Some small and mid-sized endowments and foundations are questioning the value of an “Endowment Model” portfolio that includes uncorrelated alternatives instead of a blind 60/40 portfolio of stocks and bonds allocation.  The model has been criticized for being too complex and staff heavy to manage. However, a new study from institutional consulting firm NEPC shows the majority have not forgotten the lessons of 2008.

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While a traditional correlation to stocks that ignores hedging during potential periods of economic uncertainty, a strategy that has worked well only after 2008, might not work well in the future, the report says.

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Endowment Model: 60/40 portfolio has produced outsized returns

“While the 60/40 portfolio has produced outsized returns over recent periods, NEPC does not believe it is positioned for outperformance going forward,” the report reads, then it touches on a controversial topic. Traditional portfolios fully balanced towards equities “represents a risky portfolio in many regards.”

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While alternatives have always been viewed as the higher risk, as stimulus is unwound and a growing muscular presence from Russia, China and troubles erupting in the Middle East might not bode well.

Endowment Model: Striking the right balance

While NEPC says that the entire Endowment Model, with all its complexity, might not be perfect for their needs, it advises to include uncorrelated assets in their approach to a varying degree.

“We suggest that small and mid-sized Endowments seek solutions that fall somewhere on the continuum between the simple portfolio and the complex one,” the report concluded. The problem with many smaller foundations and endowments is they can’t afford to staff alternative asset professionals to initially diagnose risk / reward of volatility investments – and have little desire to manage such investments on a going forward basis – particularly when stocks have been performing so well.

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The investment consultants recommend “a modest allocation to illiquid assets, an operable number of investment managers, a blend of active and passive strategies and a long-term perspective.” Passive models might include a simulation of a hedge fund index or broad based exposure rather than trying to pick and choose investments the traditionally equity-focused managers don’t entirely understand.

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The Endowment Model, while unnecessarily complex in many regards, forces endowments to embrace risk budgeting. “When we look at the portfolio from a risk budgeting perspective, we are trying to gain perspective on how the portfolio’s overall risk is distributed,” the report said.

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It is this distributed risk – particularly during periods when all investments correlate to one – that the alternative investments matter most.