The right combination of high returns, predictable correlations and tolerable volatility holds the key to the objectives of most investors. The last few years have not been easy for many — in part because of the rather unusual relationships among the main asset classes that feature in strategic asset allocations.
However, there is one group of investors – endowments and foundations – whose inherent characteristics provide, at least on paper, greater flexibility and longer staying power to harvest the benefits of their portfolio positioning. But for them, too, it has not been easy. And their discomfort can be amplified by crucial funding requirements and noncommercial objectives that many of them often face.
When it comes to portfolio construction and asset allocation, endowments and foundations can best be thought of as pools of permanent capital whose financial objective is the predictable funding of specified activities (most notably universities’ operating expenses), while also retaining the real purchasing power of capital over time. With traditional spending rules and longstanding assumptions about the inflation of costs, this often translates into target average annual returns of around 8 percent.
Compared with hedge funds in particular, endowments and foundations are inherently better structured to tolerate more volatility — especially of the unanticipated type — as well as prolonged periods of unusual correlations among asset classes. After all, they aren’t subject to tight drawdown limits, and they don’t need to worry about investor redemptions. It also helps that the bulk of their public reporting is limited to an annual reporting that cites performance, its drivers and general portfolio positioning.
For that reason, endowments are able to venture into less liquid and less-frequented asset classes. In doing so, they have often blazed a trail for others to follow. Historical examples include Yale University’s early use of private equity, Stanford’s activities in venture funding, and Harvard’s pioneering investments in natural resources (particularly timber).
Although it’s well known that recent years haven’t been kind to hedge funds on average — so much so that capital allocated to this group has fallen due to strained performance and a high closure rate — less well known is that endowments and foundations have also faced headwinds. Many have found it hard to meet their return target. Indeed, if it weren’t for new inflows from large donations, the amount being managed there would have also declined.
The average also conceals a significant dispersion among its components. Consider the 2015-2016 data on university endowments: Yale did well again, returning more than 3 percent, while at the other end, Duke, Cornell and California experienced negative returns of around 3 percent.