Information about http://www.tiff.org/TEF/articles/Six_Percent_NACUBO.pdf
6% Real or Bust …
Tags: amount of time, bust, city hall, decent chance, elusive goal, endowment management, few words, investment expertise, management forum, mayor richard daley, nacubo, news conference, news conferences, no apologies, organizers, preface, press secretary, richard daley, saying things, sentences,Pages: 9
Language: english
Created: Wed Jan 30 11:11:32 2002
Display cached document
Page 1
Page 2
Page 3
Page 4
Page 5
Page 6
Page 7
Page 8
Page 9
6% Real or Bust
NACUBO Endowment Management Forum
New York City
January 17, 2002
Good morning. I'm reliably told that one reason NACUBO keeps inviting me back as a speaker is
because I have strongly held opinions on just about every aspect of endowment management --
opinions that I'm not afraid to share publicly. To make maximum use of the time allotted to me
today, and to make sure that I don't run into the same problems that Chicago's late mayor Richard
Daley used to run into, I've actually written out the main part of the talk I've prepared for today.
As some of you know, Daley had a habit of saying things he shouldn't have, especially during
news conferences. Indeed, some of his remarks during one news conference produced such
embarrassing headlines the next day that Daley forced his press secretary to call reporters back to
city hall for a scolding. "You guys printed what the mayor said," the press secretary complained,
"instead of what he meant to say."
I'm going to say exactly what I mean here today, and I'm going to say it rather rapidly, the
forum's organizers having asked me to cover a number of tricky topics in a limited amount of time.
To make sure that I say at least a few words about all of these topics -- the most important of which
is how all of you can take steps that give you a decent chance of achieving the elusive goal of a six
percent real return -- I've had to limit my comments on certain aspects of this challenge to just a
few sentences. I make no apologies for this, because you're an audience made up of folks with
varying degrees of investment expertise, and it's better to leave some of you begging for more on a
given topic than bore any of you by talking too much about topics you already know lots about.
A few more comments by way of preface:
First, by design, some of the thoughts I'm about to share with you are unoriginal. They're
unoriginal because my ongoing review of the literature on asset allocation confirms what the Bible
teaches about human affairs, namely that "There's nothing new under the sun." [Bet you didn't
know that came from the Bible. Ecclesiastes 1:9.] This doesn't mean that tired topics don't merit
revisiting, of course. As the German poet Goethe once observed, quote, "Everything has been
thought of before. The problem is to think of it again." In fact, knowing that some of us at TIFF
spend almost as much time thinking about asset allocation as Yankee manager Joe Torre spends
thinking about baseball, a number of investment committees for whom TIFF manages money have
asked us to keep them apprised of our "best thinking" on this topic. Our latest effort to do so takes
the form of the material I'm about to share with you -- a modified version of which TIFF will
publish in its 4Q 2001 Commentary.
As the front side of the handout indicates, my talk today is divided into two parts, each covering a
crucial aspect of the challenge alluded to in my talk's title how to earn real returns high enough to
support a six percent withdrawal rate. The first part of my talk focuses on the most daunting
aspect of this challenge, which is to avoid the many pitfalls that confront trustee groups engaged in
investment policy-making. As you'll see and hear, to give you a concrete sense of what to do as
well as what not to do with respect to asset allocation, the first and larger part of my talk includes a
summary of my current best thinking with respect to an appropriate policy portfolio for
endowments seeking to maintain purchasing power while spending six percent a year. The second
part of my talk focuses on what's hot and what's not in alternative assets. I've kept part two very
brief because other speakers will be discussing most of these asset classes at length and it would be
rude to steal their thunder.
Turning to part one of my talk, you can see that it comprises the 10 most important things that, in
my opinion, investment committees need to keep in mind as they go about their work.
Point #1. There's no such thing as an "ideal" asset mix or policy portfolio, even for endowed
charities with identical spending rules. Why? Because the true test of the appropriateness of a
given mix for a given endowment is whether it will produce the maximum return for whatever level
of risk the endowment's trustees are willing to bear. But few if any trustee groups can accurately
gauge their tolerance for poor results until those results actually roll in.
