Type: Whitepaper

Since TIFF’s first direct investment alongside an independent sponsor in 2014, we have completed more than 60 deals with over 25 different sponsors, making TIFF one of the most active institutional capital providers in the market. Over the past decade, the market has evolved significantly, and our approach to working with independent sponsors has evolved alongside it.

When we began investing in this space, we believed independent sponsors could serve as both a great source of attractive returns on individual deals and as potential long-term partners for fund commitments. We viewed this work as an extension of TIFF’s longstanding history in the lower middle market and our commitment to partnering with emerging managers. Expanding our direct investments into the independent sponsor arena offered a firsthand view of compelling lower middle market opportunities (which we generally define as companies with less than $100M in revenue or $25M in EBITDA), while allowing us to build relationships with high-potential managers well before they raised their first fund.

Our aim was to create a virtuous cycle around our sponsor diligence and deal diligence, leveraging our deep experience in fund underwriting to identify and assess exceptional independent sponsors while also relying on our direct investment experience to underwrite transactions alongside them. By examining both the sponsor and deal, we expected to improve our insights into each opportunity.

We believed the thesis was sound, but we did not know how it would play out in practice. More than a decade later, we can safely say the strategy has exceeded our expectations, resulting in meaningful partnerships with independent sponsors and access to compelling investment opportunities. Importantly, we have had a front row seat for the development of the independent sponsor market itself. With more than ten years of experience, we reflect on what has changed, what has remained consistent, and what we have learned.

Observation 1: The independent sponsor market has exploded in scale

The number of new PE firms continues to expand, many of which begin as independent sponsors. While no consistent data set exists on the number of independent sponsors in the market or the number of traditional PE firms that began as independent sponsors, the expansion is evident in deal activity, market events, TIFF’s own CRM, and even our inboxes. A decade ago, encountering an independent sponsor was relatively rare; today, the universe has grown, encompassing a wide range of independent sponsor types and profiles. The ecosystem of lawyers, lenders, intermediaries, and investors catering to these sponsors has expanded as well, highlighting the market’s maturation.

Observation 2: The independent sponsor deal model is gaining acceptance

While the independent sponsor model has existed in various forms for decades, its success over the past several years, both in terms of deal-by-deal returns and in serving as a pathway to raising a committed fund, has attracted more seasoned investors who have left established PE firms to launch their own independent platforms. This shift has raised the overall quality of professionals in a market that was previously populated largely by younger investors without an attributable track record, ex-bankers or consultants seeking to transition into investing, or operators pursuing deals in their niche areas of focus.

Observation 3: Capital structures and economic terms continue to evolve

Similar to the broader private equity universe, terms in the independent sponsor market continue to balance manager and investor interests. In our view, terms for independent sponsor deals are more clearly structured to align interests between investors and sponsors. Monitoring fees based on EBITDA and tiered carry structures, now relatively standard across deals we see in the market, create stronger incentives for equity value creation compared to most private equity investments. Rather than charging a flat fee and significant carried interest for minimum performance, independent sponsors must grow EBITDA and return high multiples of money to generate significant wealth. On occasion, we see an independent sponsor try to negotiate for a “premium carry” tier of 25%, but these negotiations are typically not successful and would only apply in truly outsized returns scenarios.

In an attempt to bridge the gap between an one-off deals and fully-fledged funds, we have seen pledge fund-like structures grow in popularity. These structures involve an investor and manager agreeing to certain terms and investment amounts in advance of any specific transaction. They typically include a small management fee, with the investor retaining the option to decline any individual deal. These structures can blur the line between deal-by-deal investing and traditional fund commitments in troublesome ways, providing neither the capital certainty of a fund nor the deal-specific alignment of typical independent sponsor deal.

