Key Factors in Asset Allocation Decisions for Endowments

There are several broad subjects that an effective investment policy statement (IPS) should include in its contents and address clearly and specifically as they relate to an endowed institution. This blog will take a deep dive into asset allocation considerations related to your IPS. 

A critical challenge for institutions may be 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.  

At its most fundamental level, diversification means apportioning investment funds among categories of assets. Broadly, those categories are equities, fixed income, real assets and cash/short-term securities. These categories are refined, divided and subdivided in an effort to optimize returns while managing risk. A traditional portfolio of publicly traded stocks, 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 equity (U.S and/or global buyouts, growth equity and venture capital), private credit, real estate, natural resources and environmental sustainability, commodities, distressed debt and marketable alternative investments (hedge funds, absolute return, market neutral, long/short, 130/30, event-driven and derivatives). 

In recent years, additional approaches to asset allocation have emerged. Two of these include functional diversification combined with traditional asset allocation and factor-based diversification. (Read the full whitepaper to learn more.) 

Beyond specifying what the endowment may hold and in what mix, the IPS should also identify investments and/or strategies that are prohibited. Some nonprofits forbid investments in fossil fuels, for example, while others may exclude investments in industries such as alcohol, tobacco and weaponry or in companies associated with unfair labor practices. In terms of instruments and/or strategies, for example, an IPS may prohibit derivatives or strategies such as short selling. An investment committee should take care not to invest with a hedge fund that uses derivatives and routinely goes short unless it has first inserted language in the IPS to allow for the use of derivatives and short-selling as part of a hedging strategy. The institution should know what it is investing in and be sure that permissions and prohibitions in the IPS reflect the reality of the decisions being made for the portfolio. 

Liquid and Illiquid 

Stewards of endowments have long been advised that allocating to illiquid, or private, investments is critical to achieving intergenerational equity. As compensation for allocating capital to these private asset classes (many limited partnerships can be 10-plus years in duration) a return premium is expected, though not guaranteed. This “liquidity premium” can be a key factor in generating the returns necessary to achieve intergenerational equity. Therefore, determining the right size for a private investment program or policy allocation is critical and should be carefully based on finding the intersection between the need, ability and willingness to take on illiquidity.  

• Need: This is a matter of the return objective required to sustain the mission in perpetuity. Variables such as spending rate, inflation expectations, costs, and contributions are some of the factors in determining a return objective. These inputs should be paired with asset allocation modeling to answer the question of how much illiquidity (and assumed liquidity premium) is needed to achieve the long-term objective.
• Ability: The ability to take on illiquidity should be addressed at the portfolio level and at the institutional level. There are internal and external sources and uses of liquidity that must be understood. At the portfolio level, spending and contribution flows, private capital calls, and distributions and rebalancing transactions are all sources and uses of liquidity. At the institutional level, revenues, debt capacity, contributions, and draws on unrestricted endowment or special appropriations are among the liquidity dynamics that must be considered. The ability to take on illiquidity, or make investments in private programs, is unique to each institution and should be based on scenario analyses that evaluate normal and stressed environments and the interconnectedness of portfolio and institutional liquidity sources and uses.
• Willingness: When it comes to a decision, there must be willingness by the fiduciaries to make the choice to allocate to illiquid investments. Admittedly more qualitative in nature, it is harder to quantify this willingness. Institutions can use several strategic inputs (operational, markets, risk tolerance, etc.) to make this decision and put parameters around implementation. Ideally, and often times through thoughtful and detailed education, the willingness and ability dynamics of this exercise align.

Rebalancing the Allocation  

Over time, certain asset classes/strategies will have higher or lower returns than others and the portfolio will need to be rebalanced to restore it to the target (policy) levels.  

Most asset allocation policies are written so that a policy allocation is assigned to each asset class or strategy; each allocation is also assigned high and low limits that establish an accepted range. If the ranges are not exceeded, rebalancing may not be called for, but may be enacted at the discretion of the investment committee, CIO, investment advisor or OCIO. Having ranges also allows the investment committee to express a more tactical view on particular investment opportunities or risks without departing from the overall allocation scheme. Asset allocation should be reviewed at every meeting of the investment committee—not necessarily with the idea of making changes, but to stay abreast of how the portfolio is currently allocated versus the policy allocation (rebalancing, if necessary). 

To learn more about what you should be considering in your IPS download our full whitepaper, “The Investment Policy Statement: Guiding and Guarding Nonprofit Endowments”.