Asset Allocation and Portfolio Construction

This section of the curriculum presents a case in which a university endowment is deciding on its asset allocation, as well as its liquidity needs. This summary may be used in conjunction with the reading as a synopsis or may be used on its own to highlight cases that may be typical come exam day.

Background

Members of the investment committee of a university endowment are getting ready to meet to discuss an adjustment to the strategic asset allocation and the liquidity profile of the fund. Members of the committee prepare by updating capital market expectations and using variance mean-variance analyses to update their research on the proposed adjustments.

Increased Exposure to Alternative Investments Proposed

The strategy team proposed a higher allocation to alternative investments, prompting them to use unsmoothing techniques on illiquid investments. These techniques remove the impact of serial correlation on risk estimates due to outdated market pricing. As a result, they found that the proposed alternative investments have higher standard deviations than previously estimated. The committee is now questioning whether the increased exposure to private equity is justified.

They presented a data table with forecasts for expected real and nominal returns, standard deviations, and Sharpe ratios for each asset class in the current portfolio. They also provided a forward-looking asset class correlation matrix with the latest expectations (un-smoothed data). The proposed change would raise the allocation to private equity from 18% to 23% and real assets from 13% to 16%, leading to reductions in allocations to public equities and fixed income to accommodate these increases.

Optimization Results and Monte Carlo Simulation

Optimization results indicate that increasing allocations to private equity and real assets would enhance the endowment's long-term risk-return profile. The team also includes Monte Carlo simulation results, illustrating the probability of a decline in long-term purchasing power. The risk profile, measured by volatility, aligns with the endowment's risk tolerance guidelines, set at a volatility range of 12% to 14% based on long-term risk measures. Below are the optimization results for this case:

$$ \begin{array}{l|c|c}
\textbf{Characteristic} & \textbf{Proposed} & \textbf{Current} \\
& \textbf{SAA} & \textbf{SAA} \\ \hline
{\text{Expected nominal return (annual average,} \\ \text{geometric, next 10 years)}} & 7.80\% & 7.50\% \\ \hline
{\text{Expected real return (annual average,} \\ \text{geometric, next 10 years)}} & 5.30\% & 5.00\% \\ \hline
{\text{Standard deviation of returns (annual)}} & 13.20\% & 12.50\% \\ \hline
\text{Sharpe ratio} & 0.34 & 0.33 \\ \hline
{\text{Probability of 25% erosion in purchasing} \\ \text{power over 20 years with 5% spending rate} } & 30\% & 35\%
\end{array} $$

Looking at the chart above, it's evident that both real and nominal returns are expected to be higher with the proposed asset allocation, although it comes with higher standard deviations. To assess whether the increased return justifies the added risk, the final two characteristics in the chart provide insights. The improved Sharpe Ratio, albeit slightly, indicates a better risk-return tradeoff. Additionally, the reduced probability of a 25% erosion in purchasing power under the proposed allocation reflects an improved risk profile. This probability is determined through a Monte Carlo simulation, considering a 20-year horizon and a 5% spending rate.

Arguments in Favor of Increasing Exposure to Alternative Investments

In general, for a long-horizon institutional investor, the ability to tolerate illiquidity creates an opportunity to improve portfolio diversification and expected returns as well as access a broader set of investment strategies. This has been demonstrated by the investment committee team via the optimization results.

In addition, the case states that:

“The endowment has been building exposure to these strategies over the last two decades in a gradual manner. As a result, the illiquid portfolios are now well-established, mature, and well-diversified in terms of fund managers, strategies, and vintages. At the same time, the long presence in the market and the ability to access alumni networks have helped the endowment develop a strong network of connections in the industry and gain access to best-in-class managers in these spaces–Answer choice A represents a notification period indicating how much advance notice is needed. Answer choice B refers to a gate which sets a restriction on withdrawal amounts. Lastly, answer choice C corresponds to a lockup period, specifying the duration after an investment during which withdrawals are restricted. A hard lockup implies no redemptions are allowed, while a soft lockup permits withdrawals with a penalty building a reputation as a well-informed, patient, and reliable long-term investor.”

