Think Like an Endowment
While many investors (and their advisers) still think about investment portfolios solely in terms of cash, stocks, and bonds, a growing number of investors and advisers have expanded their investment universe to include non-traditional investments, often called “alternatives”. The primary benefit of using non-traditional investments in a portfolio is to augment the risk-adjusted returns provided by a common stock-bond portfolio. This strategy is commonly referred to as taking an “endowment approach” because the endowments of large universities were early adopters of non-traditional investments.
As an example, as of June 30, 2016, Harvard University’s Endowment was valued at $35.7 billion, making it the single largest university endowment. The Table to the right outlines Harvard’s asset allocation shifts over the years:
As can be seen, the percentage allocation to non-traditional investments increased from 13% in 1995 to almost 38% by 2016.
Harvard University Endowment’s annualized performance over the last 10- and 20-year periods ending June 30, 2015 was 7.6% and 11.8%, respectively, as compared to a standard 60% stock / 40% bond portfolio (using the S&P 500 Index and the Barclays Aggregate Bond Index), which provided 6.8% and 7.9% average annualized returns over those same time periods.
 Source: Harvard Management Company Annual Report 2016.
 Source: Harvard 2015 Annual Report.
OUR INVESTMENT PHILOSOPHY
When performing back-testing analysis, a traditional 60/40 stock-bond portfolio declined 30.8% from peak-to-trough over the period January 2000 to December 2012. Conversely, a portfolio with equal allocations to the S&P 500 Index, the Barclays Aggregate Bond Index, and the Dow Jones Credit Suisse Hedge Fund Index only lost 23.2% during the same period. Moreover, the annualized volatility of the “endowment” portfolio was 6.5% as compared to the 60/40 portfolio at 9.2%.
J.P. Morgan Asset Management performed its own back-testing analysis comparing the return and volatility of portfolios with different allocations. As the chart to the right highlights, in every scenario, adding an allocation to non-traditional investments improved the portfolio’s return while reduced the average volatility.
 Data Source: Morningstar
 Source: Barclays, Burgiss, Cambridge Associates. FactSet, HFR, NCREIF, Standard & Poor’s, Towers Watson, J.P. Morgan Asset Management. The portfolios that do not contain alternatives are a mix of S&P 500 and the Barclays U.S. Aggregate, in the amounts highlighted in the chart. The 20% allocation to alternatives shown in the other portfolios reflects the following: 10% in hedge funds, 5% in private equity, and 5% in private real estate. The volatility and returns are based on data from 1Q90 to 4Q14.
Implementing an Endowment-Styled Investment Portfolio
Atomi Financial Group’s endowment-style investment portfolios are constructed per the following four-step process:
Step 1 – Define Investment Universe
Atomi’s Investment Committee begins by defining what investment types are suitable for its investors in general without regard to any specific investor. By evaluating regulatory, macroeconomic, and other market factors, certain asset classes or investment types may be eliminated either permanently or temporarily. Atomi’s current universe of potential investments include:
Step 2 – Establish Client’s Investment Policy Statement
An Atomi Personal Strategist helps the client complete the Atomi Investment Policy Statement Questionnaire. Data gathered from the questionnaire ultimately helps create the client’s investment policy statement (“IPS”).
The purpose of an IPS is to establish a clear understanding between the client and Atomi as to the investment choices and policies applicable to their investable assets. An IPS is not a financial plan, but is a component of financial goal setting. A financial plan can help clients gain a better understanding of their current financial situation and determine attainable financial goals. Within that context, an IPS helps outline a prudent investment philosophy and identifies appropriate investments and portfolio construction.
An IPS is also not a contract, but it does provide a framework within which Atomi exercises investment discretion. In addition, an IPS identifies any restrictions or prohibitions to a client’s portfolio or assets and outline both the client’s and the adviser’s duties and responsibilities.
Step 3 – Construct Portfolio
Using the current universe of available investments, a client’s IPS, and other inputs from the client, Atomi will create a customized endowment portfolio that is comprised of both liquid and non-liquid investments. It is not uncommon for this step to require several passes as investment selections and allocations are refined.
Step 4 – Implement in Tranches
For better or worse, implementation does not happen quickly. It is critical that the client understand each new investment entering the portfolio. However, given that most investors are not familiar with non-traditional investments, this process takes time as only a few investments are introduced for each investment tranche.
Step 5 – Ongoing Monitoring
At mutually-agreed intervals, the client and the Atomi Personal Strategist meet to discuss portfolio performance. While tactical allocation changes are typically happening all the time at the asset level, in particular for the liquid assets, strategic allocation changes never occur without a thorough discussion between the client and the Atomi Personal Strategist. Updates to a client’s strategic allocation are typically made only when there has been a significant change to global economies, market trends, or a client’s situation.
