The Outlook for Endowment and Pension Funds

Because the 60–40 allocation is very simple to implement (subject to rebalancing rules)—and because it has generated strong absolute and relative risk-adjusted returns over time (i.e., it had a significantly higher Sharpe ratio than did an allocation to either equities or bonds alone)—it has long been a benchmark asset allocation method for endowment and pension fund managers. Thus, it is likely that endowment and pension funds will perform well if the 60–40 allocation performs well (and vice versa). This article provides evidence that the drivers of US equity market returns have changed over time. Specifically, while equity returns are more rate driven in earlier periods (i.e., lower rates are better for equities), they are more economically driven in more recent periods (i.e., a stronger economy is more compatible with equities). Therefore, if the US economy remains sluggish and rates are still low, the 60–40 allocation is likely to perform more poorly in the future than in the past, and, by extension, so are endowment and pension funds. TOPICS:Foundations & endowments, portfolio theory, portfolio construction, performance measurement Key Findings ▪ In the future, endowment and pension fund returns will be primarily driven by the performance of risk assets. It follows that endowment and pension funds will only be able to achieve their objectives if the future environment is favorable to equities. An analysis of recent years’ returns reveals that the only environment in which equities are expected to perform well in the future is one of sustained strong economic growth coupled with accommodative monetary policy. In the absence of such an environment, endowments and pension funds may be unable to sustain planned spending levels. ▪ Individual investors’ future asset allocation choices will necessarily involve real trade-offs. In the past, the 60-40 allocation generated equity-like returns with bond-like volatility, so investors who chose the 60-40 allocation had ‘it all’: high returns and low volatility. However, in the future, the 60-40 allocation will likely generate sharply lower volatility but also meaningfully lower returns, relative to a 100% equity allocation. Investors focused on reducing risk may still find the 60-40 allocation useful, but investors with funding needs and higher returns targets will need to increase their allocation to risk assets. ▪ Individual investors allocating to illiquid risk assets need to be aware that endowments and pension funds will likely significantly increase their allocations to illiquid risk assets in an attempt to achieve their required returns. The magnitude of these institutional inflows may lead to lower returns for illiquid risk assets, as is often the case when large amounts of capital chase a more limited opportunity set.