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DISCUSSION PAPER PI-1008

DO ENDOWMENT FUNDS SELECT THE OPTIMAL MIX OF ACTIVE AND PASSIVE RISK

Keith C. Brown and Cristian Tiu

The investment decision confronting managers of multi-asset class portfolios can be characterized
in terms of the passive (i.e., benchmark, or policy) and active (i.e., market timing and security
selection) strategies they adopt. In this paper, we investigate whether managers select the appro-
priate combination of active and passive allocations in their portfolios. Noting that this issue is
ultimately a risk management question, we adapt and extend a simple framework for establishing
what constitutes the optimal level of active and passive risk exposure. We then examine the ques-
tion empirically using a database consisting of the allocation decisions and investment performance
of a large set of university endowment funds over the period from 1989 to 2005. Our findings show
that (i) the average endowment had too little active risk exposure in its portfolio, (ii) endowment
funds could have significantly increased their risk-adjusted performance by enhancing the scale of
the alpha-generating strategies they were already employing, and (iii) this tendency to under-utilize
active management skills was more pronounced for larger endowments than for smaller ones. We
conclude that the typical endowment fund could have improved its performance by increasing the
commitment to its active management skills.

JEL Classification Codes: G11; G23

Keywords: Risk budgeting, Active-passive allocations, Investment performance, Endowment funds.