The strategy team should also examine whether the allocation to private equity and real assets is exposed to idiosyncratic risk factors, which could mean more risk being taken on than intended.

Implementation Costs

The team analyzed the costs associated with implementing the proposed portfolio allocation changes. Private equity and private real estate strategies typically have higher investment management fees and performance fees than fixed-income and public equity strategies. By using returns net of fees, the team incorporated the impact of higher expected investment management fees arising from higher allocations to more illiquid investments.

Liquidity

The committee member in the case is shown to be working on improving the endowments liquidity management framework. This includes improving the tools used in that process and taking a comprehensive, enterprise-wide approach. Using her approach, the expected cash outflows and inflows for the endowment portfolio are modeled over various time horizons both under normal circumstances and in periods of severe market stress.

The member is concerned that the portfolio's liquidity characteristics will deteriorate in periods of severe market stress due to:

• Capital calls in private markets exceeding capital distributions. This would increase the allocation to private markets in the overall portfolio.
• Activation of gates. Some investment vehicles that provide quarterly or annual liquidity have provisions in their investment prospectuses allowing the investment manager to refuse investor withdrawal requests (activate gates) during stress periods to protect remaining investors in the fund.
• The smoothing effect. Investments in private markets tend to incorporate market valuations with a lag that leads to a relative increase in their portfolio weighting during periods of market stress and a relative decrease in the portfolio weighting of more liquid assets. This does not reduce the effective liquidity of the portfolio in dollar terms, but it does impact the percentage of assets in the overall portfolio that could be used to satisfy liquidity needs in periods of market stress.

To address her concerns, the member asks her team for an analysis of the current and proposed portfolios under normal and stressful market conditions. This results in a set of pie charts, which explain how market crises would affect portfolio liquidity under both the current and proposed asset allocations.

Compared to the liquidity profile of the current portfolio, the proposed asset allocation implies a shift toward more liquid investments. As a result, there would be a reduction in the highly liquid and liquid categories in the endowment's liquidity profile and an equal increase in the semi-liquid and illiquid categories under both normal and stress conditions. The proposed allocation results in an increase in the overall illiquidity profile because a higher percentage of the portfolio will be invested in private equity and private real estate, which are the most illiquid asset classes in the portfolio.

The team needs to ensure that even under stressful conditions, the proposed allocation continues to comply with the liquidity budgeting framework in place for the fund, which satisfies the various liquidity needs of the portfolio for both cash outflows and rebalancing. Ensure that the portfolio's liquidity profile is closely monitored and stress tested periodically by the member and her team to ensure that portfolio liquidity remains adequate.

Tools to address Liquidity Management Framework

Among the tools that could be used are cash flow forecasting and commitment-pacing models, liquidity budgets, and stress test analyses. To begin with the cash flow modeling, estimate expected cash outflows and inflows. For cash outflows, project distributions from the endowment to the university. These uses of cash can then be factored into the estimation of expected outflows and inflows through the spending rate policy (5% annually of the endowment while preserving the endowment's purchasing power over time).

Conclusion of Case

Based on the analysis, the university board approves the proposed changes to the asset allocation and instructs the team to proceed with implementation. These changes are also presented to the trustees as part of the university treasurer's financial report at the trustees' next regular meeting. 

Question

All but which of the following could be expected to reduce portfolio liquidity?

1. Capital calls.
2. Activation of gates.
3. The unsmoothing effect.

Solution

The correct answer is C.

Answer choice C should be labeled the “smoothing effect”. This refers to investments in private markets, which tend to incorporate market valuations with a lag that leads to a relative increase in their portfolio weighting during periods of market stress and a relative decrease in the portfolio weighting of more liquid assets.

A and B are incorrect. Both answer choices, A and B could be expected to reduce liquidity. A capital call means an infusion of cash must go from the portfolio into the investment fund, and a gate is a restriction on withdrawals from the fund back into the portfolio,

Portfolio Management Pathway Volume 2: Learning Module 7: Case Study in Portfolio Management: Institutional; Los 7(c) Analyze asset allocation and portfolio construction in relation to liquidity needs and risk and return requirements and recommend actions to address identified needs