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From Modern Portfolio Theory to Pioneering Portfolio Management: The Endowment Model

Implications of Modern Portfolio Theory

Traditional and widely used institutional policy portfolios commonly consisted of a majority of U.S. equities and a reciprocal proportion of U.S. bonds, e.g., 60% stock/40% bond portfolio. The modern portfolio theory (MPT) was developed in the 1950s through the 1970s, particularly, Markowitz 1952, Sharpe 1963, 1964, Ross 1976. Despite all the input estimation challenges, the implications of MPT serve as the foundation of many later research and studies.

  1. It is the foundation of mean-variance optimization. Investors can optimize their portfolios by selecting from only two investment alternatives, i.e., the market portfolio and risk-free assets.
  2. The concept of standard deviation is a critical piece of foundational material for measuring risk.
  3. Computer spreadsheets and published statistical tables can be used to estimate the probabilities of various outcomes.
  4. Asset allocation should attempt to balance reasonable estimates of risk and reward – the primary idea is to find a balance between higher expected return and higher risk.
  5. Pragmatic realities such as home ownership seem to run counter to full diversification of the market portfolio.
  6. There is political risk that host government will restrict a foreign investor from free access to his or her assets.

Despite its importance, MPT is not an ideal investment strategy since it makes many assumptions about investors and markets, which compromise the framework to some extent, for instance, the assets returns are normally distributed random variables. In addition to its flawed assumptions to the model, the risk, return, and correlation measures used by MPT are based on expected assets, which are mathematical predictions of the future; in reality, investors need to take account of new circumstances that did not exist when the record was created.

  • MPT has generally used performance measures of stock and bond portfolios over single periods as long-only investments with symmetrical return patterns; however, such idea oversimplifies the market.
  • One of the bases of MPT is “market efficiency,” however, as a matter of fact, markets are not fully efficient.
  • MPT focuses on past performance; however, successful investors look at future expectations for corporate earnings growth, global economic conditions, and interest rate movements that drive future returns.

Endowments and Foundations

Endowments refer to the permanent pools of capital owned by institutions such as colleges, universities, hospitals, museums, and religious institutions. If managed and funded well, an endowment can provide a permanent annual income to the institution, while maintaining the real value of the initial gift assets in perpetuity, keeping them intact during economic or business fluctuations.

Most endowments are run by a single organization, but they may be funded by thousands of donors. In the U.S., each organization is typically organized as a tax-free charity, in which individuals receive a tax deduction for making donations; beside that, the investment income of the organization may also be tax-exempt. The gifts of the endowment fund of an organization may be segregated to fund specific scholarships, professorships, academic programs, or whatever efforts the donor sought to fund.

In fiscal year 2012, the 831 institutions that participated in the study of National Association of College and University Business Officers (NACUBO), representing over $406 billion in endowment assets, experienced an average decline of 0.3%, compared with a total return of 19.2% in fiscal year 2011.

Average Return by Asset Class for Fiscal Year 2012

Exhibit 1.1 Average Return by Asset Class for FY 2012

Similar to endowments, the income generated by operating foundations is used to fund the operations of charitable organizations. Community foundations are based in specific geographical area, and designed to dedicate to the social improvement of the given place. The gifts and investment returns received by the community foundation are distributed in the form of grants to other charities in the community. In contrast to endowments and operating foundations, community foundations do not operate their own programs, but donate funds to other organizations in their community. Corporate foundations are sponsored by corporations, with gifts provided by the corporation and its employees. Most independent foundations are funded by an individual or a family, and they typically do not receive gifts or subsequent gifts from external donors.

Endowments versus Foundations

Unlike endowments, many foundations cannot survive in perpetuity, as foundations are established with a pool of assets and no further funds are added to it; whereas endowments can fundraise on an ongoing basis. The ability of endowments and foundations to solicit gifts greatly increases the probability of the organization’s assets lasting into perpetuity.

The Endowment Model and The Yale Model

The evolution of portfolio theory and the emergence of the endowment model were largely driven by a growing awareness of alternative asset classes – aggressive return targets and the perpetual life of endowments have led to an aggressive asset allocation. The endowment model typically allocates a substantial portion of assets to alternative asset classes which are featured by illiquidity, longer investment horizons, less-than-transparent valuation, such as real assets, hedge funds, private equity, and structured products.

According to the 2012 NACUBO-Commonfund Study of Endowments, the world’s largest college endowments continue to increase their allocation to alternative asset classes. As of fiscal year 2012, the institutions with over $1 billion assets had a total of 60% allocation to alternative investments on average, with 26% in private equity (LBOs, mezzanine, M&A funds and international private equity), 33% in marketable alternative strategies (hedge funds, absolute return, market neutral, long/short, 130/30, event-driven, and derivatives), 8% in venture capital, 14% in private real estate, 15% in energy and natural resources (oil, gas, timber, commodities, and managed futures), and 4% in distressed debt.

Traditional asset classes such as stocks, bonds, and cash tend to be highly correlated with each other during the down markets. The long-only investments may not meet the changing needs of investors, as a combination of equities and bonds do not provide enough diversification. In a traditional portfolio of stocks and bonds, the major sources of risks are essentially equity beta and interest rate.