Point #2. Most endowed charities pursue investment policies that are best described as
conventional rather than conservative, the latter defined literally as conducive to the maintenance of
endowment purchasing power in the face of reasonable annual withdrawals. Conventional policies
differ from conservative policies because comfort and expected return are inversely related, a point
underscored by the table entitled "Changing Fashions" on the flip side of the handout. The plain
truth is that the more comfortable an asset class or investment strategy becomes, the lower its
prospective returns get pushed, often into negative territory.
Point #3. Although institutions are accused of being hopelessly myopic in their decisionmaking,
especially with respect to manager selection, they're actually too far-sighted in other respects,
especially when investing in so-called "alternative assets," a term that is defined unhelpfully but
most commonly as anything other than publicly traded US stocks or bonds. The basic problem is
that people tend to forget that the current price of an asset is always more important than historical
averages. Indeed, studies extolling the virtues of specific "alternative assets" have a nasty
tendency of appearing close to secular peaks in the returns on such investments. This is one
reason why, on average and over time, most institutions have earned far less than they've expected
to earn from "alternative assets."
Point #4. "The beginning of wisdom," Socrates observed, "is the definition of terms." Many
institutions employ policy portfolios comprising, "asset classes" that aren't truly worthy of the
name. The most common offenders these days? One, "hedge funds." Two, "alternative assets."
To merit treatment as an "asset class" by endowment trustees, an asset type or strategy must (a)
embody a distinct, homogenous, and consistently conspicuous set of return "drivers" and risks and
(b) be sufficiently scalable (that is, susceptible of absorbing meaningful inflows without
undermining its capacity to generate competitive risk-adjusted returns to tax-exempt investors).
Grouping such disparate strategies as fixed income arbitrage, distressed debt, and -- God help us
-- macro investing into a fund segment labeled "hedge funds" is really silly. Lumping "hedge
funds" with such non-traditional but potentially non-correlated strategies as venture capital or
emerging markets into a segment labeled "alternative assets" is even worse. When determining
how best to parse the ever-expanding universe of investment choices available to them, trustees
should focus rigorously on how each asset type or strategy under consideration will perform under
worst case conditions, including a major inflation or deflation. As we'll see in a few minutes, their
rigorous use of this test is one reason that cutting-edge investors are increasingly replacing separate
allocations to US and foreign stocks with a unified allocation to global equities.
Point #5. Most institutional investment programs are logically inconsistent in at least one
important sense: the targeted weights for each asset class typically are based on the indexed or
passive return that each asset class is expected to produce, but the bulk of money invested in each
asset class is actively managed. For this and other reasons discussed in a long commentary on
asset allocation that TIFF published a few years back and that I'd be pleased to furnish upon
request, computer-based asset allocation models tend to be highly flawed: they tilt toward asset
classes and strategies whose superior risk-adjusted expected returns necessarily ignore the fact that
big future inflows into a given investment niche will reduce its expected returns. To give you a
concrete example, consider how foolish it would be for the $140 billion California state
employees' pension fund to assume that allocating 15% of its assets to private equity will produce
the same percentage return as a $1 billion endowment's allocation of 15% of its assets to the same
niche. To avoid such foolishness, the expected returns from size-constrained investment niches
-- including most of those that will be discussed at this conference -- have to be adjusted to reflect
the actual dollars that would be allocated to them pursuant to any "model" portfolios being
considered. These niches merit such special handling for two reasons: one, they can't be accessed
on an indexed or passive basis; two, individual manager results within them tend to be
2
distressingly dispersed. Indeed, you're often better off shunning such niches altogether than
accessing them via second-rate managers.
Point #6. In practice, few if any investors are both able and willing to do what's needed to
actually realize the returns that "efficient" asset mixes theoretically produce. "Efficient" asset mixes
presuppose rebalancing moves that are (a) uncomfortably contrarian and (b) difficult if not
impossible to implement with respect to illiquid assets. That said, most institutions could enhance
their long-term returns by adopting more sensible "rebalancing" disciplines, even if the application
of such rules is limited primarily to the marketable portions of their portfolios.
