“Illiquidity Premium” that fuelled endowment returns falls back to 2005 levels

May 7th, 2009 | Filed under: Guest Posts, Today's Post | By:
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Back in early 2008, the Economist marveled over the gravity-defying returns of US university endowments.  In early 2009, AllAboutAlpha.com contributor professor Christian Tiu wrote on these pages that “all endowments are relatively unconstrained, tax exempt and large enough to hold different asset classes”.  But what happens when a major driver of returns for these “different asset classes” runs out of gas?  Michael W. Crook, CAIA, of Barclays Wealth examines this issue today.

Special to AllAboutAlpha.com by: Michael W. Crook, CAIA, Vice President, Alternatives Strategist, Barclays Wealth

The revelation last month of serious problems in the Harvard Management Company’s portfolio brings into question the viability of the so-called “endowment model” of asset allocation. Harvard has essentially been forced into a liquidity-driven unwinding of its portfolio, due in part to some specific recent mistakes, but also due to its adherence to the prescriptions of the endowment model.

The endowment model is associated closely with the investment philosophy of David Swensen and the management of the Yale University portfolio. It has been adopted (or imitated) by other endowments around the nation and by some foundations, family offices, and private investors. The main differences between a more traditional asset allocation and the endowment model are:

  1. An overweight to equities, typically through private equity,
  2. An overweight to hedge funds,
  3. Allocations to “new” asset classes (e.g., timber), and
  4. Elimination of low volatility liquid assets (fixed income).

These adjustments reflected two fundamental assumptions: that there are additional returns associated with illiquidity and that the returns on private equity, hedge funds, and new asset classes were very stable and, therefore, helped to increase portfolios’ risk-adjusted returns.

The recent period has, however, cast doubt on these assumptions. During periods of crisis the premium associated with liquidity becomes even larger, resulting in negative relative returns for illiquidity. The recent crisis has been unusually severe in this respect and has made it clear that these returns to illiquidity came with an unlikely but potentially devastating downside risk. Additionally, many adherents to endowment model, who didn’t pay enough attention to their actual liquidity needs, are now suffering the consequences. Finally, investors discovered that the relatively steady returns realized by some of the “alternative” asset classes concealed serious “fat-tail” risk.

Liquidity Premium

It has been well documented that liquidity impacts asset prices, and that on average a less-liquid instrument that is functionally similar to a more liquid instrument will be priced more cheaply (implying greater future returns). This can be seen in equity and fixed income markets, among others, by isolating liquidity risk from other sources of risk and then measuring the return over time associated with that risk factor.

We have created a proxy for the illiquidity factor by forming a portfolio that is long off- the-run treasury securities and short on-the-run treasury securities. This creates a liquidity mismatch because off-the-run Treasuries are slightly less liquid than on-the-run Treasuries, even though both have the same underlying credit risk. We hedged interest rate risk by matching duration within the portfolio. Figure 1 shows the cumulative return of this portfolio since 2000.

Figure 1: Cumulative liquidity returns, January 1, 2000 – March 31, 2009

This illustration makes it clear why many endowments oriented their portfolios toward illiquid investments. Illiquidity appeared to provide an additional element of stable, low volatility positive returns to the portfolio. However, the recent period has made it clear that those returns came with a negative fat-tail risk, as the recent negative returns associated with illiquidity more than wiped out over 3 years of gains in less than 3 months.

The Future of the Endowment Investing

Many endowments are now confronted with the question of whether or not they should move in increase portfolio liquidity. For some this will be an easy answer. Portfolios that are either experiencing a forced unwinding of positions or that are not able to provide funding for their institutions should certainly target a higher level of liquidity going forward. For others the answer is less clear. Illiquidity, in this context, should be viewed as a source of risk and return. It simply becomes part of the asset allocation decision. In the same way that managers allocate to equity risk, credit risk, and interest rate risk, they should be consciously and deliberately managing their allocation to illiquidity risk, i.e., by considering both the upside and the downside.

Considering the new information we have regarding the risk and return associated with illiquidity, we believe many portfolio managers will decide to reduce their exposure to illiquidity risk. This likely means that equity risk will move to public equities from private equities, arbitrage hedge funds will be sold in favor of fixed income and allocations to emerging asset classes will be made more cautiously.

A recent academic article also brings into question whether the endowment model really was responsible for outperformance all along. Brown et al found that endowment outperformance should be attributed to an overweighting of their best managers rather than the increased allocations to specific asset classes. That sounds like good advice for all investors.

- M. Crook, May 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or the CAIA Association.

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