Asset allocation for non-profits: a US perspective

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Following what was the worst global downturn in more than a generation, many institutional investors were forced to sell prematurely the most liquid portions of their portfolios, deviate from stated investment policy targets and/or issue debt to meet spending and cashflow needs.

Using the lessons learned during this period, we believe that non-profit institutional investors can improve their liquidity and efficiency by incorporating relationships between spending rule, liquidity and asset allocation in a flexible, integrated asset allocation model rather than the asset-only approach that has historically been used to set their long-term investment structure.

Migration in asset allocation

As non-profit institutional investors increasingly sought diversified sources of return and the exploitation of active management in an effort to keep asset pools growing ahead of inflation, allocations to non-traditional asset classes such as hedge funds and private equity increased. According to a 2008 market study by Greenwich Associates¹, US endowments and foundations reported that approximately 4.8% of total assets were invested in hedge funds in 2001. The following year, this had nearly doubled to an estimated 7.8%. By 2008, non-profits collectively allocated over 15% to hedge funds.

While allocations to alternatives are expected to include liquidity constraints and lock-ups on committed capital, institutional investors were generally surprised by the heightened level of correlation among asset classes during the credit crisis and the impact that the lack of liquidity could have on investment pools. Endowments and foundations, unlike other institutional peers (corporate and public plans), had a more difficult time, as they were expected to spend despite the downturn. Furthermore, many institutions calculate their spending rule based on trailing annual or multi-year asset values, resulting in a higher spend rate (as a percentage of assets) just at the point when the institution can least afford it. As a result, in many cases the most liquid assets were sold in 2008 to 2009 to fund spending needs. This had the effect of further increasing the total fund’s exposure to illiquid assets.

Going forward, we expect more attention to be paid to liquidity, debt and the potential for high positive correlation between asset classes. By using a flexible, integrated asset allocation model, we believe institutions can better marry the relationship between choice of spending rule, liquidity and asset allocation.

Overview of an integrated asset allocation approach

We believe that an asset allocation approach should follow three basic steps, as follows:

1. Planning
Individuals and committees governing non-profit investment pools articulate their organisation’s views on investment beliefs, spending policy and gifting expectations. It is also critical to understand and articulate other factors, such as regulatory and legal requirements, and any outside commitments that may encumber the investment of the asset pool during the planning phase.

2. Modelling, setting risk level and risk mitigation
Most non-profits are faced with the risks of asset depletion, spending power erosion and liquidity. Evaluating and determining the appropriate balance of these risks with expected rewards is a key outcome of this phase.

3. Determining actions based on results and implementation
The final phase in the asset allocation process involves deciding on the appropriate changes in the asset allocation policy and determining both timing and procedures for implementation. Any modelling of asset allocation structures is iterative by nature, and the results must be reviewed in detail with buy-in from the ultimate decision makers to ensure that appropriate risks and parameters are accurately captured. A transition or journey plan for moving from the current policy to a new policy, particularly in relation to illiquid assets, is determined during this phase.

Summary

It is critical for non-profit institutions to consider an integrated approach to managing their investment programmes. The 2008 to 2009 market downturn raised important questions about the effectiveness of some asset allocation structures. Understanding the relationship between investment structure and spending policy is an important criterion in setting long-term asset allocation. By employing a flexible, integrated approach to asset allocation, institutions will be better prepared to understand the risks inherent in their investment programmes, improve investment efficiency, better manage liquidity and ultimately achieve their mission.

¹US Investment Management Study, Greenwich Associates, 2008.