An operating charity in the Northeast is in the process of implementing a risk-based investment policy for its $30 million endowment. The organization’s seven-member Investment Committee includes individuals with experience at leading securities and investment firms; a majority of the Committee members are graduates of the university that was the organization’s original sponsor and with which it was long affiliated.
In drafting its investment policy statement (IPS), the Committee created a separate section entitled “Risk Tolerance”. In that section, it set forth the following specific risk parameters:
Intergenerational equity was set as a minimum goal, but expansion of the endowment was also viewed as desirable. This meant that the endowment would need at least to keep pace with inflation, while also meeting its annual average spending target of 4.25 percent, net of fees and expenses, into the indefinite future. For this reason, the portfolio would have to have a bias toward equities in order to obtain the potential for future growth.
The Committee set a liquidity budget requiring that one year’s targeted spending, or 4.25 percent of the endowment, be retained in “highly liquid, low volatility instruments” on an ongoing basis. While highly illiquid instruments such as private capital limited partnerships could be part of the port- folio, this liquidity budget requirement would take priority.
Turning to market risk, the IPS required that the portfolio be constructed in such a way that there would be less than a 5 percent probability of an annual drawdown of greater than 10 percent.
With these guidelines as background, the Committee then turned to the question of constructing a portfolio that would meet these criteria. Using a Monte Carlo simulation model, four portfolios were analyzed, with equity allocations ranging from 43 percent of the portfolio to 61 percent, of which private capital allocations ranged from nearly 5 percent to over 14 percent. Fixed income and hedge allocations were also part of these proposed portfolios, as were non-U.S. dollar investments.
When it examined the results of the simulation, the Committee found that none of the portfolios met all of its requirements. The maximum drawdown constraint, in particular, led to a portfolio with an unacceptably low annual return of 6.9 percent, compared with a somewhat looser but still well-diversified portfolio that had a projected annual return of 7.6 percent. Equally relevant, the limited-drawdown portfolio had just a 38.5 percent chance of maintaining intergenerational equity over a 20-year period, while the somewhat looser portfolio’s intergenerational equity likelihood was 54.9 percent.
The Committee decided to concentrate on the looser portfolio, which had a target allocation of 55 percent to public equity, 30 percent to fixed income, and 15 percent to private capital strategies. While the final portfolio construction has not yet been determined, the Committee agrees that the ability to perform this kind of analysis has been crucial in enabling it to construct a portfolio with a greater likelihood of behaving according to the risk prescriptions in the IPS. Further iterations will be necessary for the Committee to reach a final decision, and the parameters of the resulting portfolio will be recorded in the IPS when it is adopted by the Board.