Observation 4: The lower middle market remains an attractive and under-capitalized space

Given typical deal sizes and the ability to add value through improved strategy and operations, most independent sponsors play in the lower middle market. Yet, this segment represents only a fraction of overall U.S. deal volume. According to PitchBook data on the U.S. PE market, deals valued less than $100M have consistently accounted for between 11% and 13% of total transaction volume from 2015 through 2024. Deals valued at less than $25M, which is consistent with the range targeted by independent sponsors, have consistently represented between 2% and 3% of total deal volume since 2015.1 Despite growth in the independent sponsor market, this segment still represents a relatively small part of the broader PE market. This relative scarcity reinforces the opportunity: fewer competitors, lower entry valuations, and greater inefficiency create fertile ground for differentiated sponsors.

Observation 5: Attractive valuations continue to create compelling entry points

Despite the rapid growth in the independent sponsor market and rising interest in the lower middle market by private equity, deal valuations are still well below market medians. According to the McGuireWoods Independent Sponsor Survey in 2024, 54% of independent sponsor deals were completed at EV/EBITDA valuations less than 6.0x.2 For TIFF’s own direct deals, we have averaged between 5.7x and 8.4x EV/EBITDA acquisition multiples since 2018.3 Comparatively, median private equity multiples in both the middle-market and large-cap segments are dramatically higher. Middle-market multiples have stayed between 10.2x and 14.9x while large-cap multiples have stayed between 11.1x and 13.3x.4 One would expect smaller companies to trade at lower valuations, but these independent sponsor deals are still priced well below median market multiples in larger market segments.

Observation 6: Institutional investors are still largely absent

While the market has grown and more institutional investors recognize the return potential in the lower middle market, many still remain on the sidelines when it comes to investing with independent sponsors. There is limited historical data on market participation by investor type, but across deals from 2021 through 2024, only 5% of lead investors were institutional investors. Most deals were led by family offices, mezzanine or equity funds, or other private equity funds.5 In Citrin Cooperman’s 2024 Independent Sponsor Report, only 11% of capital for independent sponsor deals came from institutional investors.6 Despite the broader expansion into private equity by institutions, they have yet to enter the independent sponsor market in a meaningful way.

Why have institutions mostly avoided this segment so far? Institutions are not monolithic, but several likely reasons are at play. The average investment size for independent sponsor deals is generally quite small for most large institutions (close to 50% of independent sponsor deals have a total enterprise value of less than $25M).7 Investment teams at these institutions are also rarely staffed to evaluate direct opportunities quickly and effectively. Additionally, institutional risk appetite tends to be relatively low, with a preference for more “traditional” investment structures even at the expense of higher returning opportunities. As a result, the independent sponsor market has remained the domain of more adaptable investors who have team structures in place that are better suited to take advantage of the market’s distinct dynamics.

Observation 7: Access to follow-on capital can make or break deals

Regardless of the plan at the outset of an investment, something will likely deviate from plan. Growth may not materialize as expected, macro conditions could worsen, interest rates may fluctuate, key team members could leave, etc. It is common for investments to require more capital than originally anticipated. This is particularly true for minority growth equity investments in businesses that are cash-flow neutral to slightly negative. Even if the sponsor puts cash on the balance sheet at close and expects the business to be cash flow positive going forward, one small operational hiccup can quickly lead the company to require additional capital.

For investments made from a fund, a larger pool of capital is available at the sponsor’s discretion to support the initial investment and to provide growth or rescue capital as needed. For independent sponsors, having experienced investors around the table is critical for navigating any potential headwinds or additional cash needs. Consistent and committed investors who understand the dynamics of lower middle market company performance, and who can over-equitize businesses at the outset or provide follow-on capital when appropriate, can dramatically improve the odds of successful investment outcomes.

Observation 8: Portfolio construction is essential to long-term success

Investing in independent sponsor deals requires consistency and discipline to build a strong portfolio. The risk profile of companies in the lower middle market, combined with the risks of investing with less proven or less experienced managers, requires a portfolio approach to achieve strong long-term returns. The range of return outcomes for any single deal can be wide, so diversification across managers, companies, sectors, and deal profiles can help mitigate some of the risks inherent to this market while maximizing the opportunity to achieve superior returns over a multi-year investment horizon. A portfolio approach also creates more opportunities for learning from deal to deal and from sponsor to sponsor. Approaching the independent sponsor market in a fleeting or haphazard manner is a recipe for disappointment.

