Constructing and overseeing an investment portfolio is at the heart of endowment management — the nucleus around which everything revolves. Being that the investment portfolio is the core component to effective endowment management, this will be the first of two parts outlining the critical considerations within portfolios. (Read about Purpose, Policy and Process.)
If the strategic document behind the portfolio is the investment policy statement, the most fundamental tenet underpinning a wide range of decisions is asset allocation. Fundamentally, asset allocation is apportioning investment funds among categories of assets. Broadly, those categories are stocks, bonds, cash and real assets.
Today, however, these categories are divided and subdivided to optimize returns while managing risk. A traditional stock portfolio, for example, may include allocations to growth and value styles; small, mid- and large cap stocks; international (non-U.S. developed markets); and emerging markets. For many nonprofits today, the largest single allocation is to alternative investment strategies. These include private capital (venture capital, private equity and international private equity), real estate, natural resources, commodities, distressed debt and marketable alternative investments, (hedge funds, absolute return, market neutral, long/short, 130/30, event-driven and derivatives).
Historically, asset allocation decisions have been based on the asset classes and strategies identified in the previous paragraph. Today, however, there are other ways of looking at portfolio diversification.
Many endowments employ a functional classification in combination with traditional asset allocation. This approach diversifies across asset classes/strategies based on their role in the portfolio: growth, risk reduction, inflation protection, liquidity, opportunistic investments and duration.
Another approach is factor-based asset allocation, factors being the attributes that can explain differences in returns. Most factors fall into two broad categories: macroeconomic factors (a focus on broad risks across asset classes, e.g., inflation, credit and economic growth) and style factors (a focus on risks and returns within asset classes, e.g., growth, value and momentum). A factor-based strategy involves tilting equity allocations toward or away from specific factors.
Investors are also mindful of the liquidity position of their portfolios in order to meet short-term cash needs. Typically, there are three liquidity categories:
A critical challenge is choosing a strategic asset mix that will generate the returns necessary to support the agreed-upon spending policy at an acceptable level of risk. When experienced investors make asset allocation decisions, they do not seek to maximize returns, but instead focus on risk-adjusted returns, or maximizing returns for a given level of risk.
What investors seek to do by diversifying their portfolios is to combine assets that are relatively uncorrelated. Investing in asset classes that can be expected to move together produces little diversification benefit. However, adding asset classes that on their own might be considered risky can lower an endowment’s overall risk profile if these classes have a low correlation with each other. The Investment Policy Statement (IPS) may be reviewed once every two or three years, unless extenuating circumstances intervene.
Asset allocation, however, should be reviewed at every meeting of the investment committee—not necessarily with the idea of making changes, but to review how the portfolio is currently allocated versus the policy allocation and to rebalance, if necessary.
A decision to rebalance should be made when the agreed-upon asset allocation (the policy portfolio) has become distorted by the relative performance of one or more allocations. Outperformance by one or two allocations and/or underperformance by others will alter the risk/return profile of the portfolio.
Traditionally, endowment managers have rebalanced annually, or even less frequently. Rebalancing too often can be disruptive and costly, while rebalancing every two or three years may incur excessive portfolio risks.
To continue learning about the ins and outs of the role of portfolios in endowment management, download our complete guide, Principles of Investment Stewardship for Nonprofit Organizations.