The typical investment policy for the unrestricted assets of an endowment or foundation is to earn a return of 5% after inflation over a long-term time horizon. If these policies are met, the portfolio can support a 5% spend/distribution rate net-of-fees and preserve real purchasing power in perpetuity.
Time horizon is the amount of time until the organization needs to access the assets. A longer time horizon allows an investor to invest more aggressively, as they have longer to weather market volatility, and also translates into less need for liquidity. With a shorter time horizon, a more conservative approach helps to prevent significant losses just before withdrawing assets. For endowments, generally only a small portion of the assets is needed in the short term; the majority of the funds have a time horizon that is essentially perpetual. This very long time horizon makes it possible for endowments to consider incorporating riskier, less liquid asset classes that can provide greater return potential over that long-term horizon.
Data suggests that most E&F portfolios, especially those with total assets of less than $1 billion, are more naively invested than their time horizons call for. Contrary to smaller institutions, larger organizations tend to build portfolios with less fixed income and higher allocations to alternative investments, such as real estate, real assets, private equity, and absolute return strategies. These alternative asset classes, implemented properly, can both enhance returns and reduce volatility of the overall portfolio. You can see in the chart below that endowments with larger allocations to private equity (>15%) have performed in the top half among their peers more than those endowments with smaller allocations to private equity (<5%) over a ten-year time period.
It is important to recognize that incorporating alternatives does reduce portfolio liquidity; however, given a truly long-term time horizon, illiquidity should not preclude these investments from the portfolio.
We regularly educate and recommend that our endowment and foundation clients position portfolios to be in line with a perpetual time horizon. For those clients where it’s prudent to do so, we normally recommend low levels of fixed income, given the current low interest rate environment, and higher levels of illiquid investments, particularly private equity. Moreover, when the portfolio is prudently implemented for the long term with alternatives such as private equity, meeting a 5% real return is much more achievable.