Point #7. The longer and more detailed an endowment's asset allocation guidelines are, the l e s s
useful they tend to be. The reason is clear, and was clearly demonstrated by Bill Clinton's
shockingly long State of the Union speeches: excessively windy policy statements typically mask a
failure to perform the first duty of effective leaders, which is to make intelligent and well-informed
tradeoffs among competing policy aims. In my opinion, investment policy statements should
consist of two things and two things only: first, quantified return expectations and allocation
ranges for each of the asset classes or strategies that a fund is permitted to employ; second, a
succinct rationale for why each asset class or strategy is included in the policy mix. As you can see
from the table on the back side of the handout, with not much effort, you can easily fit all of the
necessary information on a single page.
We'll come back to this table later in my talk, because it constitutes my answer to the central
question I was asked to address here today how can we structure our funds in a manner that
gives them a decent chance of earning a six percent real return over time horizons appropriate to
perpetual life charities? But before you flip back to the front side of the handout, let me walk you
through item number eight (Point #8) in my list of ten do's and don't's with respect to asset
allocation. Item eight anticipates a question that I'm sure many of you would ask about the policy
portfolio I've put together if given the chance. The question is this: why doesn't the table in the
handout include estimates or should I say guesstimates of the recommended portfolio's risk or
volatility, if not in the absolute sense then relative to competing alternatives? After all, one of the
alleged virtues of combining non-correlated assets in the manner I've recommended is that doing
so makes overall fund results less volatile than they would be otherwise.
The reason I've deliberately omitted guesstimates of volatility or standard deviation is because they
tend to be misleading at best and useless at worst. They're misleading because the way most
computer-based approaches to asset allocation work, the volatility or risk measures they spit out
reflect assumed correlations under normal as distinct from extreme market conditions. Forgive me,
but I don't really care about my portfolio's volatility under so-called normal conditions, whatever
the heck that means. I care about its volatility under worst case conditions -- conditions that
almost always cause correlations to soar way above forecasted levels.
The second reason I don't like to place much weight on risk estimates is that they tend to be
useless, by which I mean something quite precise: if -- as we've already discussed -- liquidity as
well as behavioral constraints prevent endowments from making the rebalancing moves needed to
make so-called efficient asset mixes efficient in the first place, well, it doesn't seem very useful to
choose among competing policy mixes based on wholly unrealistic estimates of risk-adjusted
expected returns.
Speaking as we just were of rebalancing, Point #9 addresses a fundamentally important question
that most investment committees don't spend nearly enough time thinking about. The question is,
"How often should we rebalance?" Interestingly, and I think importantly, my preferred answer to
this question is identical to my preferred answer to the related question of how often committees
should review their policy portfolios. The only valid answer to both of these questions is easily
stated: on an as-needed basis. What do I mean by that? Well, with respect to rebalancing, it ought
to be done as frequently as possible consistent with sensible and sober assumptions about trading
costs. In general, most endowments don't do nearly enough rebalancing, due in part to the
unavoidable liquidity constraints we've already discussed but perhaps in larger part to a
3
combination of understaffing and unfortunate if not irresponsible reporting delays. As for policy
reviews, these too should be done not on a preprogrammed basis as is usually the case -- every
few years being the norm among endowments supervised by volunteer committees -- but rather on
an as-needed basis, with the triggers or catalysts being not big market movements but rather
material changes in the number or fundamental character of asset classes available for investment.
Point #10. My tenth and final point about asset allocation hearkens back to the first. Just
because there isn't an ideal asset mix for all endowed charities -- or even a universally approved
method for identifying an appropriate mix for a specific fund -- doesn't mean that one person's
opinion on such matters is as good as the next. Precisely because effective asset allocation requires
as much art as it does science -- by which I mean intuition and experience -- you need to make
sure that the right people perform it in the right settings. With respect to the types of people best
suited to investment policy-making, I've found that the most effective contributors display at least
two common attributes: one, they're experienced and successful investors in their own rights; two,
due largely if not solely to the experience I've just mentioned, the most effective policy-makers
approach investment planning issues from an owner's rather than an agent's perspective. With
respect to the proper setting for investment policy-making, the smaller the group that bears
responsibility for this task the better, subject to a minimum of three. Indeed, if you asked me to
identify the ideal size for an investment committee, I'd tell you it's three people, provided of course
that they display the attributes I described a moment ago.
