Endowment investing in the post-crisis world

Like most asset allocation strategies, the ‘endowment model’ for investing was challenged by the financial crisis and its practitioners have learnt lessons from the episode, according to Sandra Urie, CEO at Cambridge Associates, an asset consultant with deep experience in the field.

Like all asset allocation strategies, endowment-style investing was pressured by the systemic breakdown of the financial crisis and the ensuing volatility and liquidity scarcity.

“Those weekend events” – Urie says, employing a euphemism to describe the 2008 Wall Street bank crises – “just kept coming.”

But not all endowment-style investors fared badly. About 80 per cent of Cambridge’s endowment clients did not experience liquidity problems during this period, Urie says, and like other investors, they learned some lessons.

They learnt the reality that absolute portfolios can decline – they don’t have a “floor” – and that investment risk should be viewed in dimensions other than volatility. It also takes the form of leverage, liquidity, equity beta, currency, inflation, interest rates, credit spreads and exposure to active management, Urie clarifies.

“We’ve been doing modelling in trying to get at how you can deconstruct that overall volatility in a portfolio and assign it accordingly.”

She says investors had taken these lessons on board rather than becoming shy of risk.

“I don’t think the appetite for risk has been hurt. It’s more about understanding the risks you’re taking and why.”

The endowment model of investing became famous throughout the industry as the Yale and Harvard university endowments posted impressive returns that were, in large part, attributable to investments in hedge funds, venture capital, timberland and other alternatives. Observing this, some pension funds began eyeing these strategies – particularly as they sought to diversify away from equity beta after the dotcom crash. Talk of ‘endowment envy’ percolated throughout the industry.

But the financial crisis brought an end to the long stretch of outperformance enjoyed by many endowment-style investors as liquidity pressures and the market rout of 2008 unceremoniously grounded their consistent double-digit returns.

Too often, the endowment model was incorrectly viewed as just an alternatives-heavy approach to asset allocation, when it is purely a framework for thinking about institutional investment, Urie says.

“It is a form of investing with a long-term horizon. Each investor steps back and asks: ‘What is the role of this portfolio, and what is the financial structure of our organisation? How dependent are we on our portfolio for operating revenue?’ That can lead to an asset allocation that includes alternatives, because it’s consistent with what they’re trying to achieve.”

This means that most endowment-style investors do not employ a ‘set and forget’ approach to asset allocation. These investment policies must be revisited, tested and again be proven worthwhile.

Investors should also take into account the emergence of new asset classes which can help in meeting their objectives.

More recently, institutions have broadened their view of asset allocation to one which classifies assets according to the roles they perform in portfolios, rather than the asset class they belong to.

“What we have seen more recently is investors taking these traditional asset buckets and acknowledging more explicitly the role they play in the portfolio.”

This progression, from asset class silos to roles, has resulted in Cambridge clients segmenting their portfolios into four categories: growth, macro-hedging, diversifiers and cash as “dry powder” to make opportunistic investments, Urie says.

These days, endowment investors are keeping more cash at the ready to meet funding needs as well as capitalise on opportunities. Distressed credit was a big opportunity in the past two years, but “there is no table-pounding buy out there now”, Urie notes, adding that leading US endowments have only changed their investment policies “at the margins”.

For investors seeking more macro protection at the expense of growth, Urie offers a reminder: “The more you put into the macro-hedging asset classes, the more you take out of the long-term growth engine of equities.” In other words, an institution does not need to focus on how it will earn what it needs to spend while also preserving the purchasing power of its portfolio.

Investors should also keep watch for asset bubbles. There are some expressions, which resurface from time to time, that should stop them in their tracks: new paradigm, new era, new age. Urie saw them as prompts to thoroughly check market fundamentals.

“When things start to get two-to-three standard deviations away from the long-term, and you begin to hear talk of a new paradigm, you have to step back and ask yourself if you believe it, and if you do, then why.”

Asset bubbles are strange phenomena, and have few parallels outside investment markets. In supermarkets, for example, if popular goods increase in price, demand naturally pulls back as consumers tire of paying higher prices. “But in markets, when prices go up, people buy more.”

Conversely, when goods are cheap, shoppers rush in to buy. “But when markets are falling and risk has been beaten out of the system, people are fearful.”