Active asset allocation for endowments and foundations

Erika Murphy is a portfolio manager on a team that manages multi-asset class portfolios on behalf of institutions, including endowments and foundations (E&Fs) and pension plans. Here she shares her insights on the role played by active asset allocation in E&F client solutions.

Active asset allocation is an investment approach that allows investors to invest across asset classes and dynamically allocate more (or less) to asset classes that they believe are relatively more (or less) attractive at a given point in time. The goal of active asset allocation is to outperform a static multi-asset benchmark. The processes and implementation of active asset allocation strategies can vary significantly.

1. Navigating strategic market risk

In a multi-asset portfolio, the strategic asset allocation (SAA) determines the biggest portfolio exposures held in the portfolio over time, and therefore it drives most of the portfolio's return and risk. Non-profit institutions' strategic asset mix tends to be driven by long-term capital market returns and risk assumptions to better align their portfolios with their very long-term (often perpetual) investment horizon. On paper this long-term alignment makes perfect sense. In practice, however, we know that strategic asset allocation mixes can experience significant return volatility in the short-term. This is especially true for E&F strategic asset allocation mixes that are significantly skewed toward equity market risk. History suggests that on average we should expect at least a -10% public equity drawdown 5–6 times within a 10-year window, and at least a -20% drawdown 3–4 times within a 10-year window. These equity losses can introduce meaningful short-term volatility into endowment and foundations annual spending levels.

One way to potentially mitigate spending volatility is to diversify the strategic asset allocation with more dynamic sources of return, including active asset allocation (tilts in/out of asset classes). Not only does this allow endowments and foundations to respond more quickly to evolving market conditions, but our research has shown that our active asset allocation process may be lowly or negatively correlated to these institutions' strategic asset allocation benchmark (see table below), suggesting that active asset allocation returns can help endowments and foundations' portfolio returns "zig" when their SAA returns "zag." We also found that our active asset returns can add diversification relative to our security selection alpha.

Source : Fidelity Investments, as of September 30, 2023.

Effective 1/1/2023, the strategic benchmark is comprised of 60% MSCI ACWI IMI, 2% Bloomberg US Corporate High Yield, 2% S&P/LSTA Leveraged Loan, 2% J.P. Morgan EMBI Global Diversified, 2% MSCI ACWI Commodity Producers Sector Cap, 2% Bloomberg Commodity, 4% Bloomberg U.S. Inflation Linked Bonds, 1% S&P Global Infrastructure, 4% FTSE NAREIT Equity REITs, 8% Bloomberg US Aggregate, 3% Bloomberg US Long Government, 10% Diversifiers Composite (30% Bloomberg US Aggregate/ 70% MSCI ACWI IMI). From 10/31/17 to 12/31/22, the strategic benchmark was comprised of the following: 25.5% US Equities, 20% International Equities, 10% Global Low Volatility Equity, 10% Alternatives, 7.5% Emerging Market Equity, 7.5% Investment Grade Debt, 3% Inflation Linked Debt, 2.5% Floating Rate Debt, 2.5% Emerging Market Debt, 2.5% High Yield Debt, 2.5% Real Estate Debt, 2.5% Long US Treasury STRIPS, 2% Commodity Equities, 2% Cash & Other Assets.

2. Fidelity approach to active asset allocation

Being a part of a well-resourced asset manager with specialists across different investment disciplines allows us to draw from a variety of research inputs spanning across proprietary quantitative models, macro and geopolitical insights, bottom-up fundamental research, and sentiment and technical research. These insights help us build a mosaic view to identify potential short- to medium-term dynamics that may impact asset class returns. Active asset allocation allows us to express our investment views across global equities, fixed income, and inflation-related assets classes, leaning in and out of asset classes that we believe will face headwinds and tailwinds over short- to-intermediate horizons.

From a portfolio construction perspective, active allocation views are applied across a diversified set of assets and are always sized to align with our client's risk tolerances. Position sizes are constrained by pre-defined exposure and tracking error limits to ensure that the active asset allocation views do not overwhelm other return drivers in the portfolio.

Our active asset allocation strategy has provided modest but positive annualized alpha over time with some favorable return asymmetry. For example, we captured upside returns in equities and commodities when these asset classes did well, while losing less when these asset classes did poorly (Exhibit 1). We believe this asymmetric profile resulted in better compounded returns over time.

Exhibit 1: Active asset allocation investing added value and diversification over the long term.

Asymmetric Outcomes in Active Asset Allocation (Last 5 Years)
We captured more in risk-seeking markets, we lost less in risk-off markets

Past performance is no guarantee of future results. U.S. equities represented by the S&P 500 Index, global equities represented by MSCI ACWI Index, commodities represented by the Bloomberg Commodities Index and U.S. Agg represented by the Bloomberg U.S. Aggregate Bond Index. Source: Fidelity Investments and Bloomberg Finance, LP data, as of September 30, 2023.

Note: Active asset allocation is measured over the last 5 years versus strategic asset allocation benchmark. Upside (downside) capture is measured as the average monthly alpha generated when each asset class is positive (negative).

Conclusion

Active asset allocation can be viewed as a tool to allow endowments and foundations to better navigate business cycles and enhance portfolio diversification. By providing a layer of diversification relative to the strategic asset allocation risk, non-profit institutions may be able to reduce total portfolio and annual spending volatility.