There's a second and arguably more important reason why it's important to keep the number of
folks involved in investment decisionmaking to a reasonable minimum -- a reason rooted in some
of the hard truths about investing that we've already discussed. Given the fact that some of the
most important work that investment committees do is best done on an as-needed rather than pre-
programmed basis, it logically follows that investment committees should meet on an as-needed
basis also. Most committees don't do this, of course, for reasons that are understandable but
regrettable: they meet on a regularly scheduled rather than as-needed basis because there are usually
too many people on them -- so many people that it's virtually impossible to get all of them together
on short or even not so short notice. This is not good, because regularly scheduled investment
committee meetings often do more harm than good. Why? Because when they assemble
infrequently, on dates set far in advance, committees tend to want to do something, even when
inaction would be the wiser course. As I've already mentioned twice in connection with
rebalancing, committees that only take up important business on a regularly scheduled basis also
tend to miss opportunities to act when action is in fact called for.
Enough about asset allocation. Before opening things up for questions, I'm going to do as I was
told and comment briefly on some of the alternative or non-traditional asset classes and strategies
that I've included in the policy portfolio on the back side of the handout. As I mentioned at the
outset, I'm going to discuss each of these only briefly because I don't want to steal thunder from
the good folks you'll be hearing from later today and tomorrow. I also want to leave some air time
for those of you who are confused or merely outraged by any of the things I've already said about
endowment investing.
Turning back to the policy portfolio I've outlined, let's take a minute or two to talk about foreign
stocks. I know that most folks don't view foreign stocks as alternative assets any longer, although
they were certainly viewed as such when I began working with college endowments 20 years ago.
Indeed, I doubt if you'll be hearing much if anything from this workshop's other speakers about
foreign stocks, by which I mean publicly traded issues as opposed to foreign private equity. This
is OK by me, because it means I can say a few words about foreign stocks without worrying that
I'm stealing anyone else's thunder. I feel compelled to comment on foreign stocks because if they
keep performing like they have the last few years they may wind up making a full circle in a policy-
making sense, going from forbidden fruit in the 1970s, to the height of sexiness as the alternative
asset of choice when Japan was soaring in the 1980s, to forbidden fruit once again. As many of
you know, 2001 was the fifth year in the last six in which the average foreign stock
underperformed the average US stock. Given this dismal performance, and the steadily increasing
correlation of US and foreign stock returns under extreme market conditions, a lot of trustee
4
groups are questioning why they should have anything invested in publicly traded foreign stocks
on a more or less permanent basis.
Let me give you at least two reasons why they should. First, investment policy-making should be
based on long-term considerations -- like the fact that foreign stocks have more than held their
own against US stocks over multi-decade holding periods -- rather than on recent and potentially
non-recurring trends -- like the fact that Japan has imploded in recent years. Or the fact that the
US dollar has moved sharply higher against most foreign currencies, including the yen. These
recent trends could persist for a while longer, but they're not going to persist over time horizons
appropriate to the endowments represented in this room.
The second reason trustees should stay the course with foreign stocks is because the broader an
endowment's opportunity set is, the higher its expected return, all else equal. To arguments that all
else is not equal -- that American ways of doing business are and will remain forever superior --
I have a ready rebuttal: arguments that one nation's "system" is permanently superior to others'
tend to be good contrary market indicators, as we all recall from the late 1980s, when the land
underneath the emperor's palace in Japan had an implied market value greater than all of the
privately held real estate in California. Just as there are differences between good companies and
good stocks, so too are there differences between sound economic systems and attractively priced
means of owning a piece of the action in them. Investing in stocks on a global basis enables US-
based charities to exploit these differences to a greater extent than if they confine their investing to
US shares only.
