Alternative Investments - Black Keith H.

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market or an emergency increase in the debt burden. Greater cash holdings are necessary for universities with larger outstanding commitments to private equity and real estate funds, greater leverage, higher spending rates, more frequent rebalancing, or larger allocations to less liquid assets.

      To avoid liquidity crises, Siegel (2008) suggests laddering allocations to private equity and real estate funds, ideally at a schedule in which distributions from maturing funds are sufficient to fund capital calls of partnerships of more recent vintages. When adding real estate and private equity partnerships to the portfolio, investors are encouraged to spread the new commitments over multiple years rather than making a large initial commitment in a single vintage year. In addition to spreading capital commitments over time, Siegel suggests that liquidity can be improved by growing the gift income of the endowment, borrowing, or reducing the allocation to less liquid alternative investments. Private equity and real estate partnerships are less liquid investments, while commodity futures funds and hedge funds with lockups of one year or less are more liquid alternative investments.

      Leverage can also create liquidity issues. Short-term leverage, such as that provided by prime brokers to hedge funds, may not be sustainable or affordable during times of crisis. When credit lines are reduced or not renewed, investors may have to repay loans on short notice, which can require the sale of investments at very low prices. Many fixed-income arbitrage and convertible bond arbitrage funds suffered significant losses during the most recent crisis, as a reduction in leverage from eight times to four times required the immediate sale of half of the portfolio. When the market knows that these sales are coming, and a number of hedge funds are simultaneously forced to sell due to credit line reductions as well as investor redemptions, liquidity risk is extreme as buyers of these fixed-income assets wait to purchase until the prices of the convertible and mortgage-backed bonds have fallen precipitously. Endowments and foundations that invest in leveraged hedge funds must be prepared for the potentially large drawdowns in these strategies, as well as the potential for the erection of gates that prevent investors from redeeming their assets from hedge funds during times of market crisis.

      The liquidity crisis of 2008 brought criticism to the endowment model. Williamson (2011) quotes Daniel Wallick, principal of Vanguard's Investment Strategy Group, as saying that the endowment world's pre-2008 blind emulation of the Yale approach has passed. Endowments and foundations today need to focus on having greater access to liquidity in their funds, which may lead both to declines in the commitments toward future private equity and real estate funds, and to increases in the cash and fixed-income allocations. Within alternatives, the focus has turned toward more liquid holdings, such as equity hedge funds and commodity futures investments. Between June 2008 and June 2010, Commonfund notes that cash allocations increased by 4 %, while U.S. equity allocations fell by 8 % and international equity allocations declined by 2 %. Alternative investments, especially those with greater liquidity and lower volatility, increased allocations by 6 %.

      Not everyone, though, thinks that the endowment model has passed its prime. Keating (2011) believes that after some tweaks in liquidity, conviction in the endowment model has actually strengthened. He notes that the Harvard University endowment has changed its cash target from –5 % to +2 %, while reducing its uncalled capital commitments to real estate and private equity partnerships by more than $4 billion in the past two years. Similarly, Yale University increased its cash holdings to 4 %, while putting external lines of credit into place. Keating (2010) states that the liquidity crisis was not caused by an overallocation to alternative investments but by an underallocation to fixed-income and cash investments.

      There are important lessons to be learned from the experiences of pension funds and endowments during the most recent financial crisis. Plan sponsors, portfolio managers, and asset allocators could use the framework set forth by the Bank for International Settlements to create a robust process to estimate their liquidity needs and establish a clear liquidity risk tolerance that reflects the needs of their current and future beneficiaries. They should establish sound processes for identifying, measuring, monitoring, and controlling liquidity risk. This process should include estimates of future cash flows arising from both assets and liabilities. A sound and robust risk management process should allow pension funds and endowments to take full advantage of the available investment opportunities, including earning premiums for bearing liquidity risk at levels their institutions can tolerate.

      3.5.3 Rebalancing and Tactical Asset Allocation

      Among large endowments, the growth rate of allocations to alternative investments may be approaching the largest possible level. Other institutional investors continue to increase allocations to alternative investments in hopes of catching up with the top universities in terms of both returns and the size of the assets allocated to alternative investments. In addition to a large allocation to alternative investments, emulating the largest endowments also requires aggressive rebalancing, careful sourcing of top-performing managers, and embracing liquidity risk. This is easier said than done, however, as inevitable market crises will test the patience and liquidity structures of investors with large holdings in alternative investments.

      Another reason to maintain liquidity in an endowment or a foundation portfolio is to facilitate rebalancing activity. Swensen (2009) believes strongly in keeping portfolio weights close to the long-term strategic weights, a practice that requires regular rebalancing. Without rebalancing, the asset allocation of the portfolio will drift, with the asset classes earning the highest returns rising in weight relative to the rest of the portfolio. Assuming that the highest-performing asset class is also more volatile and increasingly overvalued, the risk of the portfolio rises significantly when rebalancing activity is delayed. Market price action makes it relatively easy to rebalance publicly traded securities, as the investor is buying as prices fall and selling as prices rise. Investors who rebalance are providing liquidity to the market, and liquidity providers often get paid for providing that service to other investors. This is the time when value is created, as many times purchases made during a time of price weakness can create significant value. It can take courage, though, to buy an underweighted asset class when prices are falling and most other investors are selling. To the extent that bonds increase in value as a flight-to-quality asset when equities decline, investors may need to move quickly to rebalance before returns start to move in the opposite direction.

      Rebalancing, however, can be regularly undertaken only in liquid asset classes. Within alternatives, hedge funds may have quarterly redemption windows and lockup periods of one to three years. Private equity and real estate funds must typically be held until assets are fully distributed, a process that can take 10 to 12 years. Funding capital calls to private equity and real estate funds can change the asset mix, as traditional investments are typically sold to fund the increasing allocation to the less liquid alternative investments. To the extent that alternative investments have net asset values that are smoothed or reported with a time lag, publicly traded investments will decline in allocation rapidly during times of crisis. It is important to understand the role of pricing in these less liquid asset classes, as the net asset value adjusts slowly to changes in public market valuation. Investors may react by rebalancing only within the liquid alternatives and traditional assets, while slowly changing allocations to less liquid alternative investments by modifying the size of future commitments.

      There are a number of approaches to rebalancing, such as those discussed by Kochard and Rittereiser (2008). Some investors will rebalance on a calendar basis, for example, after discussions at a quarterly meeting of the investment committee. Other investors will tie the rebalancing activity to the actual asset allocation when compared to the long-term policy asset allocation. While some investors have exact targets for the domestic equity allocation, such as 30 %, others might have ranges of 25 % to 30 %. Those with an exact target may establish a rebalancing deviation, such as a decision to rebalance when the equity allocation has strayed 2 % from its target weight. Investors with asset allocation ranges may wait to rebalance until the allocation has moved outside the range. When range-based investors rebalance, they must also decide whether to rebalance to the closest edge of the range or to the center of the range.

      For liquid investments, rebalancing can be accomplished through the use of securities or derivatives. Investors seeking to rebalance during late 2008 or early 2009 needed to sell fixed income and buy equity securities in order to restore the liquid portion of the

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