In this Q&A, Bruce Grantier, a member of the CIR Advisory Board, interviews Martin Leibowitz, author of The Endowment Model and managing director of the research department at Morgan Stanley. His book contains some key concepts that are not only applicable to endowments – they are especially relevant to pension funds. In particular, the book focuses on a “beta-based” approach, a simplified version of mean variance optimization that relates the beta of asset classes to that of US equities. In this interview, Leibowitz discusses the impact of the financial crisis on endowments and whether or not investors are ready to espouse a beta-based model in its wake.
BG: My main question would be around what the reaction has been by endowments following the 2008/2009 financial crisis? From what you have seen, how have endowments responded?
ML: Most large funds have not abandoned the endowment model, but they have made adjustments to better provide for liquidity needs in the future. They were all hit with severely declining assets in the face of increasing liquidity needs. So what have they done? Generally they have:
– Become more careful in managing private equity commitments in their pipelines.
– Paid more attention to liquidity sources such as hedge funds and their contractual and de-facto liquidity terms.
– Reviewed security lending policies and practices.
– Upgraded the quality of their fixed income holdings.
– More carefully contemplated their future liquidity requirements in stress beta environments
BG: Has there been a move towards the “beta-based” approach which you set out in the book and, which, if I may say, makes a lot of sense? Related to this has the subject of “stress betas” gained more of a following?
ML: We have seen a number of investors beginning to use beta measurement in risk control and even in monitoring individual mandates. However, there has not as yet been a broad-based adoption of the “beta-based” approach for structuring strategic allocations, despite its value as an analytic tool, its highly intuitive nature, and its simplicity compared to traditional mean-variance analysis.
On the second point, from my observations, endowments do accept that that correlations are likely to again approach “1” in future crises and lead to another “stress beta” effect.
BG: Recent endowment returns have improved which may have alleviated some pressure on endowments and their spending capacity. What have you seen in this regard and what do you see going forward?
ML: Yes, returns have come back, but fund values are mostly still below the pre-financial crisis peak, resulting in generally higher spending percentages and less flexibility in funding policies. Going forward, endowments would like to return to more sustainable spending levels. It is perhaps human nature to want to support to their institution’s objectives and/or their beneficiary needs at roughly the same level as in the past. This desire is certainly laudable, but the setbacks of the past two years have reduced their ability to do so.
BG: Your book offers the suggestion that the endowment model can earn higher returns in normal times, thus providing cushion for those unusual times of market stress. Has the recent experience of the financial crisis convinced endowments of this argument?
ML: Let me address this question in two parts.
Over the past 10 to 15 years ending in 2007, the larger, more diversified generated better returns than their less diversified brethren. However, the dollars drawn from the endowment also grew and became a larger percentage of many universities’ operating budgets. In this sense, the better returns DID create budgetary value, but they did not help to build a cushion against adverse market downturn such as we experienced in 2008.
In terms of the future, given current standard assumptions, diversified funds “should” again provide better expected returns over the long-term (even if at a somewhat lower level of expectation than earlier). The experience of 2008-2009 has been a source of many lessons, one of which is that the investment staff needs to be more tightly integrated with the university’s financial office and its spending plans. This coordination should at least result in one kind of “cushion” in the form of improved liquidity planning and greater flexibility in spending commitments.
BG: Finally, your book notes the impact of asset size on endowment returns. Have you observed any differences in larger vs. smaller endowments as to how they have reacted to the financial crisis and the observations we talked about above?
ML: The answer to that is also not clear– the window for observation is still quite small. Endowments of all sizes make lots of efforts to earn the higher returns potentially offered by alternatives. However, as is well-known, the range of manager returns within an asset class such as private equity, for example, is extremely wide. And not all small endowments can count on being able to select, access, and monitor the ever-shifting cadre of higher-tier fund managers. Consequently, over the long term, the larger endowments should continue to enjoy a certain advantage.