Next on the list of assets included in my recommended portfolio mix is private equity, which --
along with most of the other so-called alternative assets included in my mix -- other speakers will
be discussing at length. Given this fact, I'm going to comment only very briefly on each of these
asset classes, with two simple aims in mind as I comment on each: first, to give you an
approximate sense of where in their own never-ending valuation cycles each asset class seems to
be poised at the present time; second, to do this in a manner that enables me to use some favorite
quotes from my favorite sport, namely baseball.
With respect to private equity, the baseball quote that seems most apt comes from an eminently
forgettable and indeed forgotten player named Mike Smith, who played for several National
League teams in the 1980s. Responding to reporters' jabs at his unreliable readiness to play,
Smith had this to say: "I've been healthy my entire career, except for nagging injuries the last few
years." The same could be said for most top quartile PE managers operating today, and for the PE
industry as a whole, although not for all of its individual players. Indeed, the reason that the
industry as a whole has produced satisfactory long-term results (on a dollar-weighted basis) is
because its most skilled players have performed exceptionally well, thereby offsetting the subpar
returns generated by its lesser lights. Of course, most top quartile performers active today
accumulated their winning records in environments characterized by falling interest rates and rising
stock valuations, i.e., during the late bull market in financial assets.
Because private equity returns were so high during the closing stages of this bull market in the late
1990s, investors committed vast sums to PE partnerships formed around that time. Most of this
money (literally tens of billions of dollars) remains uninvested. If and when this mound of capital
gets put to work, its sheer size makes it probable that, on average, deals will get funded at prices
that will cause the average returns produced by the partnerships in question to fall well short of
their limited partners' (LPs) ex ante hopes. Why? Because VCs as a group are unlikely to uncover
enough opportunities to put more than a modest fraction of this vast mound of capital to work in
ventures displaying all three prerequisites for very high returns: (1) a proven management
team possessing (2) a sound business plan for capturing (3) meaningful and defensible shares
of large and addressable markets. Moreover, even if VCs as a group attract enough deals of
this sort, they're unlikely to fulfill their LPs' hopes without a full re-flowering of the equity culture
that prevailed in the late 1990s. I'd bet a tidy sum that this won't happen during the stated lives of
PE partnerships formed in recent years. Indeed, as you can see, my policy mix assumes that
global stocks will produce a real return of just 4.5% on an indexed basis over the 15-year planning
5
horizon that this mix presupposes. That's much lower than the double digit real returns that stock
investors pocketed during the great bull market in stocks that in my mind ended decisively in
March 2000. The key question for all of you is whether you can get money into the hands of
private equity managers who can deliver a sufficient return premium relative to whatever return you
expect from marketable stocks moving forward. As you can see, my policy mix assumes a 4% or
400 basis point premium from private equity, an expectation rooted in the all-important assumption
referenced in the third bullet above the table, namely that the hypothetical endowment adopting this
mix will have access to top-tier managers in all of the markets in which it's investing. As an aside,
my very good friend David Swensen, who runs the Yale endowment and who played a vital role in
getting the investment cooperative that I head off the ground, well, David's policy mix assumes
that Yale's private equity managers will outperform Yale's marketable stock managers by 6% or
six hundred basis points a year. I personally think this is a bit of a stretch, because Yale's target
mix includes a 25% allocation to private equity, which translates into almost $3 billion at present.
David is really good at private equity, and at just about every other task that he undertakes
excepting possibly golf, but I think he may have a hard time keeping $3 billion in the hands of
private equity managers who can outperform relevant stock indices by 6% a year over the very
long term. [NB: 12.5% expected total return, which is actually 14% to most individual investors
after adjusting for Yale's implicit price deflator, which exceeds CPI by 1.5% per annum.]
