Reflections on the Endowment Model for Asset Allocation

Reflections on the Endowment Model for Asset Allocation

Reflections on the Endowment Model for Asset Allocation

The market turmoil that began in 2007 forced all investors to question the preeminent investment theories, along with the asset allocation advice that investors had relied on to preserve and grow their wealth.

In the early stages of the financial crisis, it seemed as if diversification had failed as almost all asset classes (with the exception of US Treasuries, which lived up to their “safe haven” moniker) plunged in value. Sophisticated university endowments, which had become models of long-term, absolute return investors by posting consistent double-digit gains over the prior decade, were not immune.  For example, Harvard’s endowment dropped a game-changing 27.3% in the 12-month period ending June 30, 2009, potentially putting its long-term strategic and capital goals as an institution in jeopardy.  This experience, shared by many of Harvard’s peers, called into question the endowment model of investing. Has the recent financial crisis discredited the endowment model or was it simply an aberration for an otherwise reliable strategy?

The endowment model, sometimes referred to as the Yale model, is highly influenced by Yale’s long-serving CIO, David Swensen, who was a pioneer in the use of alternative investment strategies.  The endowment model emphasizes higher returning illiquid asset classes such as private equity, while reducing allocations to lower risk/return assets, such as fixed income. Characteristics of the endowment model include:

1. Relatively stable long-term asset allocation goals

2. A willingness to accept relatively high levels of short-term volatility in investment values for the purpose of higher long-term investment returns

3. A significant portion of the portfolio invested in long-term illiquid investments (often in limited partnership form) in order to capture the “illiquidity premium”

4. Investment team resources used predominantly to seek superior external investment managers, the “top quartile” managers who it is hoped will consistently outperform the average managers in the asset class

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