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Redefining the role of funds in an endowment portfolio. Putting the Institution back into Institutional investing. 1 "Consumption is the sole end and purpose of all production" – Adam Smith This economic maxim is often disregarded by Institutional investment committees. There are times when Institutional investment committees proceed with a financial capital orientation with little consideration for the implied use of the funds, or the impact on the operational use due to the risks within the portfolio. Consideration for the portfolio growth objective does not always account for how the institution may use more money, compared to the negative operational impact of less money, at varying levels of risk. This can create a significant difficulty in assessing risk in an institutional framework. Without a variable use of funds that correlate with the volatility of the investment portfolio, risk and return are abstract concepts without real-world consequences. Simply gaining money without planning for valuable institutional use is a poorly compensated risk, as is the potential consequence of substantial operating constraints due to imprudent risk taking. Appropriate levels of risk cannot be adequately measured without some determination and institutional agreement on the use of gains relative to losses. The science of investment management is not based on measuring monetary goals in isolation but on managing the very real and constant problem with intertemporal consumption. How do you manage the tradeoffs and problems associated with varying patterns of capital and consumption (i.e., spending) across time? How do you compare consuming more today versus spending less and consuming more tomorrow? Modern investment management should be, and is designed for, assisting in solving that problem. Unfortunately, investment committees often overlook this basic foundation and focus on money as an abstract that serves for an easily comparable scorecard. Why do they do this? It's easy. Comparing two numbers seems both simple and rational. It doesn't require the fairly difficult task of understanding the institution's unique function of financial gains and losses. Then the question is: What should they do instead? The most important asset isn't the endowment, and the most important investment isn't in the portfolio. The institution is the only critical asset. The endowment is simply a component, and a tool, of the institution. Institutionally beneficial "investments" are only those that further the goals and objectives of the institution, and they all reside outside of the portfolio and within the institution itself (facilities, staff, scholarships, art collections, cancer wing, etc.) The foundation/endowment are simply way stations to manage the timing problem associated with those specific investments over a long time horizon with capital that invariably leads or lags those institutional needs. How might one approach this problem? It's important to recognize what we believe doesn't work: adopting a "total return" framework for both constructing portfolios and evaluating outcomes. This approach, often expressly stated in investment policy statements, aggressively divorces the investment decision-making from the fundamental justification of taking market risk—the future use of funds. It may also potentially expose the institution to excess risk. Without some institutionally relevant measures to compare the trade-offs of portfolio upside scenarios versus downside scenarios, the value of comparing asset-only outcomes will be limited. It is highly unlikely that the highest expected return portfolio will be the most appropriate portfolio. Maximizing return, especially for poorly defined uses, while potentially jeopardizing important investments, is likely to be suboptimal.

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