Mod Note (Andy): Read part one here
Now that this crazy week is coming to an end I have some time to write another one of these posts. Part 1 gave an overview of the E&F industry, and now Part 2 is going to go into detail on a crucial part of the E&F investment process:. Many call E&F professionals asset owners rather than asset managers, however I see them as both. Going through asset allocation discussions gives you exposure to a strategic side of investing that you won't find anywhere else. While you aren't out there picking stocks or modeling LBOs, you have to understand everything going on in the various asset classes to make the best possible decisions.
Asset Class Definitions
This sounds really simple, but there isn't a universally agreed upon way to define asset classes. The goal of defining classes is to group investments that are alike in potential returns and return drivers (i.e. equity like returns, sensitivity to interest rates, etc). The most commonly used asset classes are Domestic Equity, Foreign Equity, Private Equity, Absolute Return, Natural Resources, Real Estate, and Fixed Income. Most of these highest level classes will also have sub asset classes, such as L/S Equity and Multi-Strategy under Absolute Return. The goal is to have enough asset classes to properly diversify the potential returns and drivers of those returns, but not so many that you dilute the effects. Most endowments strive to maximize potential return, while minimizing downside risk, and that is exactly what a portfolio allocated to the above asset classes does.
Everyone endowment touts a target portfolio allocation in their annual reports, but rarely do you see an actual portfolio that is identical to the target. This can result from an asset class over or under performing its expected return or a short term change in asset allocation that does not affect the long term allocation portfolio. Ever year investment committees meet to determine what the ideal, long term asset allocation should look like. The target portfolio doesn't typically change much year-to-year, but there can be huge variations in the actual portfolio that investors need to be able to justify to their ICs. The target portfolio can vary widely between E&Fs as well, as shown below by analyzing target portfolios for two prominent endowments.
Asset Class (Portfolio 1, Portfolio 2)
Domestic Equity (11%, 6%)
Foreign Equity (22%, 13%)
Private Equity (18%, 31% )
Absolute Return (16%, 20%)
Fixed Income (10%, 5%)
Natural Resources (11%, 8%)
Real Estate (12%, 17%)
You can see that even among the greatest and largest endowments, there are huge discrepancies in asset allocation. Neither is wrong in their approach - each group has reasons for making these allocations. In addition to expected returns, target portfolios are generated based on liquidity needs, fund structures, sub asset classes, and a host of other endowment specific issues.
Deviations from the Target Portfolio
This happens all the time. You may currently be allocated on target at 13% for Foreign Equity, but something just happened in Brazil and you think this is the chance of a lifetime. You decide to give a chunk to a top Brazilian equity manager and now two years later your Foreign Equity allocation is actually 17%, not 13%. One of the most interesting parts of the asset allocation process at an endowment is determining when to make these deviations from the target portfolio. These can be career defining situations depending on your IC. If it works out, you could be the next CIO; if not, well you know where this is going. Understanding markets enough to make these calls is what makes a truly great endowment investor. A large part of the job is doing the research to determine where is best to put money to work.
Quantitative vs. Qualitative Asset Allocation
I wanted to briefly touch on this before the post concludes. There are quantitative and qualitative ways to determine asset allocation - for the target portfolio and short term deviations. The preferred approach varies by team, but in my opinion a blend of the two is the best way. Mean-variance analysis is commonly used and there are many quantitative models that can spit out the "ideal" asset allocation. However, we all know that models aren't perfect at seeing into the future and therefore a healthy dose of skepticism is needed. I think these models are a great starting point for qualitative discussions on asset allocation.
This wraps up Part 2 on Endowments & Foundations. Feel free to ask any questions or make a request for the next topic. If you are interested in working in the industry, I've seen two investment analyst postings in the last week on job boards and I am sure there are other opportunities out there that I haven't seen.