Speaking of difficult tasks, I'm going to say very little about the next asset class on my list,
absolute return, because my colleague Nina Scherago is going to give you the company line on this
very hot asset class tomorrow. As the handout indicates, the company line is that -- as with any
asset class in which individual manager returns tend to be very highly dispersed -- you need to be
very, very careful putting money to work in the absolute return arena at the present time, because
it's overcrowded at best and becoming more so every day. Searching through my vast collection
of baseball quotes for one that's relevant to the challenges confronting absolute return specialists
today, I came across a memorable line from Hall of Fame pitcher Nolan Ryan. "One of the
beautiful things about [my line of work]," Ryan once said, "is that every once in a while you come
into a situation where you want to, and where you have to, reach down and prove something."
What absolute return-oriented managers as a group have to prove over the next several years is that
their form of investing constitutes an exception to one of investing's most important rules, namely
that when too much money flows into a given niche, its returns get pushed way down, often into
negative territory. To be clear, I don't think the average institutional investor is going to lose lots
of money investing in absolute return-oriented hedge funds over the next several years, although
some are going to get embarrassed when the managers they select don't prove as absolute return-
oriented as they've advertised, meaning: adept at controlling downside risk. Given the fact that a
lot of the hedge funds we're talking about run on awfully tight leashes -- meaning that they seek to
avoid even modest short-term losses while simultaneously investing only within narrowly defined
market niches -- given this fact, my chief concern about the vast sums flowing into absolute
return strategies is that it will cause them to deliver over the next several years net returns that,
while positive, are actually below what investors could get by investing in money market funds.
Again, my colleague Nina Scherago as well as other speakers will have more to say about this
tomorrow.
Very quickly, so that we have at least some time for questions, let me share with you the baseball
quote that I came up with that best describes the current environment for the other so-called
alternative assets I've included in my recommended policy mix. In 1966, Yankees manager Casey
Stengel was asked about a ballplayer he'd competed against 50 years earlier. "Larry Gilbert?"
Casey replied. "He's dead at the present time." As most of you know, real estate, oil and gas,
timber, and other so-called hard or real assets are distinctly out of favor at the present time. I have
no idea precisely when they'll come back into favor, and I wouldn't trust anyone who claimed that
they could accurately and consistently forecast the near-term direction of any asset class. What I
am confident in stating is that if the economy does indeed remain sluggish for an extended period,
causing the prices of both real and financial assets to move sideways over a multi-year period, then
you're far better off holding real assets than you are holding financial assets, including especially
stocks. The reason I say this is because the spread between income yields on real assets on the one
hand and those on comparable quality stocks and bonds on the other is very wide by historical
6
standards. This doesn't mean that real assets are poised to soar while financial assets crumble. It
means simply that with real assets you get paid a nice yield to wait for the tide to come back in --
and you have the opportunity to enhance this yield by putting your money into the hands of
managers who typically can do much more to shape your bottom line returns than can managers of
publicly traded stocks or bonds.
The policy portfolio outlined in your handout doesn't make this immediately clear, because it
doesn't contain a specific guesstimate of the value-added that managers of real or hard assets are
expected to deliver. But that's the whole point: there really is no way to own real estate or oil and
gas properties on a truly passive or indexed basis. That's why the column labeled value-added
shows the word "Subsumed" in the rows for real estate and resources: the value-added is
subsumed in each of these asset classes' expected real return.
One more thing before I take questions. I said a moment ago that there's really no way to own real
estate or oil and gas properties on a truly passive or indexed basis. Unfortunately, in the current
environment, even though these asset classes are out of favor -- indeed, perhaps precisely because
they're out of favor -- it's actually surprisingly tough to put serious money to work in them at
prevailing prices. This is a pretty esoteric point for this audience and I wouldn't have mentioned it
except that doing so lets me close my prepared remarks with a particularly memorable baseball
quote. The quote is apt because some of the first-rate real estate and resource managers that TIFF
is privileged to employ are having trouble putting money to work even though they're willing to
pay the full asking prices on properties being offered to them. Evidently, the current owners are
earning a decent enough yield on their properties that they're not forced to sell, and they're so
intent on selling at prices close to what their properties would have commanded if they'd sold at the
peak a year or two ago that they can't bring themselves to accept even full price offers, by which I
mean offers that reflect today's valuations as opposed to earlier peaks. This rather stubborn
mindset is reminiscent of the strategy that All-Star catcher Gary Carter pursued prior to returning to
the Montreal Expos for the closing season of his very successful 19-year career. As Carter
explained to some reporters just before he re-signed with Montreal: "If the Expos come up with an
offer I simply can't refuse, I suppose I wouldn't turn it down."
