The most critical element of the investment policy is the decision of asset allocation. Since investment management involves as much art as science, the Investment Trust Committee (the Committee) uses both qualitative considerations and quantitative techniques in determining the asset mix. Statistical simulations and analysis are used to estimate the expected risk and return profiles of various asset allocation alternatives; whereas market judgment is used to help incorporate factors that quantitative analysis cannot measure. In order to meet the return objectives of the endowment fund, the asset allocation is biased in favor of equities, and consequently, to reduce volatility and diversify against adverse equity markets, the fund has allocations towards government bonds and Canadian real estate.
Each asset class selected is judged not only on its ability to deliver long-term investment returns, but the correlation of that asset class with the other classes is a key consideration, as this provides the benefits of diversification to the portfolio. Equities are still the largest asset class in the portfolio due their long-term return potential. Since the endowment fund’s goal is twofold; to provide income to fund current needs while maintaining the purchasing power of the fund for future generations of students, an equity oriented asset mix is required. Furthermore, inflation is always a concern as a highly inflationary environment has a particularly adverse effect on the endowment, so the asset mix will always favor equity-like returns over fixed income-like returns.
The current asset allocation is:
Asset Class Target
Canadian Fixed Income 10 per cent
Canadian Real Estate 15 per cent
Canadian Equities 30 per cent
U.S. Equities 30 per cent
EAFE Equities 15 per cent
With equities, the challenge will always be finding the right managers that add value while controlling risk. Burgundy Asset Management invests Canadian and EAFE equities in very concentrated portfolios with a general indifference to typical sector allocations of other managers and the relative benchmark indices. They seek the best businesses through in-depth bottom-up research, and buy the stock only when the price warrants investment. The result of this is portfolios that will deviate from short-term market returns, but be well positioned to provide longer-term success and also help insulate the portfolio during times of poor market returns as the high-quality stocks in the portfolio provide much needed downside protection.
Our U.S. equity manager J.P. Morgan faces the challenge of adding value in the very efficient U.S. investment marketplace. They do so by focusing on intensive research which allows them to identify companies that are leaders in each industry. Research analysts at J.P. Morgan are as important as portfolio managers, thus career analysts can analyze different companies in the various industries over long time horizons. The portfolio is large, robust, and very conscious of managing risk.
The other two asset classes are fixed income and real estate. The current fixed income mandate focuses on midterm issues of government bonds. Predictable cash flows and a low return volatility are the two primary reasons these bonds are held in the portfolio. Although the expected returns of bonds as an asset class are comparatively low, bonds provide liquidity, and more importantly, add diversification to the overall portfolio. In a portfolio biased towards equities, bonds help reduce risk as they respond to market conditions differently than equities. Toron-AMI manages the bond portfolio with an emphasis on quality and liquidity, and have generated returns this year that are very close to corporate returns without any of the corporate risk.
Finally, Canadian real estate provides further diversification, as it has low correlation to both equities and bonds, and the market for real estate is less efficient than that of the stock markets. Real estate offers higher expected returns than bonds, and provides these returns through both capital appreciation and net income from properties. When constructing a large diversified portfolio, endowment funds in Canada have traditionally looked first to equities and bonds, given the large, liquid and intensively research markets they operate within. Increasingly over the past several years, in order to further diversify a portfolio, and add value, alternative investments have been added as assets to Canadian endowment funds. Such mandates as real estate, hedge funds, and private equity have been adopted by many funds. The University’s investment in the Great-West Life Real Estate Fund was to further diversify the portfolio and add higher expected returns to the portfolio. The fund is well diversified across both region and property type, which allows the University to invest in real estate, while tempering the risk of investing in any one market segment.
The Committee will continue to review the asset allocation, particularly in the likelihood of changing the spending policy. Potential new asset classes will be judged on their relative merits. The difficulty in investing in private equity, hedge funds, and infrastructure is the scale of these investments; finding reputable managers whose interests are aligned with our interests; high fees; lack of liquidity; and currency risk (as many of these investments are foreign). Whether it is the adoption of new mandates, or changes to the policy target allocations, the role of asset classes and diversification will always be the most important building block in the foundation of the endowment fund.