When applied by the largest investors, the endowment model has created impressive returns over the past 20 years. However, this style of portfolio management comes with a special set of risks. First, portfolio managers need to be concerned about the interactions among spending rates, inflation, and the long-term asset value of the endowment. Second, a portfolio with as much as 60% invested in alternative assets raises concerns of liquidity risk and the ability to rebalance the portfolio when necessary. Finally, portfolios with high allocations to assets with equity-like characteristics and low allocations to fixed income require the portfolio manager to consider how to protect the portfolio from tail risk, which is a large drawdown in portfolio value during times of increased systemic risk. Those wishing to replicate the results of the most successful endowment and foundation investors need to consider the risks to inflation, liquidity, and extreme market events, while adding value through rebalancing and the successful selection of active managers. A focus on alternative investments also requires a greater degree of investment manager due diligence, evaluating both investment and operational risks.
Risk Management For Endowment And Foundation Portfolios
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Hello. This is Keith Black I'm the author of risk management for endowment and foundation portfolios in the Journal of Alternative Investments. I also serve as managing director of curriculum and exams for the Kaiya association chartered alternative investment analysts investors around the world have been attracted to the endowment model which is how the World's Best Colleges and Universities invest their long term assets. Because these large endowments have earned premium returns over the last 20 years in excess of the 60 40 mix and in some cases in excess of global equity benchmarks over a 20 year period. So now what we see according to the Okubo the National Association of College and University Business Officers that there's over 400 billion dollars of investments fromU.S. and Canadian colleges and universities invested in these endowment funds and the goal of an endowment fund is to spend money for the current generation while maintaining the value of the fund in perpetuity. And we know that colleges and universities need the money to pay for faculty and scholarships and facilities and all the other good things they do. Of the over 400 billion dollars in endowment investments we see that there is about 70 colleges and universities that have over 1 billionU.S. dollars in assets under management in their endowment funds and these billion dollar endowments do things a bit differently than other investors. In fact they have almost 60 percent of their assets invested in alternative investments relatively equally split between hedge funds private equity and venture capital as well as real assets. So how did we come to this place of investing so aggressively in alternative investments. What was the decision process that we went through to reach these levels of alternative investment allocations.
What we see is that there are approximately equally invested in hedge funds and then private equity and venture capital and then in real assets which could be commodities real estate infrastructure farmland Timberland and all of these other inflation hedging assets. We see that endowments have a very important strategic advantage in the markets and a very important goal as well. First we believe that in universities such as Harvard or Yale it is going to be a perpetuity if you have 15 or 30 billion dollars in assets in your endowment and your university is 300 years old. It's a fair bet you'll live forever into perpetuity and so according to that perpetual timeframe the 10 year lockup period for private equity fund is relatively short. In the scheme of your perpetual life. So what we see is that the universities have a very high tolerance for liquidity risk and hopefully we see that there is a premium to be earned for investing in illiquid assets. So as they invest in these less liquid assets they would have the ability to earn a higher potential return over time. Let's take private equity as an example. With an average fund wife of ten years you would commit assets in the first one to three years. It make investments for the middle five to seven years and then exit over one to three years. So with private equity funds simply had the same return as public equity. It wouldn't make sense for us to lock up our money for 10 years and if this lack of liquidity is compensated in the financial markets we see that investors able to make these less liquid investments will profit over long periods of time. But there's also a substantial risk in these perpetual endowment funds because different investors define risk in very different ways. Some investors might define risk.