DECEMBER 2012 02 Background: the Endowment Model 04 Asset Allocation Trends 06 Liquidity Management Best Practices 10 Operational Challenges 13 Success Factors for Future Investing The Asset Owners’ Perspective: Evolving Investment and Operational Models During the financial crisis, many asset owners discovered unexpected weaknesses in their investment portfolios, causing them to reconsider their asset allocation strategies. The endowment model of investing — a widely embraced method that includes increased allocations to alternative investment classes — was among the approaches that experienced challenges. While institutional investors continue to build on the foundation of the endowment model today, they are using their experiences from the crisis to change the way they approach the model and investing in general. A new emphasis on liquidity is at the forefront of investors’ priorities. They are also broadening asset allocation tools and focusing on risk management within investment portfolios. And, as investors seek to balance the need for liquidity with the need for returns, alterna- tives are playing a more vital role in portfolio construction.
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DECEMBER 2012
02 Background: the Endowment Model
04 Asset Allocation Trends
06 Liquidity Management Best Practices
10 Operational Challenges
13 Success Factors for Future Investing
The Asset Owners’ Perspective: Evolving Investment and Operational ModelsDuring the financial crisis, many asset owners discovered unexpected weaknesses in their investment portfolios, causing them to reconsider their asset allocation strategies. The endowment model of investing — a widely embraced method that includes increased allocations to alternative investment classes — was among the approaches that experienced challenges. While institutional investors continue to build on the foundation of the endowment model today, they are using their experiences from the crisis to change the way they approach the model and investing in general. A new emphasis on liquidity is at the forefront of investors’ priorities. They are also broadening asset allocation tools and focusing on risk management within investment portfolios. And, as investors seek to balance the need for liquidity with the need for returns, alterna-tives are playing a more vital role in portfolio construction.
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THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 1
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 1
Five years after the start of the crisis, State Street has undertaken a comprehensive study of institutional asset owners to explore new thinking around investment and operating models — including the endowment model — as well as challenges and opportunities related to data integration, talent management and technology. This paper outlines the findings of our research, including investors’ new strategies around asset allocation, continued reliance on alternative investments, approaches to liquidity management and manager selection. Using this insight and our own experience, this paper also delves into where portfolio management is headed and the actions asset owners must take to be successful in this new environment.
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 32 • VISION FOCUS
Pioneered by the world’s leading university endow-
ment programs at Harvard and Yale during the
1980s, the endowment model of investing played
a significant role in opening the doors to alternative
investing across the spectrum of institutional inves-
tors. By including allocations to alternative assets,
such as hedge funds, private equity and real estate,
the goal was to maintain a highly diversified port-
folio while limiting exposure to asset classes with
lower expected returns, such as fixed income. The
model gained deep traction, as other institutions
began to adopt its core tenets.
While this approach had a transformational influ-
ence on many institutional portfolios, investors were
surprised and disappointed by the high levels of
correlation between alternative assets and equity
markets during the most recent financial crisis. As
illustrated in Figure 1, nearly 84 percent of respon-
dents to our survey found that the financial crisis
exposed some weakness of the endowment model.
For example, during the crisis, some asset owners
found that the excessive amounts of leverage
inherent within the model made it difficult to
sustain this approach during a prolonged financial
downturn. Many asset owners faced liquidity chal-
lenges due to their high allocations to private
markets. Meanwhile, some were surprised at the
extent to which their portfolios were exposed to core
equity risk.
Despite these challenges, State Street’s research
found that the endowment model is still considered
a highly effective framework for today’s markets,
and a viable approach for investors with a long-term
horizon who can tolerate some volatility. However,
the financial crisis also changed the way investors
approach the model, as they are learning to better
estimate their own risk tolerance and liquidity needs,
as well as understand how to sufficiently diversify.
