The Endowment Model and Modern Portfolio Theory

Abstract

We develop a dynamic portfolio-choice model with illiquid alternative assets to analyze the ``endowment model,'' widely adopted by institutional investors such as pension funds, university endowments, and sovereign wealth funds. In the model, the alternative asset has a lock-up, but can be liquidated {at any time} by paying a proportional cost. We model how investors can engage in liquidity diversification by investing in multiple illiquid alternative assets with staggered lock-up expirations, and show that doing so increases alternatives allocations and investor welfare. We show how illiquidity from lock-ups interacts with illiquidity from secondary market transaction costs resulting in endogenous and time-varying rebalancing boundaries. We extend the model to allow crisis states and show that increased illiquidity during crises causes holdings to deviate significantly from target allocations.

Keywords: endowment model, portfolio choice, liquidity, modern portfolio theory, asset allocation, alternative assets

JEL Classification: G11, G23