Do Endowment Funds Select the Optimal Mix of Active and Passive Risks?
Keith C. Brown
University of Texas at Austin - Department of Finance
Cristian Ioan Tiu
SUNY at Buffalo; University of Texas at Austin - Department of Finance
March 10, 2010
Journal of Investment Management (JOIM), First Quarter 2010
The investment decision confronting managers of multi-asset class portfolios can be characterized in terms of the passive (i.e., benchmark or policy) and active (i.e., market timing and security selection) strategies they adopt. In this paper, we investigate whether managers select the appropriate combination of active and passive allocations in their portfolios. Noting that this issue is ultimately a risk management question, we adapt a simple framework for establishing what constitutes the optimal level of active and passive risk exposures.We then examine the question empirically using a database consisting of the allocation decisions and investment performance of a large set of university endowment funds over the period from 1989 to 2005. Our findings show that (i) the average endowment had too little active risk exposure in its portfolio, (ii) endowment funds could have significantly increased their risk-adjusted performance by enhancing the scale of the alpha-generating strategies they were already employing, and (iii) this tendency to under-utilize active management skills was more pronounced for larger endowments than for smaller ones. We conclude that the typical endowment fund could have improved its performance by increasing the commitment to its active management skills.
Keywords: Risk budgeting, active-passive allocations, investment performance, endowment funds
JEL Classification: G00
Date posted: March 13, 2010 ; Last revised: June 3, 2010