By taking advantage of their long-term time horizons and ability to tolerate short-term drawdowns, the top-tier US endowment funds achieve very strong results by investing across assets globally, with an important allocation to private investments.

The link between endowment funds and multi-generational wealth management is the similarity in investment objectives and governance. Endowments and families intent on maintaining and growing capital in real terms for the benefit of current and future generations have a lot in common: they both seek to maximise risk-adjusted returns from a portfolio of global assets, they have a long-term investment horizon and they can tolerate short-term drawdowns.

Differences between family wealth and endowments

Families’ overall wealth can be broadly allocated according to three main goals (see chart): financial security; to grow wealth in excess of inflation; and assets aligned to more aspirational goals. An initial wealth allocation of assets that takes into account all three goals is an important step towards clearly defining the perimeters of the endowment-like portfolio, which often accounts for the majority of a family’s wealth.

Source: Pictet, Ashvin B. Chhabra, «Beyond Markowitz: A Wealth Allocation Framework for Individual Investors», The Journal of Wealth Management 7, n° 4 (Spring 2005): 8-34

Multi-generational wealth portfolios and endowment funds show a broadly similar allocation to equities and real assets, providing long-term growth and helping mitigate inflation risk. However, liquidity and cash needs differ between family wealth and endowments. Cash flow needs are unique to each situation, something that must be taken into consideration when developing the asset allocation strategy for families. There are also important issues of scale and governance. Top-performing US endowment owe much of their success to their size and long experience in investing in alternative assets. In addition, the overall objectives for a family are more complex than an endowment’s.

Nonetheless, families can build an ‘endowment’-like portfolio if they allocate wealth according to three main goals: first, to provide financial security in the face of unknowable risk; second, to maintain and grow wealth net of inflation; and third, to make an impact through more ‘aspirational’ investments. The second goal in particular could be managed using an asset allocation similar to that for endowments.

The risks involved

The main risk around this investment approach is the permanent loss of capital, not volatility in the asset or portfolio value. Given an endowment portfolio aims to exist in perpetuity, there are three key risks we focus on (with risk defined as the probability of permanent capital impairment).

First, inflation can significantly impact long-term purchasing power. Therefore, most of a portfolio needs to be invested in equities and real assets, whose cash flows can be expected to provide protection in real terms.

Second, the forced disposal of investments at distressed prices in adverse financial markets to provide liquidity can significantly impact long-term value. As such, forecasts of future cash flows need to be prudent.

Finally, changing the investment policy to reduce risk at times of market stress can lead to disposal of assets at depressed valuations, and therefore permanent losses.

Nonetheless, despite the risks and pitfalls to be avoided, an initial allocation of family wealth assets that takes into account the three goals mentioned constitute an important step towards dearly defining the perimeters best placed to earn ‘endowment’ type returns for family wealth portfolios.