Observation 9: Sponsor diligence is just as critical as deal diligence

The independent sponsor market blends manager selection with deal selection. When done well, investing in the market can create a virtuous cycle in which strong manager diligence builds confidence in the sponsor’s thesis, diligence, and value-add plan, while strong company diligence informs a perspective on the manager’s areas of strength and weakness. Success begins with the ability to source, evaluate, and partner with exceptional managers in the independent sponsor market. As the market has expanded, more experienced and high-potential managers are launching as independent sponsors, but more low-quality or undifferentiated managers enter the market as well. In our view, having a clear view of what defines an exceptional sponsor is essential for long-term market success.

Observation 10: Consistent success is predicated on long-term partnerships between sponsors and investors

As in any market showing promise, the independent sponsor landscape has attracted participants looking for quick wins with little focus on long-term success. Our experience, however, has demonstrated that patience in selecting the right sponsor and deal opportunity, diligence to evaluate all aspects of a transaction, and alignment of interest between investors, sponsors, and company management are all essential elements in generating strong returns over time. This approach builds trust between investors and sponsors, creating durable partnerships that span multiple deals in which all participants make vital contributions to investment success. While one-off transactional arrangements in this market may appeal to inexperienced investors, we remain focused on building and maintaining our long-term partnerships with exceptional sponsors.

Conclusion

After a decade of active participation, we see the independent sponsor market as more attractive today than when we began. The market is deeper and more professionalized, valuations remain well below mainstream PE levels, and institutional competition is still limited. This combination — depth without crowding — creates fertile ground for identifying attractive opportunities to generate outsized returns. Our focus remains unchanged: partnering with exceptional managers to back differentiated lower middle-market companies.

As TIFF enters its second decade of independent sponsor investing, our conviction has never been higher. We believe this direct deal strategy has delivered outstanding results while building meaningful partnerships with our sponsors. We will continue to build on these relationships and the insights gleaned over the past ten years to refine our process, focus our approach, and maintain the same level of diligence and rigor that has been central to this strategy since 2014.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

Executive Summary

• The hedge fund industry is no stranger to AI, but recent advancements have improved the way hedge funds invest.
• Data is a key competitive advantage for hedge funds leveraging AI. However, investors should understand how that data is sourced, processed, and interpreted.
• Key impediments to broader AI adoption include the high cost of computing power and difficulty attracting top-tier talent.
• Despite AI’s growing role, human judgment remains a critical component of investment decision-making.

Introduction

Leopold Aschenbrenner, a 23-year-old former OpenAI engineer and founder of the $1.5 billion hedge fund Situational Awareness, wrote recently that “Everyone is talking about AI, but few have the faintest glimmer of what is about to hit them.”1

For an industry that hires some of the smartest people in the world and prides itself on innovative investment approaches, how vulnerable is the hedge fund industry to an AI invasion?

In reality, hedge funds have been incorporating forms of AI for decades. Large systematic (quantitative) funds have existed since the 1980s. Even more recent funds like Numerai, which relies on public tournaments to crowdsource quantitative trading signals, have been around for over a decade.2

Let’s explore how hedge funds are deploying AI today, along with the challenges that still exist.

Data and Delusion

Put simply, AI models take large amounts of data and aim to predict the future of market movements based on this data (Figure 1). Yet we often hear the question: “Isn’t data just data? Can’t everyone just buy the same data?”

Not so. In practice, we have found that access to proprietary, well-structured data has become one of the key differentiators in determining which hedge funds have an edge in the AI race.

Systematic funds represent some of the earliest and most prominent adopters of AI in the hedge fund industry. They utilize vast quantities of data to identify patterns and generate predictive signals. Investors often assume these funds have pristine data and can forecast with precision. In reality, many predictions are based on small tidbits of information. The process can sometimes be like trying to guess a picture of a dog when all you are given is 5 pixels. Many systematic funds operate with hit rates slightly over 50%, but small gains with enough repetition can lead to large gains. Unsurprisingly, systematic funds have invested heavily in their data capabilities in recent years.

