Embracing endowment-style investing
By focusing on longevity, investors seek to grow both capital and income over a long time horizon – sometimes in perpetuity
THE endowment-style model of investing was pioneered and shaped by leading US universities in the 1980s. Such institutions invest with the aim of achieving financial independence and stability over a time horizon designed to serve future generations.
But the benefits aren’t limited to those kinds of organisations. Investors might be individuals, families, or institutions looking to achieve high returns over long periods.
They take a multi-decade – perhaps multi-generational – view. They have the flexibility to extend time horizons, shielding them from the need to make exits in challenging circumstances, and are prepared to stand fast through periods of market volatility.
All these elements enable them to make the most of macro uncertainties, accessing opportunities to learn and even benefit from short-term market stresses.
The focus for these investors is on longevity. They seek to grow both capital and income over a long time horizon – sometimes in perpetuity. They must be able to tolerate short-term drawdowns and volatility, and to commit a portion of assets to opportunities offered by less liquid assets, such as private equity.
Ultimately, they look to realise returns that can maintain – or even increase – the purchasing power of their capital.
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The power of asset allocation
Building strong endowment-style portfolios starts with a clear strategic asset allocation (SAA), designed to serve the ultimate aims of the portfolio.
The SAA is one of the few things investors can truly control, and creates a framework for other decisions. It focuses investors’ attention away from short-term losses and gives them the freedom to think beyond the noise of the markets.
These are driving factors in creating and maintaining a resilient, sustainable and successful investment portfolio.
Traditionally, endowment portfolios were balanced – 60 per cent in stocks, 40 per cent bonds. But Yale, under the governance (1985 and 2021) of its then-chief investment officer, the late David Swensen, demonstrated that further diversification, in particular into alternative assets, is key to improving returns.
Following Yale’s lead, the largest endowment funds now have an average allocation target of 50 per cent to alternative investments, looking to niche markets for additional sources of return.
SAA is also considered the most important factor in achieving long-term investment success. Research has shown that more than 90 per cent of a portfolio’s return variability can be attributed to asset allocation.
Prioritising the SAA encourages a long-term mindset and reduces reliance on the less predictable influences of security selection and market timing, the latter of which can expose investors to factors outside their control.
Importance of diversification
In managing risks, there is no tool more powerful than wise diversification. With this, investors can steer exposure away from uncontrollable dynamics and gain the power to construct a portfolio built on factors they can control: fundamental principles and strong convictions, backed by a combination of experience and empirical evidence.
Investors can diversify across business models, industries, asset classes, markets, currencies and geographies.
At its most basic, diversification is about spreading risk by investing in assets that respond differently to various market forces. Those often-volatile influences and their corresponding markets can pose the greatest threat to the performance of an overly concentrated portfolio. Diversification diminishes the overall risk of a portfolio, without diminishing returns.
The equity bias
Weighting a portfolio towards equities improves the potential for strong returns. This is because holding these assets for a long period not only brings dividend and capital value growth, but also the potential for compounding returns.
The SAA provides the framework for equity selection, driven by a focus on inherent value and opportunities to improve fundamentally good assets.
Portfolios containing private assets tend to perform better than those limited to publicly traded stocks and bonds. This superior performance results from several key factors, including investment horizons, financial leverage, and the investment specialists’ ability to transform assets and enhance value.
Some asset classes, particularly alternatives, will always perform strongest in skilled hands. Private markets present opportunities to enhance returns, diversify investments, and improve risk management in ways that are not available in public markets.
Private asset investments include a variety of categories, such as private equity, venture capital, real estate, private debt, timber, agriculture, and infrastructure.
Among these, private equity has gained significant importance. Since 1996, the number of publicly listed companies worldwide has decreased by half, while the number of private companies has grown to about 8.5 times larger than public firms.
Long-term investors understand the importance of equity ownership and diversification as the primary principles underpinning their asset allocation.
Bonds are generally considered a “safe” asset class because, in the case of government bonds, investors have the backing of the government; and in the case of corporate bonds, bondholders’ claims come before those of equity holders. But lower risk means lower returns.
The risks associated with equities can be mitigated through wise diversification. This might be across private equity, absolute return strategies, and global equities – which enable both geographic and currency diversification.
Importantly, the “equity bias” should be viewed as precisely that – a heavier weighting in equities and equity-like alternatives. The primary aim should be to build and maintain a portfolio of assets that responds differently to external forces and influences on returns.
Finding the right manager
Investors hoping to benefit fully from an endowment-style approach must find a manager with a strong track record of resilience. The manager needs to be disciplined, confident about sticking to a long-term perspective, able to execute well-judged diversification, while maintaining a steadfast focus on preserving capital.
In-house expertise in alternatives and thematic equities will be a strong advantage, while those that operate with an open architecture approach are best-placed to provide the right support, giving clients access to a global network of external, trusted, best-in-class specialists.
With this, investors can access the best available talent, skills, and deep knowledge beyond what can be offered by a single institution or expert.
Investors will succeed with managers who integrate these attributes into their broader model. The best choices are made where the approach comes naturally to the manager, and where interests align.
What serves the manager must serve the client. When this is one and the same, the best results will be achieved.
The writer is chief Asia strategist and head of Asia research, Pictet Wealth Management
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