By Mohamed A. El-Erian
(Bloomberg View) --The right combination of high returns, predictable correlations and tolerable volatility holds the key to meeting the objectives of most investors. The last few years have not been easy for many -- in part because of the rather unusual relationships among the main asset classes that feature in strategic asset allocations.
However, there is one group of investors -- endowments and foundations -- whose inherent characteristics provide, at least on paper, greater flexibility and longer staying power to harvest the benefits of their portfolio positioning. But for them, too, it has not been easy. And their discomfort can be amplified by crucial funding requirements and noncommercial objectives that many of them often face.
When it comes to portfolio construction and asset allocation, endowments and foundations can best be thought of as pools of permanent capital whose financial objective is the predictable funding of specified activities (most notably universities’ operating expenses), while also retaining the real purchasing power of capital over time. With traditional spending rules and longstanding assumptions about the inflation of costs, this often translates into target average annual returns of around 8 percent.
Compared with hedge funds in particular, endowments and foundations are inherently better structured to tolerate more volatility -- especially of the unanticipated type -- as well as prolonged periods of unusual correlations among asset classes. After all, they aren't subject to tight drawdown limits, and they don't need to worry about investor redemptions. It also helps that the bulk of their public reporting is limited to an annual reporting that cites performance, its drivers and general portfolio positioning.
For that reason, endowments are able to venture into less liquid and less-frequented asset classes. In doing so, they have often blazed a trail for others to follow. Historical examples include Yale University's early use of private equity, Stanford's activities in venture funding, and Harvard's pioneering investments in natural resources (particularly timber).
Although it is well known that recent years have not been kind to hedge funds, on average -- so much so that capital allocated to this group has fallen due to strained performance and a high closure rate -- less well known is that endowments and foundations have also faced headwinds. Many have found it hard to meet their return target. Indeed, if it wasn't for new inflows from large donations, the amount being managed there would have also declined.
The average also conceals a significant dispersion among its components. Consider the 2015/2016 data on university endowments: Yale did well again, returning more than 3 percent, while at the other end, Duke, Cornell and California experienced negative returns of around 3 percent.
Unlike hedge funds, where the breakdown in conventional correlations and volatility patterns has been vexing -- mostly because of the unusual involvement of central banks in asset markets -- the major issue facing the average endowment or foundation is sufficient return generation. And with insufficient returns comes additional pressure because of two other factors:
Many endowments and foundations constitute important sources of funding for their owners, particularly universities. Harvard and Yale finance about a third of their operating budgets from the endowment, and Princeton more than 50 percent. As a result, durable shortfalls in return-generating capacity carry the risk of having a consequential impact on student scholarships, research, the hiring of academic staff, facilities, and so on.
In addition, because of the nature of their stakeholders, these endowments are often under greater pressure to restrict part of their investment activities, including the exclusion of certain areas altogether (for example, tobacco, alcohol and coal) for reasons of social responsibility.
Concern about a prolongation of such shortfalls has been tempered in recent weeks by the equity rally that has followed Donald Trump's election. After all, the most feasible -- if not the only -- path for endowments and foundations to fulfill their multiple objectives is, of course, by harvesting high markets returns. Indeed, even with continued disappointing alpha from active management, this makes it a lot easier to simultaneously fund university spending, preserve and enhance the real value of capital and meet various noncommercial objectives.
Should these returns fail to materialize in a durable fashion, however, the potential brake could be significant for institutions that rely heavily on transfers from their endowment. Rather than just wait and hope for the best, they would be well advised to deploy even greater efforts now to raise new gifts for the endowment, to look into increasing other sources of revenue and to take another look at the allocation of their spending. In doing so they would be reducing the one risk that can seriously disrupt academic activities: that of a sudden stop to the funding of research, financial aid, teaching and capital programs.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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