Questions?
7
6% REAL OR BUST
NACUBO Endowment Management Forum
January 17, 2002
David A. Salem, President and CEO
Enhancing the investment returns
of non-profit organizations The Investment Fund for Foundations
ASSET ALLOCATION -- THE 10 MOST IMPORTANT THINGS TO KEEP IN MIND
1 -- Mimicry Decried. There's no such thing as an ideal asset mix or policy portfolio, even for endowments with
identical spending rates.
2 -- Conservatism Defined. Most endowed charities pursue investment policies that are best described as
conventional rather than conservative. See "Changing Fashions" on reverse side.
3 -- Myopia Defended. Institutions tend to be too short-sighted with respect to manager selection yet too far-sighted
with respect to asset allocation, paying too much attention to asset classes' long-term historical returns and too little
to their current prices.
4 -- Colloquialisms Deflated. Many institutions employ policy portfolios comprising "asset classes" that aren't
worthy of the name. The most common offenders: "hedge funds" and "alternative assets."
5 -- Consistency Demanded. Most institutional investment programs are logically inconsistent in at least one
important sense: the targeted weights for each asset class typically are based on indexed or passive returns but the
bulk of money invested in each asset class is actively managed.
6 -- Rebalancing Deified. Few if any institutions are both able and willing to do what's needed to actually realize
the returns that make "efficient" asset mixes efficient in the first place.
7 -- Prolixity Deplored. The utility of asset allocation guidelines is inversely related to their prolixity. The best
guidelines comprise (a) quantified return expectations and ranges for permissible asset classes and subclasses and (b)
a succinct rationale for why each class or subclass is included in the policy mix. See "Illustrative Policy Portfolio"
on reverse side.
8 -- Alchemy Denied. Choosing among alternate policy portfolios based on guesstimates [sic] of their risk-adjusted
expected returns is perilous because (a) correlations tend to soar under extreme market conditions and (b) liquidity
and behavioral constraints tend to inhibit the rebalancing that the most conspicuously "efficient" mixes presuppose.
9 -- Torpor Derided. Policy-making, like rebalancing, should be done on an as-needed basis, meaning frequently
with respect to rebalancing, infrequently with respect to policy-making.
10 -- Dilettantism Devalued. Policy-making is best performed by (a) seasoned investors (b) meeting in small numbers
(c) on an as-needed basis and (d) thinking like owners rather than agents.
ALTERNATIVE ASSETS -- WHAT'S HOT, WHAT'S NOT
Hot Lukewarm Cold
Be Careful Be Patient Be Bold
Absolute Return Private Equity Real Estate
Inflation-Linked Bonds Resource-Related Assets
Copyright © 2002 s All rights reserved s This document may not be reproduced or distributed without written permission from TIFF. 1
ILLUSTRATIVE POLICY PORTFOLIO
s Primary goal = 6% gross real return (5% spending plus 1% investment-related expenses).
s Secondary goal = avoid peak-to-trough declines in endowment unit values exceeding 25%.
s Assumes a 15-year investment horizon (20022016) and access to top-tier managers in all markets.
s Assumes ILBs purchased near or below par to maintain their utility as deflation (and inflation!) hedges. See TIFF Commentary for June 30, 2000.
s Normal allocations for this policy portfolio differ from the "Neo-Modern" mix below by design.