Managing Liquid Assets
Nearly all liquid investment strategies are rooted in Modern Portfolio Theory (“MPT”). The central tenant of MPT is that diversification is the key to optimal returns over time. As it turns out, there are two approaches to diversification. Of the two options, we believe that Risk Factor Diversification and Allocation, and not Capital Asset Diversification and Allocation, is the most critical determinant of an investment program’s success.
Because asset class returns are largely explained by their underlying risk factors, it is better to specify desired risk factor exposures and then gain them through a strategy designed to provide an efficient combination of assets, rather than to specify an asset allocation and be left with unspecified and potentially concentrated exposures to underlying risks. This is particularly true because we believe the global economy and markets are continuously evolving, increasingly interconnected, facing unprecedented changes in global drivers of growth and capital flows, and innovating instruments and structures which help to isolate, diversify and magnify risks.
Our core belief is that investors looking to diversify risks should do just that, not simply diversify asset classes and hope that it results in risk diversification. Those investors who can accurately identify these trends, efficiently translate those views into investment positions, and concurrently protect against the inevitable periodic crisis will find considerable potential for compelling long-term returns.
Conversely, investors adhering to traditional approaches or assume that asset class diversification will equate to risk diversification amid global transformation, may find it difficult to achieve their long-term return objectives. Investors earn dollars, spend dollars, and invest dollars, but they feel risk.
Liquid managed portfolios are built per the following four-step process:
Step 1 – Establish a macro-view
The starting point of the allocation and investment process is an annual macroeconomic outlook and multi-year capital market expectation (“CME”). The macro view frames the environment for growth, and the CMEs frame the investment landscape as we see it. The process of forecasting asset class returns and volatilities has three components:
Historic asset class risk and returns over 1, 3, 5, etc. year periods.
Risk premia build up – This starts with the acknowledgement that each asset class is comprised of a stack of risk factors. These risk factors can be identified and valued independently, then recombined to derive the “fair risk” value for the asset.
Asset panel – This involves gathering data from other money managers and analyzing for trends. For example, if all the large investment houses are bullish on emerging markets, then all will allocate more money to EM and it will go up.
Step 2 – Build a “risk budget”
The next step is to establish a “risk budget” for each strategy and then spend that amount of risk using the most attractive risk factor compartments with which to build the portfolio. We think of it as starting at the finish line of the desired risk and return characteristics, then reverse engineering into the solution set of asset classes.
Step 3 – Screen / select investment universe
The next phase of the process involves scouring the ETF and Fund universe for the purest, lowest cost, most liquid and most stable ingredients. In a perfect world, they would always exactly match the index and be inexpensive. Funds and ETFs are screened for a variety of common sense factors, such as: size of the fund, longevity of fund, traded volume of fund, expense ratios, tracking errors, 1-, 3-, 5-year total returns, and volatility. In addition, there are few proprietary metrics of purity that are included in the overall evaluation.
The resulting portfolios typically hold approximately 10 to 20 positions. On average, the composition is 80% ETFs and 20% mutual funds. Portfolios capture a blend of approximately 20 discrete risk factors which is the stuff that assets are made of. In the aggregate, literally thousands of securities are represented in each strategy.
Step 4 – Ongoing monitoring / refinement
The final element of the process is ongoing. Models are reviewed by analysts every day. Monthly Investment Committee (“IC”) meetings are held to discuss a wide range of topics including model performance, accounts, attribution, etc.
With respect to rebalancing, our philosophy is that tactical asset allocation, or tactical risk allocation (“TRA”) as we practice it, should be incremental. Once an allocation change has been decided, exposure will be built up in 1% to 2.5% increments. To maintain target exposures, we typically rebalance quarterly and try to fold any tactical shifts into the rebalancing trades. Overall, portfolio turnover is around 25%.
Managing Direct Investments
Unlike liquid assets, which are managed per a desired risk allocation, when managing direct investments, there is no investment theory on allocation or diversification that can be relied upon. Therefore, Atomi’s approach to managing direct investments is based on the collective wisdom of its team and due diligence associates, thus making their experiences and connections all the more important.