Including alternative asset classes will involve several risks beyond the typical risks associated with traditional investments, such as the nature of higher fees, less liquidity, less transparency; however, in general, the benefits of such implementation outweigh its risks over the long run, and the risk/reward potential of including alternative assets into a portfolio differs depending on the strategy.

David F. Swensen, Chief Investment Officer at Yale University since 1985, believed strongly in an equity orientation, avoiding asset classes with low expected returns, which is also the central of the Yale Model. In the interesting Bloomberg article of Oct 3rd 2013, “Time to Ditch the Yale Endowment Model,” the writer mentioned the three core ideas inform Mr. Swensen’s thinking:

  1. Savers are paid to take risk. If you want to generate big returns, you have to be willing to endure large losses at any point.
  2. Universities and other institutional investors have long time horizons because they expect to exist forever. This makes them different from regular people who save for retirement.
  3. Contrary to standard academic theory, which suggests that savers should invest in broad indices and avoid fees, market imperfections create opportunities for talented investment managers. They can improve a portfolio’s performance through a combination of high returns and diversification benefits.

Yale University chooses not to invest in either investment-grade or high-yield bonds due to the inherent principal-agent conflict, although they serve as liquidity and a hedge against tail risk. It is worth noting that not all endowments have a similar affinity toward alternative investments.


Exhibit 1.2 The Yale Model Asset Allocation - As of June 2012

Over the past two decades, Yale dramatically reduced the endowment portfolio’s allocation in domestic marketable securities. Considering the return potential and diversification benefit, Mr. Swensen re-allocated the assets to alternative asset classes, which by their nature, tend to be less efficiently priced, providing an opportunity to exploit market inefficiencies through active management. In 1992, approximately 51 percent of the endowment was invested in U.S. stocks, bonds, and cash equivalents.

Essential Portfolio Theory vs. Modern Portfolio Theory

The Essential Portfolio Theory (EPT) was originally published in April 2005 by Professor John Mulvey, Princeton University. EPT extends Modern Portfolio Theory (MPT) by taking into account the factors that influence today’s financial markets but were not considered in the MPT. There are seven tenets of EPT:

  1. Take advantage of true diversification – true diversification is enhanced by using a variety of strategies that have the potential to perform independently of each other during periods of market volatility.
  2. Using leverage with diversification to achieve a targeted risk/return
  3. Offset the constraints of long-only portfolios
  4. Move away from cap weighting – most benchmarks used by investors are market-cap weighted; the overweighting of the largest companies could subject investors to the potential perils of a non-rebalanced buy-and-hold approach, as most indices have built-in concentration risk
  5. Incorporate current and forward-looking data – the true implementation of EPT mandates a more forward-looking methodology. It focuses on the use of current data in an attempt to generate future expectations and maximize future returns.
  6. Implement multi-factor strategies – many model portfolios suffer from an over-reliance on the CAPM, under which that the expected return is equal to the risk-free rate plus the market return times expected beta; however, there are limitations in relying on single factor (beta in this case) to value a portfolio, as neither beta nor the risk-free rate is static over time, nor does beta account for other factors that impact market performance, such as investor behavior, and changes in GDP.
  7. Employ rules-based rebalancing – when better-performing asset classes become too heavily weighted in a portfolio, it adds to the risk of the portfolio

Essential Frontier vs. Efficient Frontier

Essential Frontier seeks to improve information, trading systems, and enhance risk management techniques. In addition, the Essential Portfolio Theory (EPT) extends the Modern Portfolio Theory (MPT) and takes advantage of true diversification, which is enhanced by using various alternative assets that have the potential to perform independently of each other during periods of market volatility.

Portfolios with Alts_Page_2

Portfolios with Alts_Page_3

In this simple illustration, the Essential Frontier reallocates 25% of the traditional Efficient Frontier portfolio to alternatives and allocates equally to five asset classes: commodities, long/short equity, multi-strategy hedge funds, real estate, and private equity.

As can be seen from the chart and table, the Essential Frontier line shows the incorporation of alternative investment strategies affects the Efficient Frontier by moving it leftward, resulting in higher returns and lower standard deviation.

Below is a “Growth of a Dollar” graph comparing a traditional diversified portfolio with stocks and fixed income securities only (Portfolio A) to three scenario portfolios with different allocation of alternative investment strategies.

Portfolios with Alts_Page_4

However, it is necessary to note that these results are not indicative of future performance.

Generally speaking, large endowments tend to outperform due to their advantages in:

  1. An aggressive asset allocation
  2. Effective investment manager research
  3. First mover advantage
  4. Access to a network of talented alumni
  5. Acceptance of liquidity risk


  1. Advanced Core Topics in Alternative Investments by Keith H. Black, Donald R. Chambers, and Hossein Kazemi, 2012
  2. AIER Modern Portfolio Theory by Donald R. Chambers, Sept 20, 2010
  3. Essential Portfolio Theory – John Mulvey, Princeton University, 2005
  4. Essential Portfolio Theory – Rydex Investments, 2005

One comment on “From Modern Portfolio Theory to Pioneering Portfolio Management: The Endowment Model

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