The Callan Nonprofit group has been having more discussions lately with clients and colleagues about the various portfolio models used by not-for-profit organizations. Determining what model to use is one of the early, most important, and complex decisions to make. This blog post looks across various models to define their key features, strengths, and weaknesses. Understanding each model helps us better understand its performance and risk potential in the current investing environment, as well as at other times during the market cycle.

Throughout the history of portfolio management, old ideas are recycled with a new name by an innovative marketing team. In truth, most of the models include a fair dose of Modern Portfolio Theory (MPT) (developed by Harry Markowitz in 1952) with a dash of the Returns-based Style Analysis / Factor Model (from William Sharpe (1988) and Eugene Fama-Kenneth French (1992)) to combine different asset classes into a portfolio efficiently, taking advantage of the risk-reducing impact of diversification. There are a multitude of different models and variations on models in use today. We will focus on three primary ones:

• Traditional (60/40): Sometimes called the simple portfolio, especially for benchmarking. Risk is calibrated by adjusting the mix of bonds and equities.
• Yale Model: Also known as the Swensen Model, this adds illiquidity and complexity through other asset classes as sources of return.
• Total Portfolio Approach (TPA): This model steps away from asset classes to use macroeconomic factors to define the portfolio.

The portfolio model decision should be informed by the needs and limitations of the organization. There is no one-size-fits-all approach. We recommend performing an enterprise review prior to the asset-allocation process to understand the root requirements of each portfolio. The best model for each nonprofit is one that links investment risk with organizational risk and offers well-defined metrics to evaluate the performance of the portfolio through the appropriate lens.

Breaking Down the Primary Nonprofit Portfolio Models

The Traditional 60/40 (or 70/30) Model is the most straightforward implementation of MPT and uses a mix of stocks and bonds. Risk in this portfolio construct is dialed up by increasing the allocation to equity and conversely is dialed down by increasing the allocation to fixed income.

The strengths of this model are simplicity, low cost, and liquidity when implemented using liquid mutual funds or ETFs. The simplicity of the portfolio streamlines governance, providing straightforward implementation on the front end and performance measurement on the back end.

This model relies on negative correlations between equities and bonds to achieve the risk-reduction benefit; since 2000 we have primarily been in a negative correlation regime with low rates. This feature may make the model struggle during periods of high correlation between bonds and equities, such as inflationary periods that coincide with a drawdown in equities. This model has performed well recently due to strong public equity market performance and positive correlations between bond and equity returns.

The low cost and high liquidity make this a preference for smaller endowments or foundations.

The term Yale Model is used to describe the more complex portfolios that add additional asset classes such as private equity, private credit, hedge funds, real estate, and other less liquid investment options. The model was developed during the ‘80s at Yale University by David Swensen and Dean Takahashi.

This model expands the scope of investable assets to include those with less liquidity and more complexity. The strength of this model comes from the diversification benefits of a broader set of assets in reducing risk, while adding a premium to the return of traditional assets from complexity and illiquidity.

The Yale model requires a long-term investment horizon, a sophisticated management and governance team, and less need for liquidity on an ongoing basis. In this model, once the asset allocation has been decided, the focus moves to manager selection. In the less liquid private investment options, the return dispersion between top quartile and bottom quartile managers can overwhelm the asset class decision. This model is more expensive to manage as investment manager fees increase with complexity, as does the cost of staff and consultants to select and monitor investment managers.

This model has come under scrutiny in recent years. Public equity markets, driven by the largest tech and AI firms, have outperformed private markets.

The Yale model is best for large, sophisticated endowments with stable inflows and governance depth.

The Total Portfolio Approach is basically a new name for factor-based investing that grew out of a Frankenstein combination of MPT and Fama-French Factor modeling. In the mid-2000s, large sovereign wealth funds (Canada, New Zealand, and Singapore) adopted a factor-based approach to investing.

The focus of this approach is to build a portfolio combining several factors, not asset classes, to produce an efficient portfolio. These factors may include: equity risk, inflation sensitivity, liquidity risk, and credit risk, among others. Assets are grouped by exposure to factors rather than by asset class. Another risk measurement and management tool, principal component analysis, is often employed to further tune the portfolio and avoid unwanted correlations. Scenario analysis is often used with this approach to better predict portfolio performance across the market cycle with shifts in varied factors.

TPA presents governance challenges due to its complexity and reliance on a strong investment staff to monitor factors on an ongoing basis. Governance at the board level is difficult as changes in factor expected returns, risks, and correlations are more fluid than strict asset classes. In addition, factors are one step removed from the asset classes, making a comprehensive understanding of the risks more challenging.

This is best for sophisticated investment committees willing to move beyond asset buckets.

How Recent Thinking Has Changed

Aside from the renaming of previously developed models for a marketing deck, there are other developments in how nonprofit portfolios are managed. The most significant shift is the explicit linking of investment risk, organizational risk, and mission to provide a more holistic and effective portfolio framework. This increased emphasis on understanding the entire enterprise is a practice thoughtful investors have integrated into their thinking for some time.

Putting This into Practice

Each nonprofit has its own unique governance, operating environment, resources, intellectual capital, liquidity needs, risk tolerance, and most importantly mission. A thorough enterprise review will help define these and other parameters that will drive the operating, governance, and portfolio model. Picking a model off the shelf from those included here is not best practice. Further customization often occurs by layering in complementary risk or performance measures to inform decision-making, or taking some aspects of more than one model to compose the best model for the organization.

One example of this is a large foundation that uses a modified Yale model, adding different benchmarks to measure various aspects of performance. For quarterly and annual performance, manager and asset class benchmarks are used. Other secondary benchmarks are referenced for longer-term assessment. One addition is a simple portfolio benchmark, with equivalent risk, to evaluate the portfolio against liquid public markets. The second is a factor-based breakdown of the portfolio to assess risks not captured by asset allocation alone.

Making It All Work

The best time to reassess your portfolio model was yesterday. The determination of what portfolio model to use is one of the early, most important, and complex decisions to make. It is essential to perform an enterprise review prior to the asset-allocation process to understand the root requirements of each portfolio based on the goals and limitations of the organization. The best portfolio model for each nonprofit is one that links investment risk with organizational risk and offers well-defined metrics to evaluate performance of the portfolio through the proper lens. No matter what the market environment, thoughtful asset allocation and rigorous due diligence in manager selection will never go out of style.