produced extremely strong returns that boosted the values of endowments by large multiples, net of spending. The post-2000 drawdown in equity markets led endowments to have an even stronger focus on alternative investments, moving to increase exposure to hedge funds and other assets with lower correlations to equities while reducing exposure to publicly traded equities.
Once an asset allocation is determined, a spending rule must also be established. The earliest endowments spent income only, which tilted the portfolio toward income-producing securities. Later, endowments moved toward spending at a fixed percentage of the current value of the endowment, such as 4 %. This fixed spending rate, however, created volatility in the amount of income available to the university. In a year when the return and gifts received by the endowment generated a 20 % increase in endowment value, the income to be spent also increased by 20 %. Conversely, during a 20 % drawdown, the spending rate of the university was slashed by a significant amount. A sticky spending rate, such as $3 million per year, provides certainty of income to the university but can create concerns of intergenerational equity after a large gain or loss in the value of the endowment.
Recognizing that volatility in the income provided to university operations was unwelcome, more flexible spending rules were developed. Spending 4 % of the average value of the endowment over the trailing three to five years creates a smoothing process that dampens the impact of the volatility of portfolio returns on the income provided to the university.
David Swensen developed a spending rule for Yale University: each year, the endowment could spend at a rate equal to 80 % of the prior year's dollar spending plus 20 % of the endowment's long-term spending rate (4.5 %). This formula incorporates the prior 10 years of endowment value into the spending rate calculation, providing a stronger smoothing effect than a simple moving average rule.
Swensen (2009) expresses concern about the impact of inflation, market volatility, and high spending rates. Some 70 % of endowments use spending rates of between 4 % and 6 %, with 5 % being a popular choice. Yale has set its long-term spending rate at 4.5 %, as simulations show that, based on a five-year average of endowment values, a 5 % spending rule has a 50 % probability of losing half of the endowment's real value at some point over the course of a generation. Using a longer averaging period and a lower spending rate reduces the probability of this disastrous decline in the real value of the endowment portfolio.
Inflation has a particularly strong impact on the long-term real value of university endowments. Ideally, endowments should seek to maintain the real value of the corpus rather than the legal requirement of the notional value. When maintaining the real value of the corpus, long-term spending rates can keep up with inflation; when maintaining the nominal value of the corpus, long-term spending has an ever-declining value in real terms.
The focus on inflation risk has led many endowments to increase allocations to real assets in recent years. Between 2002 and 2014, the largest endowments increased their average allocations to real estate and natural resources from 6 % to 14 %. Interestingly, while endowments invested a greater portion in real estate than in natural resources in 2002 (4.3 % versus 1.7 %), they are currently investing the same amount in both natural resources and real estate (7.0 %). Real asset investments include inflation-linked bonds; public and private real estate investments; commodity futures programs; and both direct and private equity fund investments in mining, oil and gas, timber, farmland, and infrastructure. Ideally, the real assets portfolio would earn long-term returns similar to those of equity markets, with yields similar to those of fixed income, while experiencing low volatility and low correlation to the fixed income and publicly traded equity assets in the portfolio, as well as higher returns during times of rising inflation.
A report from Alliance Bernstein (2010) calculated the inflation betas of several asset classes. An inflation beta is analogous to a market beta except that an index of price changes is used in place of the market index, creating a measure of the sensitivity of an asset's returns to changes in inflation. Just a few assets demonstrated a positive inflation beta, where the assets act as an effective inflation hedge. The majority of assets have a risk to rising inflation; that is, they have a negative inflation beta. According to Alliance Bernstein, commodity futures offered the greatest inflation beta at 6.5, whereas farmland had a beta of 1.7. In the fixed-income sector, 10-year Treasury Inflation-Protected Securities (TIPS) had a beta of 0.8, whereas three-month Treasury bills had a beta of 0.3. Equities and long-term nominal bonds had a strong negative reaction to inflation, with the Standard & Poor's (S&P) 500 Index exhibiting an inflation beta of –2.4 and 20-year U.S. Treasury bonds suffering returns at –3.1 times the rate of inflation. Within equities, small-capitalization stocks had an even greater risk to rising inflation. Companies with lower capital expenditures and fewer physical assets also had a stronger negative response to rising inflation.
3.5.2 Liquidity Issues
In the aftermath of the 2008 financial crisis, many pension funds and endowments have begun to reevaluate their asset allocation policies and, in the process, are paying increased attention to their risk and liquidity management practices. Liquidity represents the ability of an entity to fund future investment opportunities and to meet obligations as they come due without incurring unacceptable losses. These obligations include the annual spending rate as well as the capital calls from private equity and real estate limited partnerships. If there are mismatches between the maturity of an entity's assets and its liabilities, the entity is exposed to liquidity risk.
While liquidity is certainly a risk for endowments, these funds have long lives and can afford to take a fair amount of liquidity risk. Studies (Aragon 2004; Khandani and Lo 2011; Sadkay 2009) have shown that the illiquidity premium is generally positive and significant, ranging from 2.74 % to 9.91 % for some investment strategies. Ang and Kjaer (2011) suggest that investors should demand steep premiums to bear liquidity risk, as holding less liquid assets may cause investors to forfeit the lucrative opportunity to buy assets at distressed prices during a crisis. For 10-year lockups, this premium may be 6 %, while two-year lockups require a 2 % premium. The size of this premium varies through time, with studies suggesting that illiquidity premiums declined in the years leading to the financial crisis. Therefore, similar to management of other risks, a portfolio manager has to consider carefully the trade-off between the liquidity risk and the illiquidity premium in determining the size of the illiquid assets in the overall portfolio. These studies also show that, everything else being the same, funds with long lockup periods generally provide a higher rate of return to investors. A long lockup period is a vital tool employed by managers to reduce the cost of liquidity risk. During the most recent financial crisis, funds with long lockup periods were not under pressure to sell their assets at distressed prices. It is important to note that if the underlying assets of a fund are less liquid than the liquidity provisions it offers to its investors, the cost of liquidity risk will increase for all investors, even if only a small fraction of the fund's investors decide to redeem their shares during periods of financial distress. The fact that some pension funds and endowments have decided to reduce their allocations to illiquid assets may signal that the illiquidity premium will be higher in the future. Pension funds and endowments cannot afford to ignore such an important source of return if they are to meet the needs of their beneficiaries.
Effective liquidity risk management helps ensure the ability of a pension fund or an endowment to meet its cash flow obligations, which may not be completely predictable, as they are affected by external market conditions. Due to lack of effective liquidity risk management, many funds experienced severe liquidity squeezes during the latest financial crisis. This forced some to sell a portion of their illiquid assets at deep discounts in secondary markets, to delay the funding of important projects, and, in certain cases, to borrow funds in the debt market during a period of extreme market stress. These experiences have led some to question the validity of the so-called Yale model of pension and endowment management and, in particular, to discourage pension funds and endowments from allocating a meaningful portion of their portfolios to alternative assets.
In The Global Economic System, Chacko et al. (2011) explain