At Atomi, when evaluating a potential Direct Investment Program (“DIP”), we evaluate numerous aspects, such as sponsor experience and track record, deal structure, and general suitability. We also look at how a sponsor would complement our organizational structure, distribution capabilities, and current portfolio offerings. The following outlines how Atomi evaluates potential DIPs:
Step 1 – Assembly of Due Diligence Team
Based on the guidance and direction from Atomi’s Portfolio Investment Team, from time to time, prospective DIPs will be selected for potential inclusion onto Atomi’s investment platform. To complete due diligence on any candidate DIP, a Due Diligence Team is organized that includes members of Atomi’s Direct Investments Team as well as Atomi’s Chief Compliance Officer. Roles and responsibilities include:
Chief Compliance Officer (CCO) – Manages firm-wide compliance, including approval of DIPs on the platform. The CCO maintains final approval / rejection authority.
Due Diligence Officer (DDO) – Manages one or more due diligence projects. The DDO reports makes approval / rejection recommendations to the CCO.
Due Diligence Analyst (DDA) – Responsible for detailed due diligence data gathering. DDAs do not make any recommendations.
Step 2 – Initial Screening
To assist Atomi with determining whether a DIP is appropriate for inclusion, candidate sponsors are asked to complete an initial questionnaire. The purpose of the initial questionnaire is to determine if, based upon the sponsor’s representations, this is a sponsor Atomi should complete a formal due diligence review on. Data is not verified at this time as verification comes later in the process. Based upon the information collected, Atomi’s DDO makes a recommendation whether to proceed or decline with due diligence.
Step 3 – Formal Due Diligence and Review of Documents
Atomi’s DIP Due Diligence Checklist is used to assist the Due Diligence Analyst (DDA) in determining what documents and information should be considered for examination during the formal due diligence process. In addition, the DDA reviews the following documents:
Private Placement Memorandum or Offering Circular – All sponsor-related offering documents are reviewed to help the DDA identify areas of risk/concern and items for further clarification.
Third Party Due Diligence Reports – These reports may help the DDA identify additional areas of risk/concern and items for further clarification. Of course, the qualifications and competency of third party experts retained to perform the investigation on its behalf are also evaluated.
FINRA Notice 10-22 – FINRA’s memo on due diligence best practices is reviewed to help ensure the DDA work meets FINRA’s standards.
Due Diligence Internal Report Template – This document contains a list of questions developed by Atomi from our past experiences. This document is reviewed by the DDA to ensure that the documents we obtained are sufficient to complete the questions on this document.
During the review of sponsor and third party documents, the DDA documents any information encountered that should be reviewed in greater detail or requires additional verification. Special attention is paid to anything that may be considered a “red flag” that would alert a prudent person to conduct further inquiry. Red flags might arise from information that is publicly available or information that is discovered while completing due diligence. Either the DDA or the DDO follows up on any red flags as well as investigate any substantial adverse information about the issuer/sponsor.
All notes and observations are documented in the Due Diligence Internal Report.
Step 4 – On-Site Review
After substantial completion of Step 3, a visit to the offices/facilities of the issuer occurs to meet with the sponsor’s management team to discuss the issuer's business plan, knowledge of their industry, competitors, and any other relevant issues.
Step 5 – Completion of Internal Due Diligence Report
Upon completion of the due diligence process, the DDA completes the Due Diligence Internal Report by creating a summary memo that highlights the review process, significant findings, etc.
Step 6 – Final Review and Approval/Rejection
Based on the research completed by the DDA, the DDO will make a recommendation whether to sign the sponsor onto the Atomi platform. Upon review of materials, the CCO may affirm or reject the DDO’s recommendation.
Step 7 – Periodic Reviews
At least annually, Atomi’s DDO conducts a review of each DIP sponsor to ensure that the DIP’s performance is within expectations and its business strategy is still aligned with investors’ interests. At any time, Atomi’s DDO may choose to cancel a DIP selling agreement.
Direct Investment Program Suitability Guidelines
When considering which investments are suitable for an investor, Atomi begins by considering the general suitability of the DIP itself, particularly considering the composition of the client’s total portfolio. Issues such as investment risk, stability of income, concentration risk, among others are considered. Ultimately, what may be appropriate for one client may not be prudent for another.
DIP Concentration Guidelines
As a general guideline, Atomi does not recommend more than 10% of a client’s investible net worth into any one DIP. If a client requests more than 10% of their net worth to be invested into a single DIP, Atomi will have the client sign Atomi’s Additional Risk Disclosure Form, highlighting the concentration risk.
In addition to the above program allocation limits, Atomi advises that no more than 20% of a client’s total portfolio should be allocated to a single sponsor. If a client requests more than 20% of their net worth to be invested into a single sponsor, Atomi will have the client sign Atomi’s Additional Risk Disclosure Form, highlighting the concentration risk.