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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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CHAPTER 3

Risk Management for Endowment and Foundation Portfolios

When applied by the largest investors, the endowment model has created impressive returns over the past 20 years. However, this style of portfolio management comes with a special set of risks. First, portfolio managers need to be concerned about the interactions among spending rates, inflation, and the long-term asset value of the endowment. Second, a portfolio with as much as 60% invested in alternative assets raises concerns of liquidity risk and the ability to rebalance the portfolio when necessary. Finally, portfolios with high allocations to assets with equity-like characteristics and low allocations to fixed income require the portfolio manager to consider how to protect the portfolio from tail risk, which is a large drawdown in portfolio value during times of increased systemic risk.

3.1 SPENDING RATES AND INFLATION

There is an important tension between the spending rate of the endowment, the risk of the endowment portfolio, and the goal of allowing the endowment to serve as a permanent source of capital for the university. When the endowment fund generates high returns with a low spending rate, the size of the endowment fund increases. This may lead to concerns about intergenerational equity, as the spending on current beneficiaries could likely be increased without compromising the probability of the endowment continuing into perpetuity. Conversely, a conservative asset allocation with a high spending rate ...

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