Does the Endowment Model Need a Makeover?

William Jarvis, managing director of the Commonfund Institute, speaks with aiCIO's Paula Vasan about the endowment model of investing, and how the model should be applied following lessons of the financial crisis.

(December 17, 2012) — The endowment model of investing–an approach that allocates a significant portion of assets to non-traditional, more illiquid asset classes such as absolute return, private equity, and real estate–has widely come under attack, especially following the financial crisis.

A recent article in The New York Times, dated October 12, for example, makes the case that the model is inappropriate for all but the largest endowments and that it has underperformed a traditional 60/40 stock/bond portfolio. The article by James B. Stewart–titled “University Endowments Face a Hard Landing”–argues that for the one- and three-year periods that ended June 30, 2012, a basic 60/40 portfolio outperformed a more diversified portfolio.

However, according to William Jarvis, managing director of the Wilton, Connecticut-based investment firm the Commonfund Institute, the 60/40 portfolio underperformed significantly for the trailing five- and 10-year periods. His conclusion: A longer-term outlook is needed to judge the success of the endowment model.

Endowment investors contacted by aiCIO note that the general failure of university institutions around the country to weather the financial crisis–many still struggling to reach their pre-crisis peaks–has less to do with the model itself, and more to do with the way the model was applied. The number one mistake of endowment managers was their failure to provide for adequate levels of liquidity in their asset mixes, says Lou Morrell, Wake Forest University’s chief investment officer between 1995 and 2009. “The endowment model was originally based on the principle of a willingness of educational institutions to make longer-term asset commitments in return for accepting illiquid assets, which provide higher long-term performance. Since most schools only spend about 5% of the market value of their endowments, they were in an excellent position to tie up their money for longer periods and thus demand higher returns for the use of their capital,” he says, noting that the system worked well for many years. The system began to fail, however, when some institutions placed far too much money in alternatives, which require long lock-up periods that reduce liquidity. “In effect, the schools got greedy and focused on high returns instead of the purposes for which the endowments exist,” Morrell concludes.

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The real issue, many endowment managers say, has been how the endowment model was applied, not the effectiveness of the model. “The Times should have focused on management practices, not the investment strategy, and the Commonfund should have defended the endowment model and not been critical of The Times for reporting on such an important issue for higher education,” Morrell asserts. He adds that unlike individual investors, endowment funds are presumed to last in perpetuity and thus must base investment decisions on the long-term. Short-term performance conclusions can thus be faulty.

Earlier this month, State Street Global Advisor (SSgA)’s Dan Farley and the financial firm’s Foundations and Endowment Head Rebecca Schechter collaborated to produce a report combining insights from its asset management and asset servicing business called, “The Asset Owners’ Perspective: Evolving Investment and Operational Models.” The report quantified what they all had been hearing in meetings with clients–namely, that investors are altering their approach to endowment-style investing, in the wake of some hard lessons.

“Investors are looking to manage liquidity risk while also saying, ‘I have to generate returns,’” Farley said. “We’re spending a lot of time with our clients recognizing that they have dual objectives. At highest level, those objectives can be conflicting.” In total, nearly 84% of respondents found that the crisis had exposed some weakness of the endowment model, and liquidity (or lack thereof) was the number one concern. “I’m still a big believer in the endowment model,” said one US private endowment manager surveyed. “I think it works better than everything else…but the two big weaknesses that came out [of the crisis] are the two Ls–leverage and liquidity.”

Watch the video above to learn how the Commonfund Institute’s Jarvis feels the endowment model should be applied to both large and small institutions, along with what chief investment officers should consider when framing an endowment policy.

The Commonfund Institute’s response to the New York Times article.

Contact the writer of this story:

Paula Vasan
Managing Editor, aiCIO
646-308-2742
pvasan@assetinternational.com
Follow on Twitter at @ai_CIO

(December 14, 2012) — Institutional investors in Europe are growing more familiar with risk parity strategies, and those who learn about it would consider allocating to it, an asset management survey has found.

A third of European investors responding to a recent survey by alternatives manager Aquila Capital said they were increasingly familiar with the strategy and of this group 50% said they would consider allocating to it.

The investment manager surveyed 225 institutional investors in the United Kingdom, the Netherlands, Scandinavia, Germany, and other large European countries. The results concur with aiCIO’s annual risk parity survey, which showed 22% of non-US investors were considering the strategy.

The two surveys also agreed on the level committed to the strategy, showing most investors allocated less than 5% of their overall portfolio to risk parity.

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The Aquila survey determined that 80% of investors would maintain their allocation with the remainder increasing their holding. However, the investment managers found only 22% of the third of respondents who were aware of the strategy had actually allocated to the strategy.

Last week, attendees at aiCIO’s inaugural Influential Investors Forum at the Harvard Club discussed the pros and cons of a risk parity approach.

“Our concern about risk parity is that there are not that many risks you need to get paid for taking,” one opponent to the strategy said, adding: “Risk parity seems to absolve the investor from looking at original valuations.”

Another said: “If you lower the risk to reduce the ugly drawdowns, don’t expect great returns.” However, an advocate for the strategy countered: “If there’s more than one asset class that has a risk premium, there should be a balance.”

One of the CIOs on aiCIO’s Power 100 said that once the fund’s trustee board had heard explanations of the strategy by a provider, the board wondered why the investment team were making such a small allocation. This reflects the response to both surveys on the level of allocation.

To read the full aiCIO Risk Parity Survey 2012, click here.