What is “The Endowment Model”?
The term “Endowment Model” describes an investment strategy that has grown in popularity over the last 20 years. The concept brings the practices of institutional endowment investing to individual investors. And the idea has superficial appeal: large endowments – universities, public pensions, etc. – have tremendous financial resources with which they hire some of the sharpest investment minds in the business. Why not manage retail investor portfolios like large institutional accounts?
Following the practices of successful investors is prudent, but applying the endowment model to retail portfolios is risky – especially for retirees. In the Endowment Model, managers combine individually volatile assets to form low-volatility portfolios designed to generate a level of performance. This works because various investments respond differently in the same circumstance. That is, returns have low correlations. The goal of this method is to produce a steady, predictable return to support endowment withdrawals for scholarships, pension payments and so forth.
Time Horizon Matters
Endowments and pensions are what’s known as “perpetuities,” which means that they are designed to exist forever. They need to meet current spending needs, as well as needs 50 or 100+ years in the future. In contrast, most individual investors don’t need perpetuities. They need portfolios to sustain their spending over the course of their retirement, and perhaps to fund an estate plan for heirs.
The 2008-09 financial crisis tested the Endowment Model, and it came up woefully short. The problem? Low-correlated risky assets were suddenly highly correlated: everything tanked together. While some large endowments successfully cut back spending to weather the storm, retirees who were invested like perpetuities were rudely reminded that they are not. Just when they needed the theory to work for them most, it didn’t. In time, portfolio values in The Endowment Model recovered their pre-crisis values. However, shocked by the failure of the the Endowment Model, many retirees sold their investments and never participated in the recovery.
A Better Model to Follow
Rather than following endowments, retired investors are better off following another group of smart investors: insurance companies. Managers of insurers’ portfolios often utilize a strategy known as “Asset-Liability Matching”. In this method, managers match characteristics of certain investments (e.g. bond maturity dates) with expected future expenses. Imagine a property & casualty insurer in Florida, where hurricane damage is a significant threat, particularly for policy holders living near the coast. But, it’s also highly seasonal: the official hurricane season runs from June 1 through November 30. Insurers can structure their portfolios to provide high confidence liquidity in the second half of the year.
We think structuring retiree portfolios to match their owners’ future expenses serves them best. Sometimes, future expenses are discrete (taking the family on a 50th anniversary trip) and sometimes they reflect a more gradual change (medical expenses increasing with age). Peloton works with each investor to understand their unique future needs and to structure portfolios that match them. Because we use individual securities, we have far greater control over future cash flows than we would with mutual funds.
Every one of us would prefer to exist in perpetuity! The reality is that most retired investors need more certainty than what’s offered by the Endowment Model, and they each have unique sets of needs. We believe following the Asset-Liability Matching Model is a better way for individuals to invest.