A new endowment model? It may be coming

The Family Office Association issued a white paper called "Improving the "Endowment Model" Recipe". This is a provocative piece because it takes aim at what has been key thinking on long-term portfolio management through the Yale endowment model. It focuses on what is still the key driver of portfolio performance - asset allocation. Their premise that there is a difference between using a recipe which employs different proportions of ingredients and the use of superior ingredients. Their argument is that if you want to have a better stew the recipe matters more than the ingredients. 

The endowment model focus more on the ingredients when the real focus should be on dynamic asset allocation. Their simple description of the endowment model is threefold:

• Equity-like investments for nearly all returns
• Illiquid investments as a means of picking up extra premium 
• Added return through selection of skilled managers.

The result for those who have followed an endowment model are risk exposures not closely tied to economic growth. For those who use the Yale model there is little change in asset allocation. Changes in the target allocation are not made because of asset allocation action but because of external forces. There is too much focus on equity-like investments with less understanding of what is owned. There also is too much time spent on finding the best managers at the expense of asset allocation decisions. Simply put, the recipes are very much alike for those who use the endowment model.

The first table shows the allocations for the Yale endowment. They do not change that much. Of course, Yale University can think about the very long-run, but for all of the changes in valuation and risk over the last decade, the portfolio is very stable.

The average endowment is actually very close the traditional 60/40 stock/bond portfolio mix. The average endowment is very traditional. 

Looking at the Yale endowment, the authors find that it is similar to a 85/15 stock/bond mix which is consistent with their focus on more equity-like returns; however, the endowment also took on a similar level of risk.

What the Family Office Association suggests is a greater focus on core asset allocation decisions. Their approach is to focus on a recipe of greater emphasis on asset allocation over manager selection, a reduced dependency on equity risk, and more liquidity. The extra liquidity can be used to be more flexible and opportunistic. This is consistent with the movement to more factor-based portfolio management. Certainly, research has shown that asset allocation decisions dominate security selection. In this case, asset allocation should dominate manager selection. Get your betas right.

Unfortunately, some of the focus on manager selection. stable asset allocation, and more equity-like returns is related to the fact that many portfolio managers have not been very good at getting their asset allocations right. Of course, if you can avoid "bad" states when there is a recession you will be a hero. Unfortunately, few are good at taking risk off the table at the right time or putting it back on during the depth of the gloom.

We believe this focus on asset allocation is the reason for global macro and managed futures. These are the strategies that emphasizes asset allocation and major bets, not security selection. Get the betas right and you will create a positively convex return stream.