Case Study in Portfolio Management: Institutional
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Introduction
The development of a strategic asset allocation (SAA) for long-horizon institutional investors such as university endowments raises special challenges. These include supporting spending policies while ensuring the long-term sustainability of the endowment and establishing optimal exposure to illiquid investment strategies in the context of a diversified portfolio.
Large university endowments typically have significant exposure to illiquid asset classes. The exposure to illiquid asset classes impacts the portfolio’s overall liquidity profile and requires a comprehensive liquidity management approach to ensure that liquidity needs can be met in a timely fashion. In addition, capital market conditions and asset prices change, resulting in a need to change asset allocation exposures and/ or rebalance the portfolio to maintain a profile close to the strategic asset allocation.
Institutions often use derivatives to manage liquidity needs and implement asset allocation changes. The cash-efficient nature of derivatives and their high levels of liquidity in many markets make them suitable tools for portfolio rebalancing, tactical exposure changes, and satisfying short-term liquidity needs—all while maintaining desired portfolio exposures.
This case study explores these issues from the perspective of a large university endowment undertaking a review of its asset allocation and then implementing proposed allocation changes and a tactical overlay program. Rebalancing needs for the endowment arise because market moves result in the drift of the endowment’s asset allocation.
The case is divided into two major sections. The first section addresses issues relating to asset allocation and liquidity management. The case introduces a framework to support the management of liquidity and cash needs in an orderly and timely manner while avoiding disruption to underlying managers and potentially capturing an illiquidity premium. Such concepts as time-to-cash tables and liquidity budgets are explored in detail. Aspects relating to rebalancing and maintaining a risk profile similar to the portfolio’s strategic asset allocation over time are also covered.
The second section explores the use of derivatives in portfolio construction from a tactical asset allocation (TAA) overlay and rebalancing perspective. The suitability of futures, total return swaps, and exchange-traded funds (ETFs) is discussed based on their characteristics, associated costs, and desired portfolio objectives. The case also presents a cost–benefit analysis of derivatives and cash markets for implementing rebalancing decisions. Environmental, social, and governance (ESG) considerations arising in the normal course of investing are also explored.
Learning Outcomes
The candidate should be able to:
- discuss tools for managing portfolio liquidity risk
- discuss capture of the illiquidity premium as a long-term investment strategy
- analyze asset allocation and portfolio construction in relation to liquidity needs and risk and return requirements and recommend actions to address identified needs
- demonstrate the application of the Code of Ethics and Standards of Professional Conduct regarding the actions of individuals involved in manager selection
- analyze the costs and benefits of derivatives versus cash market techniques for establishing or modifying asset class or risk exposures
- demonstrate the use of derivatives overlays in tactical asset allocation and rebalancing
- discuss ESG considerations in managing long-term institutional portfolios
Summary
The QU endowment case study covers important aspects of institutional portfolio management involving the illiquidity premium capture, liquidity management, asset allocation, and the use of derivatives versus the cash market for tactical asset allocation and portfolio rebalancing. In addition, the case examines potential ethical violations in manager selection that can arise in the course of business.
From an asset allocation perspective, the case highlights potential risks and rewards associated with increasing exposure to illiquidity risk through investments such as private equity and private real estate. Although this exposure is expected to generate higher returns and more-efficient portfolios in the long run, significant uncertainties are involved from both a modeling and implementation perspective. Finally, the case highlights social considerations that could arise with investing.
1.75 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.