Figure 1: Did the financial crisis expose any weaknesses in the endowment model of investing, industry-wide?(All Respondents)
Background: the Endowment Model
A. 47% Yes, the crisis underscored fundamental weakness in liquidity and risk manage- ment for the endowment model
B. 37% The crisis may have exposed some slight weaknesses, but the endowment model of investing is still valid
C. 8% No, the crisis did not expose any weaknesses in the endowment model of investing
D. 9% Don’t know
A
B
C
D
Source: State Street 2012 Asset Owner Study
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 3
The 2012 Asset Owner Study, sponsored by State Street and conducted by Asset
International, was fielded online during July and August of 2012. A total of 116 responses
were received, with 84 percent of respondents located in the US and the remainder located
in Canada, Europe and Asia Pacific. We also spoke with 13 senior decision makers at 11
endowment, foundation and healthcare organizations in the US to gain additional insights.
About the Research
“I am still a big believer in the endowment model. I think it works better than everything else…but the two big
weaknesses that came out [of the crisis] are the two Ls – leverage and liquidity.”
– US private endowment investment manager
Respondents by Type Respondents by Investable Assets(Online Survey)
A. 49% Defined-Benefit Pensions
B. 43% Endowments, Foundations and Healthcare
C. 8% Other
A
B
C A. 12% Less than $100 million
B. 12% $100 million–$500 million
C. 16% $500 million–$1 billion
D. 29% $1 billion–$5 billion
E. 13% $5 billion–$10 billion
F. 16% More than $10 billion
G. 2% Did not disclose
A
B
C
D
E
F
G
Armed with a more nuanced understanding of the
liquidity and risk issues brought to light by the crisis,
institutional investors are fine-tuning asset allocation
strategies. They are seeking the best way to modify
their portfolio mix to balance the need for liquidity
with the need for returns. They are also looking for
unrelated asset classes and managers to reduce
portfolio risk. As a result, the post-crisis investment
environment has further spurred demand for viable
alternative strategies. In our study, 45 percent of
asset owners reported that low yields on traditional
assets have increased their organization’s appetite
for alternatives, particularly among institutions at
the smaller end of the market, as shown in Figure 2.
4 • VISION FOCUS
Asset Allocation Trends
45%of asset owners report that low yields
on traditional assets have increased their organization’s appetite for alternatives
Figure 2: Has the current low-yield market environment increased your organization’s appetite for alternative investment strategies to meet funding demands?
100
80
60
40
0
Respondents with:A Less than $1 billionB $1 billion-$5 billionC More than $5 billion
CBA
Percent
20
Yes No Don’t know
Source: State Street 2012 Asset Owner Study
The shift toward alternatives is not the only signifi-
cant trend. Pension funds are increasingly employing
strategies, such as liability-driven investing or
LDI, which focuses on managing the portfolio for
outcome versus the liabilities, rather than asset-only
returns. As a result, many are also adding to fixed
income positions to better align with liability streams.
Among defined-benefit (DB) pension plans, 39
percent of corporate plans expect to increase
allocations to corporate investment-grade debt in
the coming year, likely to better align the asset
portfolio to the liability discount rate. Meanwhile, 30
percent of public plans anticipate expanding alloca-
tions to emerging-market debt investments in the
coming year, which indicates they are looking for
higher return.
A New Mindset
While some major shifts are taking place in institu-
tional asset allocation decisions post-crisis, another
hallmark of the post-crisis environment is a shift
away from thinking about a portfolio in terms of
traditional asset classes and toward a focus on
the underlying exposures, or factors. For many,
the “factor model” approach is a more useful way
to achieve a holistic view of a portfolio’s alpha
sources and risk exposures. However, investment
managers are still largely organized around asset
class, creating challenges for practitioners of the
factor model.
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 5
“We don’t have asset classes. We don’t have large growth, large value, bonds, equity. We have momen-
tum growth, duration spread, liquidity. So our model is a little different, and we hedge too so we look at
exposures we don’t like and hedge them out.”
– US endowment
“In Australia, we follow a static strategic asset allocation approach. It has been found very wanting. Funds focus on peer risk and relative outcomes, not
on meeting investor needs.”