Expected Gross Returns
Real
Allocation Ranges* Real Value Total
Segment / Eligible Assets Minimum Normal Maximum Return Added** Return Reason(s) Held Benchmark
Total Return Segment 55% 70% 80% 5.8% 0.6% 6.4% Preserve and enhance MSCI All Country World
US Stocks
Non-US Stocks } 36% 40% 64% 4.5% 1.0% 5.5%
purchasing power in
non-extreme market
Free Stock Index (currently
roughly 50% non-US)
Private Equity 11% 18% 25% 8.5% subsumed 8.5% environments
Absolute Return 5% 12% 19% 6.5% subsumed 6.5%
Inflation Hedging Segment 8% 16% 24% 7.8% subsumed 7.8% Preserve capital 10-year US Treasury
Real Estate 7% 12% 17% 8.0% subsumed 8.0% values during Inflation Protected
Resource-Related Assets 1% 4% 7% 7.0% subsumed 7.0% periods of Securities (TIPS) plus 4%
high inflation
Deflation Hedging Segment 4% 7% 15% 3.0% negligible 3.0% Preserve capital 10-year US Treasury notes
US$ High Grade Bonds 4% 7% 15% 3.0% indexed 3.0% values during
Non-US$ High Grade Bonds 0% 0% 5% 3.0% indexed 3.0% deflations
All-Purpose Hedging Segment 2% 7% 12% 3.4% negligible 3.4% Avoid forced sale of 10-year US Treasury
Inflation-Linked Bonds 2% 7% 12% 3.4% indexed 3.4% other assets to meet Inflation Protected
Cash Equivalents ?*** ?*** 10% 1.5% negligible 1.5% cash flow needs Securities (TIPS)
Total 100% 5.6% 0.4% 6.0% Weighted average of
segment benchmarks
* Minimums and maximums for sub-segments may not sum to minimums and maximums for each segment because sub-segments serve as partial substitutes for each other.
** Expected value added from the use of assets or strategies that could cause a sub-segment's returns to deviate from the returns of its parent segment's benchmark.
*** Minimum and normal cash positions could be negative, subject to trustee discussion of appropriate leverage ratios. Endowed charities can lever their portfolios without
incurring unrelated business taxable income -- if they're clever about it. Of course, if leverage is permitted, non-cash ranges must be tweaked accordingly.
CHANGING FASHIONS MEMBERSHIP SUMMARY
Tradi- Neo-Tradi- Neo-
tional tional Modern Modern Number of Assets under
no some some generous Members Management
privates privates privates privates
TIFF Membership 343 $2,329 mm
Fashionable in: Dark Ages 1980s 1990s 2000s s
Private Foundations 165 $1,133 mm
Total Return Segment 60% 60% 70% 75% s
Community Foundations 34 $281 mm
US Stocks
Non-US Stocks
60%
0%
40%
15%
40%
15% } 45% s
s
Educational Organizations
Other 501(c)(3) Organizations
20
124
$185 mm
$730 mm
Private Equity 0% 5% 10% 15%
Absolute Return 0% 0% 5% 15%
Inflation Hedging Segment 0% 10% 15% 15%
Real Estate 0% 10% 10% 5% THE INVESTMENT FUND FOR FOUNDATIONS
Resource-Related Assets 0% 0% 5% 5% Enhancing the investment returns of non-profit organizations
Inflation-Linked Bonds 0% 0% 0% 5%
2405 Ivy Road
Deflation Hedging Segment 35% 25% 15% 10% Charlottesville, Virginia 22903
Conventional Bonds* 35% 25% 15% 10% Phone: 434-817-8200
Cash 5% 5% 0% 0% Fax: 434-817-8231
____________ ____________ ____________ ____________ Website: www.tiff.org
Total 100% 100% 100% 100%
Electronic mail inquiries:
Riskiness Services offered by TIFF: info@tiff.org
Short-Term Principal Loss High Moderate Moderate Low Member-specific account data: members@tiff.org
Illiquidity Very Low Low Moderate High Manager selection procedures: managers@tiff.org
Reputational Risk (circa 2002) High Moderate Low We'll See
Long-Term Return Shortfall** Very High High Moderate Low For further information about any of TIFF's services,
please contact TIFF at the address or phone number
* Deflation-hedging bonds should be high quality, long-term, and non-callable. listed above.
** Probability of earning annualized real returns below 6% over the very long term.
Copyright © 2002 s All rights reserved s This document may not be reproduced or distributed without written permission from TIFF. 2