Ben Wellington from Two Sigma highlighted this point on a recent podcast, emphasizing the importance of being present at the moment data is created to ensure proper categorization.4 In this podcast, he shared an example from the post-financial crisis era: after 2008, a major newspaper retroactively labeled articles from 2006 and 2007 as “subprime.” A researcher relying only on these labels might mistakenly conclude that the sudden rise in “subprime” mentions was a powerful predictive signal. In reality, it reflected backfill bias—a postmortem reclassification rather than a true early warning.

One area within hedge funds where data aggregation has shown its worth is in the event-driven space. Long-tenured Equity Capital Markets (ECM) funds investing in deals such as IPOs, M&A, and issuances have been able to accumulate a treasure trove of data on past transactions, which in turn helps make surprisingly accurate predictions about outcomes of future events.

For example, by identifying situations that are likely to lead to a deal break, an M&A fund could limit its exposure to left-tail events, thereby enhancing its overall return profile of the fund.

Moving forward, we believe those funds with the deepest, richest, and most proprietary data will retain a significant edge. More recent entrants will need to demonstrate more creativity in how they use available data to leapfrog incumbents.

Talent and Technology

Nvidia’s staggering ~1,200% performance5 over the past five years has demonstrated the importance of computing power to AI development. More processing power means faster hypothesis testing and portfolio optimization which may lead to faster and better signal development. For systematic funds, this could translate directly into alpha. The downside is that processing power is expensive and difficult to scale. Leasing costs for data centers for a large systematic fund can run into hundreds of millions of dollars per year, thus limiting the amount of AI a smaller hedge fund can realistically deploy.

More important than processing costs is the ability to attract talent. It is often said that 20% of researchers generate 80% of the successful signals in a given year, though the challenge is that no one knows in advance which 20%. For this reason, it is important to keep a wide cast of highly talented (and highly paid) staff on the payroll. Hedge funds are competing with technology firms for top AI talent, with pay packages now exceeding $1 million per year.  What’s more, each AI developer needs to have a supporting cast of data engineers and developers to help turn theory into reality.

That said, we have seen increasing success rate among more entrepreneurial managers who strike out on their own with assistance from AI, particularly those focused on a specific niche.

Judgement and Justification

For all of AI’s capabilities, there remain areas of investing where human judgment is difficult to replicate. Manager discretion is one of the most significant. Fundamental strategies retain an edge in situations where decision-making depends on conviction, contrarian thinking, or nuanced human interactions. For example, when a portfolio manager chooses to concentrate on a handful of high-conviction positions, or makes a contrarian trade based on direct engagement with company management, the driver is individual judgment rather than an algorithmic signal.

Management meetings underscore this distinction. Whether investors are receptively learning or seeking to influence outcomes through activism, these activities remain firmly in the fundamental toolkit, not the quantitative one. Human relationships and qualitative assessments are central to investment due diligence, and AI has not yet shown an ability to replicate these dynamics. Many of the top-performing fundamental hedge funds demonstrate a proclivity to execute judgment calls that may rest on nothing more than pattern recognition honed over years of experience in a particular market segment.

This is not to say AI cannot aid the traditional investment process. We often find that today’s fundamental investors are using AI to help them summarize information and build a baseline understanding. Tools capable of reading decades of company filings in minutes, updating financial models post earnings in seconds, and distilling real-time company news into bullet points have given these managers much greater efficiency in their decision-making.