– Australian public pension fund
6 • VISION FOCUS
Many asset owners experienced cash shortages
during the financial crisis due to elevated allocations
to illiquid assets. In particular, the financial crisis
was an eye-opener for endowments and foundations
that were highly reliant on endowment distributions
to support current spending. As a result, many asset
owners are now re-evaluating their liquidity manage-
ment approach and placing liquidity high among
priorities for asset allocation decisions.
Testing the Limits
Asset owners indicated that stress testing and revi-
sion of liquidity-related investment policies were the
top actions they took to address the liquidity crunch,
as shown in Figure 3. While some organizations had
no formal risk management prior to 2008, today
they have risk managers and strategists — and
entire functions devoted to stress testing. Others
are turning to consultants to look at their portfolios
from different perspectives. In the search for alpha
and the high returns private markets can deliver,
asset owners are discovering the limits of what their
portfolios can withstand.
“Finding unrelated asset classes to reduce portfolio risk is more challenging. Balancing
the need for liquidity with the need for returns in this environment is also difficult.”
– US public charity
Liquidity Management Best Practices
Figure 3: Top 5 Actions Taken in Response to the Liquidity Crunch of the Financial Crisis
Note: Multiple reponses accepted Source: State Street 2012 Asset Owner Study
30
20
10
0
A Conducted more rigorous portfolio stress testingB Revised investment policies related to liquidityC Increased allocation to cash
D Increased allocation to money market funds or other short-term instrumentsE Started actively managing tail risk through derivative products
D
10
%
E
8%
C
16
%
B
21
%
A
27
%
Percent
0
10
20
30
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 7
No perfect combination of liquid and illiquid assets
exists that is suitable for all investors. The optimal
mix depends on an investor’s time horizon as well
as any explicit liabilities, and can also be specified
based upon cash flow analysis and risk-adjusted
return analysis. Typically both historical analysis
and forward-looking analysis should be conducted
to stress test the performance of different asset
class combinations over various economic and
market conditions.1
Key Liquidity Strategies
The new emphasis on liquidity has prompted the
availability of a wide array of liquidity management
solutions. We went to the experts at State Street
Global Advisors (SSgA) — State Street’s asset
management business — to better understand
what options are available, and they identified four
broad approaches they use with investors:
1 Strategic Balanced Strategy: The objective of
this approach is to reduce cash drag related
to the myriad cash accounts and exposures
that asset owners may have, including benefit
payments, routine expenses or buffers against
unanticipated cash needs. Using liquid commin-
gled vehicles, a custom balanced strategy can
be created to attempt to mirror the overall
asset allocation of an entity’s strategic mix.
Funded from actual cash assets, this approach
does decrease assets available for other under-
lying managers. However, it also makes the
liquidity manager the central point of contact for
cash needs.
This approach may best fit: Asset owners who
are concerned about the effect of cash drag
on their portfolio, but are hesitant or prohibited
from using derivatives.
2 Dynamic Balanced Strategy: This strategy adopts
a holistic view of the portfolio. Cash is invested
in the asset class most underweight at the total
portfolio level versus policy. In this way, the
strategy addresses cash drag and minimizes the
variance of overall returns relative to the portfo-
lio’s strategic asset allocation. The logistical and
operational transfer of information is established
to provide a picture of the total portfolio (at the
manager or asset class level) without having
look-through into the actual positions held by
active managers.
This approach may best fit: Asset owners
who are concerned about cash drag, are sensi-
tive to tracking error and are reluctant to
use derivatives.
3 Cash Overlay: Cash overlay programs, similar to
the dynamic balanced strategy, are designed to
alleviate cash drag and minimize tracking error
while facilitating periodic cash flows without
disrupting underlying manager positions. The
key difference is that derivatives are added to
the mix, and the liquidity management program
no longer needs to be fully funded with cash
assets. Investors may designate which cash
accounts are considered part of the overlay
and move just enough cash to satisfy initial and
daily variation margin. Cash overlay strategies
increase flexibility, limit exposure to long only,
and can help equitize underlying manager cash
and receivables.
