and the Financial Crisis
April 20, 2010
Exploit liquidity risk
Investors frequently encounter opportunities to generate excess returns from accepting illiquidity. Of course, the correct conclusion is not to pursue every premium return associated with illiquid assets and the thereby create a completely illiquid portfolio.(p. 3)
The endowment model has notably altered the investing paradigm in the area of target portfolio liquidity. Illiquid assets are those which may not necessarily be purchased or sold for a ‘fair’ price at any given time. Particularly in times of market stress, certain assets may become unpopular and the available prices at which they can be sold may be far below fair value. Those who are forced to sell at these times are paying the price for taking on illiquid assets. There is a growing body of research that supports the notion that illiquid assets often provide the potential for high returns, however, and Yale’s model exploits those opportunities.
Rely on traditional portfolio theory
Yale’s portfolio is structured using a combination of academic theories and informed market judgment. The theoretical framework relies on mean variance analysis, an approach developed by Nobel Laureates James Tobin and Harry Markowitz, both of whom conducted work on this important portfolio management tool at Yale’s Cowles Foundation. Using statistical techniques to combine expected returns, variances, and covariances of investment assets, Yale employs mean-variance analysis to estimate expected risk and return profiles of various asset allocation alternatives and to test sensitivity of results to changes in input assumptions. (p.5)
This paragraph reads like a textbook definition of portfolio theory. My work has shown the consistency in risk-adjusted performance between the endowment model and portfolios that are designed based on portfolio theory. My Monte Carlo analysis uses rational forward-looking estimates of risk and return for the range of possible asset classes (see here and here).
Increase allocations to alternative asset classes
The heavy allocation to nontraditional asset classes stems from their return potential and diversifying power. (p. 7)
Real estate, oil and gas, and timberland share common characteristics: sensitivity to inflationary forces, high and visible current cash flow, and opportunity to exploit inefficiencies. Real asset investments provide attractive return prospects, excellent portfolio diversification, and a hedge against unanticipated inflation.(p.15)
From the perspective of portfolio theory, non-traditional asset classes such as commodities provide value largely because they have low correlation to the movements of the broader market, which means that combining these assets with stocks and bonds allows a portfolio to generate higher risk-adjusted returns than would otherwise be possible. An additional justification for alternative asset classes is that they are less liquid, so it is more likely that the assets are not properly priced. There is a growing literature on the excess return that investment in illiquid assets can yield. Yale’s approach to alternative assets is based on both of these effects.
Asset class risk and return
Yale identifies six major asset classes and provides expected rates of return and risk estimates for each. These values, along with the target allocation to each in Yale’s portfolio are shown below:
Yale states that it uses a rate of inflation that is 1% per year greater than the CPI to reflect the higher rate of inflation in higher education, so we can then estimate the expected total return from these asset classes if we assume a 4% base inflation rate (3% for CPI + 1% additional).
To assess the reasonableness of the projected risks and returns for the various asset classes, I created a series of proxies using ETFs. I then ran these proxies through my Monte Carlo simulation to generate estimates for the risks and returns for the various asset classes (see table below).
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