harbor, bonds are eschewed.
PERPETUAL INVESTMENT HORIZON:  While endowments have always had a perpetual horizon, the endowment investment model actually attempts to take advantage of this.
ILLIQUIDITY SEEKING:  One means of doing so, is to accept illiquidity and demand, in consequence, a higher return.
GLOBAL:  This is a corollary of diversification, but the endowment investment model was more global earlier than other investors.  The current manifestation of this approach is to overweight emerging markets relative to naive benchmarks.
LONG-TERM IN PERFORMANCE MEASUREMENT:  This is the corollary to the perpetual investment horizon, but merits separate mention.  EndowmentInvestor believe successful endowment management requires a long term view in evaluating managers and strategies.
ACTIVELY MANAGED:  Most endowments use active investment management heavily.  This is a requirement in asset classes like hedge funds and private markets where indexing is not an option.  Many commentators would characterize active management as an essential characteristic of the endowment investment model, but EndowmentInvestor does not believe it a requirement to be 100 percent active.
POTENTIALLY CONCENTRATED:  Those that believe in active management in the endowment world [the majority] avoid closet indexing by favoring a handful of concentrated managers.

As an example, on the right is the asset allocation of Harvard's endowment.

Following the popular nomenclature, I would call this portfolio a 36/13/51 allocation (36% to stocks, 13% to bonds, the rest to alternatives). We can see it's highly diversified, with no more than 14% to any single asset class. Furthermore, the high-return focus is obvious with a 87% combined allocation to equities and alternatives. Private equity, absolute return (hedge funds) and real estate are 37% of the portfolio, reflecting their capture of the illiquidity premium. 

The allocation to public equity makes up 36% of the portfolio, and of that portion, equal parts are given to domestic, foreign and emerging markets. In comparison, free float adjusted market cap weights in the MSCI ACWI (All Country World Index) gives 50% to domestic, 40% to foreign and 10% to emerging markets. Some investors don't even follow the ACWI, instead indexing their equity allocations to the S&P 500. This overweight of domestic equities is called home bias, which reflects the tendency to favor the familiar. Harvard is heavily overweight international equities, especially emerging markets, relative to the ACWI. Although Harvard's public equity allocation is one of the more extreme examples, it's an excellent reminder of the importance of avoiding home bias through global diversification. On a long term basis, most investors would benefit by following the more diversified ACWI rather than the US-only S&P 500.

One significant feature of endowments which was omitted from the otherwise comprehensive list above is the emphasis on real assets. Harvard's allocation to real estate and commodities is 23%. Unfortunately, most 401k options don't give you commodity funds (although some give you natural resource equity funds), but that doesn't mean this real asset bias is impossible to replicate. David Swenson, CIO of Yale, advocates a 20% REIT allocation in his book Unconventional Success (if anyone wants to borrow a copy, ask me). Yale's endowment itself has a 29% allocation to real assets (20% real estate, 9% natural resources). The idea is that although short term volatility could be high, even bubble-like (considering real estate's recent global boom and bust), long term fundamentals are excellent: it's the perfect hedge against inflation, and the world is running out of natural resources

To summarize, an endowment replication portfolio would be heavy in equities (particularly international), real estate, commodities and natural resources. Although private equity and hedge funds aren't available to many investors, finding a good uncorrelated absolute return manager or strategy isn't impossible (he might even be your old college roommate).

Next few posts in this series will cover 1) Norway's sovereign wealth fund and 2) Risk Parity.

*The difference between strategic asset allocation (SAA) and tactical asset allocation (TAA) is that SAA is static and TAA is dynamic. SAA can be thought of as a framework upon which TAA is overlaid, although this is not always the case. Here's a few ways in which the two are combined:

1) On one extreme, you may have a SAA with no TAA, in which case you consistently rebalance to the same static allocation (such as 60-40 stocks-bonds) and never deviate. In this case, 100% of your alpha will come from your SAA.
2) On the other extreme, your strategy could be completely TAA with no underlying SAA allocation. Mebane Faber's TAA model (here's an implementation in R) rotates among the top performing x out of 5 asset classes. This asset allocation has no "base" case since the portfolio can look drastically different at each rebalance period, such as switching from 100% stocks to 100% REITs (as it did recently) in the x=1 scenario. In this case, 100% of your alpha will come from your TAA.
3) Finally, you may have a combination of both (1) and (2). For example, your SAA may be a 60/40 stocks/bonds allocation, but your TAA strategy is to shift +/-x% depending on recent outperformance in a two-asset version of Faber's rotation system. If x=10, your final allocation will vary between 50/50 to 70/30. Both SAA and TAA contribute to your alpha, but obviously as x increases, more of your alpha will be attributed to your TAA rather than your SAA.

This post is mainly about SAA, which is irrelevant to investors who use 1) completely TAA methods, 2) bottom-up individual security selection (such as value investors) and 3) shorter term trading. However, to anyone who has 401k in which there is limited security selection (which usually consists of diversified mutual funds) and short-term trading restrictions (which usually range from a month to a quarter), SAA is pretty much the only game in town since any of those other strategies are pretty much completely forbidden. Although it is possible to use a quarterly rebalanced TAA strategy in a 401k, most investors with 401k's are in the "set it and forget it" or "buy and hold" category, which again is basically SAA.

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