1 Marino, Stacy L., “Managing Liquidity Needs in a Changing Market,” State Street Global Advisors, 2011.
8 • VISION FOCUS
This approach may best fit: Asset owners who
want to gain market exposure with manager
cash positions and increase flexibility to meet
unexpected cash flows, or those who are looking
to restructure their manager mix, as managers
can be removed without losing market exposure.
4 Strategic Overlay: Strategic overlay programs
go beyond simpler cash overlays by creating a
more flexible structure that can go both long and
short, thereby expanding its potential uses to
include cash equitization, strategic rebalancing,
portable alpha, duration extension and tactical
asset allocation. This approach can help cover
any cash overlay needs and facilitate the rebal-
ancing function of the total portfolio.
This approach may best fit: Asset owners with
relatively sophisticated portfolios — including
numerous active managers — who are seeking
a way to streamline both liquidity management
and broad oversight of the portfolio.
Liquidity and Portfolio Choice
One of the biggest challenges asset owners
face as they navigate uncertain markets is being able
to properly account for liquidity when constructing a
portfolio. New research by State Street Associates,
State Street’s research partnership with academia
and industry, can help institutional investors
value liquidity and incorporate it into asset
allocation decisions.2
Traditional portfolio construction frameworks, which
focus on optimizing the trade-off between risk
and return, do not explicitly address liquidity. As a
result, over-allocation to illiquid asset classes is an
inherent risk. Some investors attempt to correct this
by assigning liquidity scores to individual investment
types in their portfolio. Parameters are then set so
that the combined weighted average liquidity score
of the portfolio may not exceed a predetermined
value. However, given the divergent identities and
needs of asset owners, the liquidity score method
can prove too simplistic of a framework to achieve
the desired effect.
2 Kinlaw, William B.; Kritzman, Mark; and Turkington, David, “Liquidity and Portfolio Choice: A Unified Approach,” Forthcoming in the Journal of Portfolio Management, 2012.
State Street Associates’ research suggests that it is
natural to think of liquidity as a shadow allocation.
Whenever investors employ liquidity to improve
upon a portfolio’s expected utility, they should
attach a shadow asset to tradable assets to reflect
that benefit. Alternatively, when investors deploy
liquidity to prevent a portfolio’s expected utility
from falling — as in the case of rebalancing, for
example — they should attach a shadow liability
to non-tradable assets to reflect the illiquidity cost
those assets entail. The expected return and risk
of the shadow illiquidity allocation depends on how
a particular investor exploits liquidity. By casting
liquidity in units of expected return and risk, this
approach allows institutional investors to analyze
liquidity in the same context as other investment
decisions and to expand upon existing portfolio
allocation techniques.
Liquidity imparts different benefits to different inves-
tors, such as the ability to rebalance a portfolio,
meet capital calls at times of market illiquidity,
exercise market timing skills, allocate funds to new
investment opportunities and respond to shifts in
risk appetite. These benefits can be measured and
expressed in units of expected return and risk to
help investors make more efficient decisions on
portfolio choice. Correcting expected returns for
liquidity in this manner provides a powerful analyt-
ical framework for making asset allocation decisions
involving illiquid investment strategies.
Case Study: Optimal Asset Allocations
*We assume a risk aversion of 2. For the multiple funds scenario, we assume that hedge funds and private equity each consist of 10 managers, and reduce the expected return of both asset classes by 0.70 percent to reflect the multi-fund return impact that results from performance fees.
Source: Kinlaw, William B.; Kritzman, Mark; and Turkington, David, “Liquidity and Portfolio Choice: A Unified Approach,” Forthcoming in the Journal of Portfolio Management, 2012.
