The endowment model is known for its relatively high allocation to illiquid investments. Understanding the portfolio impact, having a strong portfolio construction and harvesting sustainable risk premiums are key to a successful investment portfolio, Singapore Management University’s Kif Ho says.
The opinions expressed in this article are solely Kif Ho’s own and do not express the views or opinions of his employer.
When the late David Swensen took over the helm at the Yale Investment Office in 1985, the fund had nearly three quarters of its money invested in domestic equities. Swensen set on a mission to change that and today, US securities account for less than one-tenth of the portfolio.
The endowment model, as developed by Swensen, skewed heavily into private and illiquid assets, including private equity, absolute return strategies, natural resources and real assets. Leveraged buyouts, venture capital and absolute return hedge funds are now the three largest asset classes of the US$30 billion fund.
Yale’s endowment model has been copied many times, but with varying degrees of success as the circumstances of each individual endowment can differ substantially.
In his quest to optimise the endowment model for the Asian market, Kif Ho, Associate Director at the Singapore Management University, has studied the Yale model and various asset allocation models closely.
“If you look at David Swensen and the Yale model, what they have done right is to recognise what asset classes were attractive in the long term. For example, they went to venture capital much, much earlier than others,” Kif says.
“But for us here in Asia, trying to achieve this top performance you have to get a lot of things right, including the governance, the SAA (strategic asset allocation), portfolio construction, manager selection and the way you think about investing.
“It is not just increasing your privates and increasing your illiquids,” he says.
If you look at David Swensen and the Yale model, what they have done right is to recognise what asset classes were attractive in the long term. For example, they went to venture capital much, much earlier than others
A key part to successful investing in private and illiquid assets is understanding the differences between the various liquidity profiles of each asset or fund, he says.
“You have to be very conscious of your hidden liquidity risks, your ability to handle those risks, and if you have a very strong process then that allows you to more confidently increase your alternative allocations.”
Kif says there are three main areas of liquidity risk during periods of stress in markets.
On the private alternative side, downturns are often periods where managers call in committed capital to benefit from temporary market dislocations. But these capital calls don’t occur in the same way in every asset class.
“You have to look at the type of private assets you have and, secondly, the vintage of the assets,” he says. “Some funds, for example in distressed asset funds, you can actually expect them to call more capital. They call capital and they grab up those distressed assets.
“But in other types of funds, such as debt funds, private equity funds and venture funds, the reaction to a stress event is actually a bit different in each case. If you study all those different vintages, then they all behave a bit differently and so they give you a certain type of liquidity profile,” he says.
But even in liquid assets, liquidity profiles vary per asset class. Kif gives the example of liquid alternatives, an asset class that some endowments have moved into as a form of bond replacement.
“If you move into liquid alternatives, you have to understand the underlying hedge fund strategies deeply, the pedigree of the managers to deliver, and how a pool of hedge funds behave as a portfolio. Sometimes certain hedge funds strategies that actually rely on capital markets to function properly may get marked out or they get drawn down in times of stress, losing their diversification properties” he says.
Finally, as most global investments are denominated in USD, many non-US asset owners will have currency hedges in place. “When you have a flight to safety US dollar rally, that might be another source of liquidity drain” he says.
Demand for Private Assets
The demand for private assets has only increased in recent years, as equity prices continue to rise, diminishing the chances of high equity returns in future years. Added to this is a trend of companies to stay private for longer, realising much of their growth before they become public, if they plan to list at all.
This has caused many investors who base their portfolios on the endowment model to increase their allocations to private and illiquid assets.
“You start to realise that the public markets’s risk premium have diminished over the long run and you’ve seen some of the top performing endowments in the US quietly pivoting into alternatives, into privates,” he says
“But as part of the process of increasing your investments into privates, I think this liquidity risk should be managed very carefully.”
Another force that is driving some investors towards more private assets is the changing role of bonds. From a portfolio construction point of view, bonds deliver diversification and defensiveness to the portfolio, as well as some liquidity in times of stress.
But as yields have hit rock bottom and the correlation with equities has become less stable, bonds are losing some of their effectiveness.
“For the past 20 to 30 years, bonds have been exhibiting a flat to slightly negative correlation with equities, which has been a central theme in asset allocation. Yields have also been in a more friendly place in the earlier part of this 30 year period,” Kif says.
“So right now these two things have diminished. The negative correlation has been diminishing and instead of a three to four per cent yield, which we used to get, it now becomes more like one to two per cent. The reaction from some asset allocators to that has been to increase their investments into privates or liquid alternatives.”
“I still think bonds have a place in the portfolio. It is about the type of liquidity they provide; it is still one of the assets that gives you liquidity and performance in times of stress. It is just that this very nice quality of bonds has diminished over the years, compared to the GFC (global financial crisis) times, or to the dot-com bubble,” he says.
The Innovation Premium
The Yale endowment model focuses broadly on two kinds of premia: the equity and illiquidity premia. It capitalises on these premia by staying invested in a globally diversified, multi-asset portfolio with considerable allocation to alternatives.
They also avoid market timing calls and stick to an strategic asset allocation process, while investing alongside quality managers with alignment of interest.
But Kif believes that today there is a third premium that can be harvested by savvy investors: an innovation premium. This premium can be harvested by investing in companies that are able to leverage off technology to grow quickly and disrupt existing business models, thereby producing an above average return.
And once again, investors are more likely to find these companies in the unlisted space or the venture space.
The pandemic has probably also shown that companies need to stay up front. If you don't innovate, the public markets will punish you very quickly. I think increasingly it shows that you need to reinvent yourself and as an asset allocator you need to recognise that investing has changed, not only because of innovation at the business level, but also because the lines of the asset classes have blurred
“Being not listed allows you to focus more efforts on innovation and with innovation comes growth. Staying unlisted, you don’t have those distractions of answering to shareholders and you are able to innovate faster,” Kif says.
“The pandemic has probably also shown that companies need to stay up front. If you don’t innovate, the public markets will punish you very quickly.”
“I think increasingly it shows that you need to reinvent yourself and as an asset allocator you need to recognise that investing has changed, not only because of innovation at the business level, but also because the lines of the asset classes have blurred.
“For example, the lines between hedge funds and venture capital investing have blurred over the last three to five years, with top venture capital firms starting hedge fund vehicles while top public managers have established private and venture capital arms,” he says.
“The best sources of returns gravitates to where value extraction and innovation dominates, and it is no longer that clearly defined within traditional asset class or capital allocation boundaries. Recognising these areas and investing alongside operators who can navigate the complexities of the markets are key to outperformance,” Kif says.
Achieving Excellence
Asia-pacific based endowment funds face a number of challenges compared to their US counterparts. Many US funds are several times larger than in this region and this gives them better access to some of the top managers.
“The US endowment funds, the top endowments, most of them are US$20 – 30 billion and because of their size they have this access and high allocation to illiquids, to privates. So replicating the success of the Yale endowment model is not easy,” Kif says.
“Each endowment has its own set of challenges at different stages, including the governance structure, investment team strength, size of the endowment, accessibility to top managers and strategies.
“The kind of 10 per cent plus returns that the top US endowments have produced over more than 20 years is the accumulation of many things done right and consistently so.
“I believe that excellence can be also achieved by endowments in Singapore, Asia and Australia. It is a tremendous challenge but it is achievable,” he says.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.