DR.CHENJIAZI ZHONG

All investment portfolios should be individually structured to meet clients’ objectives, cash flow requirements, and their tolerance for risk. Similar to diversification across asset classes, market capitalization, and geographic exposures, a portfolio’s liquidity profile is a vitally important consideration in portfolio design, especially for endowments.

Endowment Model

One of the distinctive innovations of the endowment model is its inclusion of alternative investments, with the aim to provide more diverse sources of return, and thereby reduce downside risk and improve the probability of consistent and positive returns that will compound over time.

Private educational institutions, on average, have lower liquidity requirements than do public counterparts, due to their richer balance sheets compared to operating costs and better coverage of debt. Tuition dependence for private institutions is loosely correlated with liquidity position, but there are many outliers; endowment dependence is also loosely correlated with liquidity, however, outliers exist as well.

2011 Fiscal Year NACUBO Result

Over 800 U.S. endowments participated in the third annual National Association of College and University Business Officers (NACUBO)  – Commonfund Study of Endowments for the 2011 fiscal year. The study indicates that smaller institutions generally have had the largest proportional allocations to marketable strategies, reflecting their preference for liquidity, even when investing in alternative strategies:

Among the 535 responding institutions, 47 percent of assets were allocated to investments with daily liquidity, 19 percent of assets were allocated to assets with monthly liquidity, 9 percent to those with quarterly liquidity, down from 11 percent last year, and 7 percent to those with annual liquidity, another 15 percent was illiquid, i.e., greater than 365 days.

In endowments’ quest to diversify with alternative assets, many endowment managers may have underestimated their need for liquidity. Illiquid assets such as venture capital, private equity, real estate, timber are interesting due to a higher expected rate of return. In tough times, illiquid assets put investment managers in a bind, because they cannot easily sell those investments to raise cash.

Among the alternative asset classes, private equity has been a particularly problematic investment for many endowment investing plans: 1) due to lack of a market exchange for private equities, it is left to the manager to determine the valuation. Price information has improved only recently through the introduction of indices, thanks to the public stock offerings made by several private equity asset managers; 2) private equity managers have the power to make capital calls.

An experiment of earlier this year by JPMorgan Asset Management suggests that for a generic endowment asset allocation, liquidity levels between 6% and 14% are optimal, all other things equal, because 95% of the time, an allocation in this range would obviate situations in which a portfolio’s payout rate exceeds its liquidity pool.

Liquidity Stress Test & Liquidity Schedule

The primary investment goal for endowments is to earn a long-term rate of return sufficient to support current spending while preserving future purchasing power. The risk-adjusted returns should account not only for market risk, but also for liquidity risk. Liquidity stress testing framework is an important tool to simulate the impact. To give a simple and straightforward example, we can assume that all the private equity commitments will be called within the next twelve months, and that we need enough liquidity to meet spending needs over the next three years. Then we compare the calls on our liquidity against the liquidity that we are sure to be available in the next twelve months. Finally, we reduce the assumed liquidity by 25 percent and 50 percent, and apply the same calculation.

It is also important to differentiate between illiquidity resulting from the account structure, due to longer lockups or redemption fees, and illiquidity resulting from the nature of the underlying investments within the account structure. For instance, although most hedge funds invest in publicly traded equity and fixed income securities that can be considered liquid, their account structures have often been designed to promote a long-term investment approach through the use of an semi-liquid or illiquid account structure.

How much liquidity is enough?

Considerations include financial structure, e.g. large versus small, tuition-dependent versus endowment-dependent, and philosophy, i.e. balance sheet as a profit center versus balance sheet as support for the mission. These drive risk tolerance, and choice of variable rate/synthetic fixed rate debt or fixed rate debt.

Reference

• Asset Allocation Investment Policies Restrictions – 2011 NACUBO Study
• Defending the “Endowment Model”: Quantifying Liquidity Risk in a Post-Credit Crisis World – The Journal of Alternative Investments
• With Implications for Traditional Market Risk Measurement and Management – Wharton Business School