Regardless of the extent to which they revised
liquidity and risk management practices after the
financial crisis, today’s asset owners are devoting
more attention to these topics, particularly at the
board level. Boards and investment committees
are focusing on liquidity and risk, considering
whether they need new policies to address these
concerns, and requesting more detailed reporting
than ever before. More than three-quarters
(76 percent) of the asset owners in our study
reported that demands from internal governance
and risk management functions pose a challenge
for their organizations.
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 9
76%of asset owners report demands from internal
governance and risk management functions pose challenges for their organizations
35
%4
7%
56
%
A
20
% 25
% 28
%
B
25
%1
4%
7%
C
20
%1
4%
10
%
D
A EquitiesB Fixed Income
C Hedge FundsD Private Equity
70
60
50
40
30
20
10
0
Title
Percent
■ Ignoring liquidity■ Accounting for liquidity, single funds■ Accounting for liquidity, multiple funds*
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 1110 • VISION FOCUS
Among the operational challenges for asset owners
in today’s complex market, the issue of data inte-
gration is at the forefront. Nearly half (46 percent) of
asset owners rated their ability to achieve a compre-
hensive look-through of their portfolio across all
security types and investment structures as less
than good, as illustrated in Figure 5. Institutions
are also not optimistic about what the future holds.
Over the next three years, almost two-thirds (63
percent) of asset owners expect their data manage-
ment challenges to increase.
More extensive investment in alternatives has
contributed to concerns around data integration.
Asset owners reported that increased complexity
stemming from alternative asset classes is a key
factor, with nearly one-third (31 percent) citing it
as “significant.”
With respondents reporting that their biggest
data challenges are risk exposure and investment
costs, as shown in Figure 6, some owners say
that managers lack of disclosure compromises
their ability to integrate data, especially at the hold-
ings level.
Operational Challenges
Figure 5: How would you rate your ability to integrate data from disparete sources to achieve a comprehensive “look-through” of your portfolio across all security types and investment structures?(All Respondents)
All
0Percent
Very poor Somewhat poor
Corp DB
Public DB
E&F
5% 13% 28% 41% 13%
6% 11% 26% 49% 9%
7% 14% 29% 25% 25%
14% 32% 50% 5%
20 40 60 80 100
Fair Good
Excellent
Source: State Street 2012 Asset Owner Study
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 11
Data management is an overall industry challenge.
While potential relief may be found in new tech-
nologies that help investors consider risk factors
and exposures, asset owners remain concerned
that the problem will worsen as markets become
more complex.
Mind the Talent Gap
Our research revealed that, just as asset owners
are considering their portfolios more holistically
today, they are also looking at talent from new
perspectives — closely examining the types of skills,
expertise and characteristics they require for port-
folio construction and manager selection. According
to the asset owners we surveyed, acquiring and
retaining talent in several key areas is a significant
challenge. A new set of expectations has replaced
the old when it comes to the selection and manage-
ment of external asset managers and other service
providers. These new priorities have refocused
asset owners’ attention as they go forward.
Not only do investors need to hire effective external
managers, they also must build and nurture the
internal talent necessary to ensure they are well
positioned for the future. As illustrated in Figure
7, asset owners cite investment management, risk
management and investment operations as the
areas of greatest challenge in the search for expe-
rienced staff members. In addition, the balance
between generalists and specialists within an orga-
nization is paramount to securing deep knowledge
within each investment type, while retaining requi-
site talent to allocate effectively across strategies.
Figure 6: Asset Owners’ Insight into Risk and Cost (All Respondents)
Two-thirds of asset owners expect data management challenges to increase
Our organization has access to portfoilio investment data that:
A Allows us to understand our total risk exposureB Provides insight into all investment costs
0Percent
Strongly disagree Somewhat disagree
A
B4% 12% 24% 34% 26%
2% 18% 25% 37% 18%
20 40 60 80 100
Neutral Somewhat agree
Strongly agree
Source: State Street 2012 Asset Owner Study
12 • VISION FOCUS
Manager Selection Tools
While asset owners may struggle to acquire talent
in certain key areas, new tools and technologies
are emerging that support the manager selection
process, such as the increased use of technology
and consultative advice. Rather than substituting
for traditional face-to-face due diligence discussions
with managers, these tools are complementary.
