Endowments Ignore Illiquidity Risk, Columbia Professor Says

(May 27, 2011) — In a recent paper titled “Portfolio Choice With Illiquid Assets,” Andrew Ang, professor of business, finance and economics at Columbia University, discusses how the inability to continuously trade an asset affects portfolio choice, detailing Harvard University’s endowment as a cautionary example.

“For Harvard, the main problem during the financial crisis was that about 1/3 of the university operating revenues came from the endowment. In 2008, that endowment, like every university portfolio, had large losses,” Ang tells aiCIO, explaining that the four ways to fill the hole is to cut expenses, liquidate the portfolio, issue debt, or increase donations.

Ang’s paper draws attention to the central question — which he describes as a philosophical one — among endowment heads: How should you be allocating your money when you have liquid and illiquid assets in your portfolio? “Harvard’s endowment fell and they couldn’t meet their cash requirement because they tied up a majority of their portfolio in investments that were illiquid. They couldn’t sell at short notice or raise cash when required,” Ang says.

According to Ang, most endowments completely ignore illiquidity risk on asset allocation, largely due to the increasing percentage they have devoted to alternatives, most of which are illiquid. The increased allocation to alternatives, Ang believes, is due to institutional investors aiming to emulate the investing approaches of Harvard and Yale’s endowments. “Endowments largely achieved high returns till 2008, but if you chase returns without taking into account illiquidity, that risk really bites.”