Diversification and Antifragility: Protecting Endowments Amid Unpredictable Markets

As investors have observed recently, markets are cyclical, not linear; they may rise and fall for extended periods of time but, ultimately, things do reverse. Institutions that rely on endowment performance may find their operations at risk when such a reversal creates a scenario where both portfolio values and distributions are lower. Thus, limiting an endowment’s downside risk is critical to its long-term success. Limiting risk, however, doesn’t necessarily mean forgoing return. We believe a diverse and antifragile portfolio can produce higher risk-adjusted returns (and sometimes higher absolute returns), a more stable spending profile, and more terminal wealth after spending than one which relies heavily on traditional allocations alone.

Diversification

At Verger, we advise institutions with long time horizons to pursue an asset allocation strategy that balances exposure across multiple asset classes to provide more predictable distributions that may better support non-profit operations. While many institutions rely heavily on equities because of the high returns they can provide, their dominance in the asset mix may pose unintended risk. Endowments are designed to exist in perpetuity, but they must cover expenses, even during a down market.

While the growth of corporate profitability is heavily correlated with equities, nonprofit investors may be better served by an allocation with diversified return streams. For example, real assets are essential to manufacturing or the delivery of services. Real assets include real estate and other tangible assets with intrinsic worth, such as energy, agriculture, and natural resources. Because of their historically low correlation with equities, these investments may serve as ballast and help buoy a portfolio during market turbulence.

Fixed income strategies are designed to provide stability and may help mitigate fluctuations in portfolio value resulting from equity markets. While U.S. Treasury obligations are the classic fixed income anchor, choosing investments in credit, emerging market debt, and direct lending could enhance yield and return while reducing correlation to the broader markets.

Additionally, allocations to alternative strategies like long/short hedge funds, absolute return strategies, or private equity and venture capital may provide a nonprofit investor with both diversification and additional sources of return. Nonprofit investors with long investment horizons may have an opportunity to benefit from the illiquidity premium typically associated with alternative investments.

Antifragility

Many investors speak of having resilient portfolios. For endowments, resilience isn’t enough. A resilient structure may not crumble when attacked, but it also doesn’t grow stronger during downturns. It is imperative to build a diversified portfolio that includes investments that may increase in value when the market environment is bleak for most asset classes. These are assets that may thrive and grow when risk and uncertainty are high. This is what is meant by antifragility.

Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better. —Nassim Taleb

Portfolio hedging is an example of an antifragile strategy that may protect a portfolio with investments designed to increase in value when the market goes down. Certain derivatives, for example, are designed to hedge market exposure in a nonlinear fashion, rising more steeply when the market falls precipitously or crosses a predetermined loss threshold. This can provide an opportunity to sell positions and purchase risk assets that are likely to be undervalued in the current market. Antifragility isn’t just about minimizing risk; it’s about finding smart ways to play offense when everyone else is playing defense.

We believe the best way to ensure long-term returns for your endowment is to limit the impact of market volatility while still taking advantage of investments that can capture upside market returns. An antifragile portfolio, featuring higher risk-adjusted returns, high Sharpe ratios, and less risk exposure, is designed to perform well in multiple market environments, helping ensure your endowment can reliably support its operations—and its mission—over the long-term.

Read more insights into our approach to non-profit investment and how to keep your endowment strong in all economic environments by exploring our insights page.