Bullseye Highlights Endowment Allocations H arvard University sits atop the academic world with a staggering $26 billion endowment fund, while the second largest university endowment fund at Yale University manages approximately $16 billion. As of the fiscal year ending June 30, 2009, the 10-year average annual returns are 8.9% for Harvard and 11.8% for Yale. Despite the volatile markets of the past decade, both endowments managed impressive performance in an environment where the S&P 500 Index returned -2.2% over the same time period. Both Harvard and Yale follow the philosophy of diversification by spreading their investments across a broad variety of asset classes. The idea, of course, is to create a portfolio that is less volatile than a standard stock and bond mix—but one that also yields better returns. Other investors have tried to duplicate these results, and many have failed.

What makes the endowment mixes of Harvard and Yale so successful? On the surface, the two endowments seem to take different approaches. For example, Harvard manages the majority of the portfolio in house, while Yale farms everything out. But they do have several traits in common.

Both are very patient with their strategies. Yale saw significant underperformance in a few asset classes for several years, but resisted the temptation to change the mix, and was vindicated when their strategy ultimately worked. Both have asset mixes beyond the traditional domestic equity and fixed income instruments. And it’s a dynamic mix, in that they expand or contract asset classes tactically when necessary.

These portfolios are quite unlike traditional stock and bond portfolios which often have predetermined allocations and scheduled rebalancing regardless of the market environment. Instead, the endowment asset allocation process is largely driven by quantitative analysis. The heart of the endowment manager’s job is to allocate assets to different classes of investments. In the 1980s, Harvard’s investing was strictly limited to U.S.

stocks, bonds, and cash. This portfolio was not sufficiently diversified. Harvard was both taking on too much risk, and missing out on opportunities in international and alternative assets.

But around this time a gradual shift began, away from U.S. equities and securities and in favor of such investment classes as foreign stocks, real assets, private equity, and what are known as “absolute return” assets. Real assets include real estate and commodities; private equity includes venture capital and buyout firms; and “absolute return” assets attempt to capitalize on market inefficiencies and special situations such as distressed businesses. These asset classes have the potential to deliver “equity-like” returns, but since they are not correlated with U.S.

equities, they cushion the portfolio against losses when the domestic stock market goes through its inevitable down cycles. Asset Class 1980 1984 1988 1995 1999 2002 2010 Domestic Equity 66% 47% 46% 38% 24% 15% 11% Foreign Equity 0% 0% 0% 20% 24% 15% 22% Private Equity 0% 7% 12% 12% 12% 13% 13% Real Assets 0% 3% 5% 15% 17% 29% 23% Fixed Income 34% 43% 37% 17% 17% 16% 15% Alternative 0% 0% 0% 0% 6% 12% 16% Total 100% 100% 100% 100% 100% 100% 100% Source: Harvard University, Annual Report of the Harvard Management Company, September 2009. Continues on back . While the markets have viewed Harvard and Yale’s portfolio changes as cutting edge, the endowment managers were really just putting into practice the evolving theories on asset allocation taught in their respective universities. The Unconventional Approach How diversified have endowment holdings become? Today, many large university endowments are allocating between 10% and 20% to absolute return strategies. Likewise, these endowments have also reduced their fixed income exposure. Why? Absolute return strategies are designed to respond in all market conditions. While bonds provide some support during down markets, they typically do not participate equally when the markets are strong. This may explain why Harvard and Yale continue to reduce their exposure to fixed income instruments. use of stocks, bonds and cash, often in the form of mutual In his book Unconventional Success, Yale’s David Swensen offers advice for the average investor.

Swensen argues that an investor has three levers over investment performance: asset allocation, portfolio strategy and security selection. portfolio diversification is through asset allocation. For years, individuals have been managing their investments with the funds. This conventional approach provides a limited degree of benefit, but lacks a tactical element—which is why the conventional approach is no longer used by professionals, such as those managing university endowments. Access to the strategies used by university endowments have historically been unavailable to many individual investors and seemed to be reserved for use by hedge funds and institutions. But today’s investors finally have access to a wide array of tactical and alternative investment mutual funds and ETFs. By combining traditional investments with alternative assets, individual investors can now create tactical asset allocation To paraphrase Swensen’s main points: strategies similar to the sophisticated approach of the investment management teams at Harvard and Yale. l Asset allocation—include six core asset classes in your portfolio: domestic equity, foreign developed equity, emerging market equity, real estate, U.S.

Treasury bonds, and U.S. Treasury inflation-protected securities. l Portfolio strategy—rebalance your portfolio annually, While many individuals lack the time or experience to implement these strategies on their own, there are now mutual funds that can do it for them. With relatively lower employing a strategy capable of making short-term bets against long-term asset allocation targets. l Security selection—buy low cost index funds or exchange traded funds; avoid hedge funds and corporate bonds. costs compared to hedge funds, mutual funds provide the access, liquidity and professional management that investors want—providing a conventional solution for an unconventional approach. RETURN The chart to the right illustrates the goal of Endowment Allocation strategies—to improve on the limitations of the traditional Efficient Frontier by reducing risk and increasing returns. It is common knowledge that one of the best ways to achieve 100% Equity Alternative Assets 100% Bonds RISK Performance displayed represents past performance, which is no guarantee of future results. The information provided here is for informational purposes only, is not intended as investment advice and should not be construed as a recommendation with regard to investment decisions.

Source for data, charts and graphs: National Association of College and University Business Office, Yale University Annual Report and Harvard University Annual Report, calculated by Arrow Investment Advisor, LLC. The material provided herein has been provided by Arrow Investment Advisors and is for informational purposes only. Arrow Investment Advisors serves as investment advisor to one or more mutual funds distributed through Northern Lights Distributors, LLC (member FINRA).

Northern Lights Distributors, LLC and Arrow Investment Advisors are not affiliated entities. 1157-NLD-8/11/2010 .