Traditional asset allocation models seem obsolete. The much heralded “Endowment Model” failed in 2008, yet asset allocators continue to cling to it as much as the Peanuts character Linus hung on to his blanket. However, the global financial markets have changed dramatically, and the macroeconomic backdrop that fueled the success of the endowment approach no longer exists.
RBA’s approach, Asset Allocation 2.0, is based on a different asset allocation construct. We no longer pigeonhole investments into traditional categories, such as Large Growth or Value, Small Growth or Value, High Yield or Distressed debt, Absolute Return, or the like. Rather, we group investments based on their returns and risk characteristics.
To our clients, Asset Allocation 2.0 looks no different from traditional asset allocation. Our external reports show exposures to traditional asset categories. Internally at RBA, however, we view asset classes very differently. An investment doesn’t necessarily belong in a fixed-income category if it acts more like an equity investment than a fixed-income investment. An equity investment shouldn’t be characterized as equity if it acts more like a fixed-income investment than an equity investment. Similarly, an alternative investment shouldn’t be classified as alternative if it acts like traditional equity or fixed-income.
Asset Allocation 2.0 also incorporates the productivity of an investment. Productivity does not mean efficiency in an efficient frontier analysis. Rather, it means incorporating a cost/benefit analysis. Fees and lock-ups make little sense when similar exposures can be gained in investments without onerous terms.
This report is not meant to change the asset allocation world. We want investors to gain greater insight as to how RBA determines the asset allocation strategies within our portfolios. We continue to believe RBA’s unique and dynamic approach to asset allocation, Asset Allocation 2.0, is likely to outperform today’s accepted strategies on a risk-adjusted basis through time.
C’mon, admit it already: The Endowment Model failed
Today’s asset allocation models largely follow the so-called Endowment Model despite that the strategy largely failed in 2008. Assets that were supposed to provide diversification suffered significant losses along with the stock market. The combination of a lack of true diversification and significant asset illiquidity forced investors to meaningfully alter or defer spending plans. For example, some large universities that followed the Endowment Model approach were forced to issue debt (effectively leveraging their endowments) in order to maintain the basic cash flows necessary to fund operations. Some foundations similarly had to limit or postpone grant spending.
Many state and local pension funds that invested using the Endowment Model became significantly underfunded. Yet, despite 2008’s flop, adherents of the Endowment Model continue to search for even more esoteric and even more illiquid investments that often offer minimal expected return or diversification benefits.
The reality is that 2008’s asset allocation debacle could have been mitigated or maybe even prevented. Although Asset Allocation 2.0 did not formally exist in 2008, the early research behind it (as far back as March 2006’s report “Uncorrelated Assets are Now Correlated”) suggested investors were ignoring the Endowment Model’s profound shortcomings.
The macroeconomic environment was critical to the Endowment Model’s success.