Today, sophisticated asset owners are leveraging
more sophisticated quantitative tools when selecting
managers. For example, using a bespoke quantita-
tive methodology, State Street Associates examines
managers’ historical returns throughout different
risk regimes, performing the analysis blindly (i.e.,
with no indication of the managers’ identities). Asset
owners can then determine whether a given manag-
er’s performance is truly aligned with their portfolio
objectives, and if the manager is providing adequate
diversification benefits. This due diligence makes it
easier to assess whether investment managers are
truly “earning their keep,” or whether a portion of
the portfolio could perhaps be replicated in a less
expensive manner. It is also important for asset
owners to truly understand how their managers
generate returns, and to seek diversification along
those lines, as well as by simple style boxes.
Regardless of the manager selection approach,
asset owners must remain in charge of all aspects of
their manager relationships. Adequate due diligence
of managers’ operations has also become increas-
ingly important. This is a key challenge for many
asset owners who realized during the crisis that
they did not have the level of control over manager
relationships they once thought. For example, asset
owners should have confidence that they under-
stand the legal documents associated with all asset
management relationships — an administrative but
highly important task that will equip them with the
information they need to successfully manage these
key relationships.
Figure 7: Does your organization experience difficulty in hiring knowledgeable, qualified staff in any of the following areas?
30
20
10
0
A Investment managementB Risk managementC Investment operations
D Asset allocation E TechnologyF Other
D
14
%
E
9%
C
15
%
B
22
%
A
23
%
Percent
0
10
20
30
F
4%
Note: Multiple reponses accepted Source: State Street 2012 Asset Owner Study
THE ASSET OWNERS’ PERSPECTIVE: EVOLVING INVESTMENT AND OPERATIONAL MODELS • 13
Five years after the crisis began, asset owners are still
incorporating lessons learned from that period, and
the continuing volatility and uncertainty is allowing
them to test the validity of these new investment
approaches. For example, while alternatives remain
instrumental investments for institutions seeking to
achieve above-market returns, asset owners know
that effective use of alternatives requires the right
oversight, staff and understanding.
Asset owners have also renewed their focus post-
crisis on risk management and liquidity. Going
forward, thoughtful institutions will continue to work
to incorporate a true understanding of liquidity and
an ability to effectively review investment decisions
from both risk and return perspectives. Central to
that understanding is an acknowledgement that
illiquid investments come with an opportunity cost.
The key is recognizing whether the return is worth
the cost within the context of the entire portfolio.
To be successful, a more holistic approach to
portfolio management is required. Proactively
constructing portfolios to maintain performance
that supports long-term objectives is one part of the
equation. Asset owners should consider allocating
to alternatives as a diversification strategy, as well as
one to gain returns. In addition, effective manage-
ment of external asset manager and consultant
relationships is critical. Asset owners are already
recognizing the necessity of hiring the right internal
and external talent to select and conduct appro-
priate due diligence of external resources.
Operational issues are another area of ongoing
concern for institutional investors. More widespread
use of the factor model in portfolio construction
has further accelerated institutions’ desire for data
integration, as they attempt to understand how each
factor of an investment strategy affects results.
A key challenge lies in extracting this data from
external managers and consultants and integrating
it successfully to satisfy risk management needs.
Going forward, other influences, such as regulation
and increased automation — particularly within the
realm of alternative assets — will continue to affect
data demands.
To successfully meet ongoing challenges in the
post-crisis landscape, asset owners can partner
with third-party service providers in a number of
areas, including liquidity and risk management,
asset manager selection, and data collection and
integration. While technology can be brought to
bear in each of these areas, the necessity of
human interaction and involvement also remains
an important element. High-touch service providers
who have mastered all of the requisite skills to help
institutions effectively navigate this ever-changing
investment environment will emerge as the partners
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