Leibowitz et al. The Endowment Model of Investing

The Endowment Model of Investing: Return, Risk, and Diversification by Martin L. Leibowitz, Anthony Bova, and P. Brett Hammond (Wiley, 2010) is a serious study by market practitioners, two from Morgan Stanley and one from TIAA-CREF Asset Management. They look at asset allocation and portfolio risk through the lens of beta. The book is therefore valuable for CIOs as well as for systems builders who want to incorporate beta into their models.

Beta, we know, measures how much a particular asset is expected to move in response to a one percent change in the overall equity market. Equivalently, beta is “the correlation between the asset (or portfolio) return and the market return, multiplied by the ratio of their volatilities.” The authors are quick to point out that although the relation between portfolio or asset class volatility and beta is “linear and positive,” market volatility has “a powerful inverse and nonlinear effect on beta.” From these relationships, one can draw some important conclusions about the benefit of adding nonstandard assets with allegedly low correlations and betas when compared to traditional equities. A low beta, the authors write, “can result from three nonexclusive conditions: (1) low correlation between an asset class and the market; (2) low asset class volatility; or (3) high equity market volatility, or any combination of 1, 2, or 3." Thus, they continue, “an asset class may have a low correlation with U.S. equity, but still have a relatively significant beta sensitivity.” (p. 14)

Although the authors focus on beta-based asset allocation, they do not neglect alpha. Contrary to many portfolio models they place non-traditional assets such as non-U.S. equity, real estate, hedge funds, and private equity in the portfolio’s alpha core, ascertaining the maximum acceptable limits for each asset class, and then they add traditional liquid assets—U.S. equities, U.S. bonds, and cash—to achieve the desired risk level for the entire portfolio. They refer to these traditional assets as swing assets.

Of course, given the hit that endowment funds took during the market meltdown the authors devote considerable space to what they call stress betas, created by the tightening of correlations of asset classes with equities. Curiously but I suppose predictably, we learn that the typical well diversified portfolio might experience more short-term downside risk than the traditional 60/40 equity/bond portfolio during times of market turbulence.

This book is thorough in its analysis at the same time that it offers a “how-to” manual for building a diversified endowment-style portfolio, a rare combination of scholarship and actionable ideas. It has many useful exhibits (the generic name for figures, graphs, and tables) compliments of Morgan Stanley Research. All in all, it’s a fine piece of thoughtful financial writing.