University endowment’s alternative allocations are highly correlated with the money flowing into the institutions through tuitions, donations, and public funding, according to research.
Princeton University’s Harvey Rosen and Alexander Sappington found endowments tended to incorporate “background income” in deciding exposures to illiquid assets.
The study of more than 700 portfolios from 1987 to 2009 revealed investors hedged against risks associated with these income flows and revenue shocks.
“It is reasonable to think of background income as another investment class in a more comprehensive portfolio,” Rosen and Sappington wrote. “Because background income entails a non-tradable risk and return, optimal investment policy typically would dictate changes in other portfolio investments when background income is added to the portfolio.”
“It is reasonable to think of background income as another investment class in a more comprehensive portfolio.” —Rosen & SappingtonUniversities benefiting from higher levels of background income or more consistent flows were more likely to invest in hedge funds, private equity, and venture capital—and more heavily.
Specifically, an endowment is 11.3% more likely to invest in alternatives in a given year with a one standard deviation increase in background income, the paper found.
On the other hand, institutions with lower and capricious background income were less likely to seek risk in their investments, the paper said, in turn shying away from alternatives.
Data showed these institutions were 8.2% less likely to allocate to alternatives with a one standard deviation increase in variability of background income.
These funds would also need more liquidity in their portfolios as they use some of the endowment capital for daily operations, according to the research.
Different types of universities also responded to background income in varying ways. The authors argued public universities tended to be more aware of changes in income flows, largely due to their more transparent nature.
“This substantial risk of public embarrassment may make endowment managers at public schools more averse to portfolio risk,” Rose and Sappington said.
In addition, their dependence on public funding—and therefore less control over their finances—added to how they considered fluctuation in background income.
Schools with large endowments were also highly sensitive to background income, the paper said, because of their sophistication. Professional management means these investors are more likely to update their asset allocation decisions often based on new income streams.
Read the full paper: “What Do University Endowment Managers Worry About? An Analysis of Alternative Asset Investments and Background Income.”