The Endowment Model and Modern Portfolio Theory

We develop a dynamic portfolio choice model with illiquid alternative assets to analyze the “endowment model,” widely adopted by institutional investors, such as pension funds, university endowments, and sovereign wealth funds. In the model, the alternative asset has a lockup but can be liquidated a...

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Bibliographic Details
Published in:Management science 2024-03, Vol.70 (3), p.1554-1579
Main Authors: Dimmock, Stephen G., Wang, Neng, Yang, Jinqiang
Format: Article
Language:English
Subjects:
alternative assets
Alternatives
asset allocation
Assets
Decision making models
Diversification
Endogenous
Endowment
endowment model
Institutional investments
Investors
liquidity
Management science
modern portfolio theory
Pension funds
portfolio choice
Sovereign wealth funds
Transaction costs
Welfare
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Summary:We develop a dynamic portfolio choice model with illiquid alternative assets to analyze the “endowment model,” widely adopted by institutional investors, such as pension funds, university endowments, and sovereign wealth funds. In the model, the alternative asset has a lockup but can be liquidated at any time by paying a proportional cost. We model how investors can engage in liquidity diversification by investing in multiple illiquid alternative assets with staggered lockup expirations and show that doing so increases alternatives allocations and investor welfare. We show how illiquidity from lockups interacts with illiquidity from secondary market transaction costs resulting in endogenous and time-varying rebalancing boundaries. We extend the model to allow crisis states and show that increased illiquidity during crises causes holdings to deviate significantly from target allocations. This paper was accepted by Bruno Biais, finance. Funding: S. G. Dimmock gratefully acknowledges financial support from the Singapore Ministry of Education [Grant R-315-000-133-133]. N. Wang gratefully acknowledges support from CKGSB Research Institute. J. Yang gratefully acknowledges the support from the National Natural Science Foundation of China [Grants 71772112, 71972122, and 72072108], Innovative Research Team of Shanghai University of Finance and Economics [Grant 2016110241], and Shuguang Program of Shanghai Education Development Foundation and Shanghai Municipal Education Commission. Supplemental Material: Data are available at https://doi.org/10.1287/mnsc.2023.4759 .
ISSN:0025-1909
1526-5501
DOI:10.1287/mnsc.2023.4759