Why The Disconnect?

In real estate investing one often hears the saying used by property experts that the three most important factors in determining the desirability of a property are “location, location, location“. For endowments and foundations (and DB plans, too) the key is liquidity, particularly in periods of market stress. In a recent P&I article, Margaret Chen, partner and global head of the endowment and foundations practice at Cambridge, is quoted as saying that “the primary concern of an endowment or foundation CIO is having adequate liquidity to meet operating expenses”, and we would agree. Yet, there seems to be a major disconnect between philosophy and implementation.

NACUBO and TIAA produce an annual study titled, “Asset Allocations for U.S. Higher Education Endowments and Affiliated Foundations”. In the review for 2018’s asset allocation study they highlighted that E&Fs >$1 billion had only 7% in fixed income investments and 32% in public equities (13% in the US), while allocating 58% of the assets for these funds in less liquid alternatives. If liquidity were so key to their success, why would there only be 7% in the only asset class that has a known cash flow? As we reported recently, despite having an absolute-orientation because of their annual spending policies, E&Fs dramatically underperformed corporate pension funds in the Northern Trust universe of large institutional funds, and that’s before we find out the true impact on all the private investments that don’t provide a true market value.

If these plans insist on investing as heavily in alternatives as they currently do, they need to adopt a bifurcated asset allocation that walls off the liquidity needs from the growth part of their portfolio. By implementing a cash flow matching strategy to meet future spending needs, they buy critical time for their alternatives to capture the liquidity premium that exists in these assets. By having so little invested in cash flow producing assets at this time they are forcing liquidity where it doesn’t naturally exist.

Why would you want to be forced to sell public equities at this point or even corporate bonds given the widening that occurred in spreads? These plans may not have a formal liability like a benefit payment in a retirement plan, but these CIOs certainly know what they will generally need in the next 5-10 years to be able to comfortably model that as if it were a benefit payment. Whether we are talking about E&Fs or DB plans, we continue to face the reality that yesterday’s strategies that haven’t worked are not all of a sudden going to work as we move forward. There are time-tested strategies focused on cash flows that should be at the center of any asset allocation strategy.

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