Back in early 2008, the Economist marveled over the gravity-defying returns of US university endowments.  In early2009, AllAboutAlpha.com contributor professor Christian Tiu wrote on these pages that "all endowments are relatively unconstrained, tax exempt and largeenough to hold different asset classes".  But what happens when a majordriver of returns for these "different asset classes" runs out of gas? Michael W. Crook, CAIA, of Barclays Wealth examines this issue today.

The revelation last month of serious problems in the Harvard Management Company'sportfolio brings into question the viability of the so-called"endowment model" of asset allocation. Harvard has essentially beenforced into a liquidity-driven unwinding of its portfolio, due in partto some specific recent mistakes, but also due to its adherence to theprescriptions of the endowment model.

The endowment model is associated closely with the investmentphilosophy of David Swensen and the management of the Yale Universityportfolio. It has been adopted (or imitated) by other endowments aroundthe nation and by some foundations, family offices, and private investors. The main differences between a more traditional assetallocation and the endowment model are:

1. An overweight to equities, typically through private equity,
2. An overweight to hedge funds,
3. Allocations to "new" asset classes (e.g., timber), and
4. Elimination of low volatility liquid assets (fixed income).

These adjustments reflected two fundamental assumptions: that thereare additional returns associated with illiquidity and that the returnson private equity, hedge funds, and new asset classes were very stableand, therefore, helped to increase portfolios' risk-adjusted returns.

The recent period has, however, cast doubt on these assumptions.During periods of crisis the premium associated with liquidity becomeseven larger, resulting in negative relative returns for illiquidity.The recent crisis has been unusually severe in this respect and hasmade it clear that these returns to illiquidity came with an unlikelybut potentially devastating downside risk. Additionally, many adherentsto endowment model, who didn't pay enough attention to their actualliquidity needs, are now suffering the consequences. Finally, investorsdiscovered that the relatively steady returns realized by some of the"alternative" asset classes concealed serious "fat-tail" risk.

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