Conclusion

We remain optimistic about AI’s potential and believe it will continue to reshape the landscape of the hedge fund industry. However, managers should be cautious not to rely so heavily on AI that they lose their judgment.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

Executive Summary

• An institution may consider changing its spend rate for various reasons, such as facing financial challenges and wanting to increase budgetary support or experiencing financial success and aiming to grow the endowment more quickly.
• When considering a change in spend rate, it is important to understand how it affects the endowment’s future purchasing power and budgetary support.
• Spend rates require careful balance: they cannot be so low that the institution lacks support, nor so high that maintaining inflation-adjusted principal becomes challenging, as the endowment must earn a return to offset spending plus inflation.
• Two main trade-offs to consider when changing spend rates:
  • Timing of value: Higher spending today versus more spending dollars in the future due to asset compounding over time
  • Impact to endowment strategy: Rate changes may require adjustments to target return requirements, risk level, and asset allocation

The Decision Framework

Whether driven by financial pressures or strategic opportunity, spend rate adjustments represent one of the most significant decisions an endowment can make. The process requires careful analysis of both quantitative impacts and qualitative institutional factors. As a reminder, spend rate is the percent an institution withdraws from its endowment on an annual basis. Please refer to our Spend Policy 101 for a foundational overview.

Balancing Mission Support and Purchasing Power

At its core, spend rate decisions involve balancing competing institutional priorities. These dual endowment goals—supporting today’s mission while preserving tomorrow’s purchasing power—create a natural tension that requires careful balance. Rates too low fail to adequately support institutional needs, while rates too high make it challenging to maintain real value over time.

Key Trade-offs in Changing the Rate

Timing of the Value

A key consideration in determining if a rate change is appropriate is identifying when the institution would benefit most from its endowment funds.

For example, funds left in the endowment will grow and compound creating a larger spend in the future, while funds taken from the endowment will provide an immediate budget impact today.

Case Study

The example below highlights the trade-off in a $100M endowment of raising a 3-year trailing average spend of 4% to 4.5%. The numbered commentary corresponds to the charts that follow.

1. There is an immediate impact on spend to support the budget, which continues for several years.
2. However, all else being equal, this larger spend reduces the size of the endowment.
3. At a certain point, the spend to the institution is now less at 4.5% than 4%, because the endowment size has been reduced over time.

Factors to Consider

When having these discussions, pairing quantitative analysis with collaborative discussion is important. Here are some key factors worth considering:

• Value of the change: Consider the net present value of the marginal budget support
  • For rate increases, determine whether they support long-term value or address one-time, short-term uses
• Duration of spend rate change: Spend rate changes are not permanent and can be changed again in the future
• Spend methodology: How the institution calculates the spend will impact the trade-offs
• Endowment portfolio construction: Consider target returns, long-term expected real returns excluding spend, and risk level
• Inflation expectations: These impact target returns as well as budget and potentially spend methodology
• Institutional factors: Evaluate current and future funding requirements, and the organization’s broader financial situation (revenue sources and stability, debt, etc.)
• Industry trends/perspective: Peer comparisons on both endowment and institutional factors exist to help contextualize each institution’s circumstances

Potential Impacts to the Endowment from Changing the Rate

Changing the rate can also have implications for the endowment, either providing more flexibility to grow or creating challenges to maintain principal. Most institutions maintain their investment strategy when lowering the rate, hoping to compound assets faster and build the endowment’s asset base for the future. The challenge arises when an institution increases its spend rate: can it adjust its risk or asset allocation enough to maintain the inflation-adjusted corpus?

Conclusion

Changing an institution’s spend rate requires careful consideration, input from a multitude of stakeholders, and thorough analysis of both qualitative and quantitative trade-offs. It is not a decision to be made without robust dialogue with key constituents. If your institution is considering a change to your spend rate, TIFF is ready to help navigate the various considerations and determine the right path for your institution.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance. There is no guarantee that any particular asset allocation or mix of strategies will meet your investment objectives.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

Executive Summary

• Investors considering timing equities should proceed with caution
• Forecasting returns, particularly over short-time horizons, is very difficult
• Underweighting equities often results in unattractive opportunity costs
• Successfully timing the decision to return to a normal long-term allocation requires extreme fortitude

The past few months have been a period of very high volatility in equities due to several factors. Items weighing on investors likely include a combination of President Trump’s decision to increase tariffs on imports, continued tensions between the US and China, unclear resolutions to the armed conflicts in Gaza and Ukraine, and uncertainty from the DOGE initiative, which could either help balance the budget resulting in a more efficient US government or weaken a variety of strategically important social services and government programs. We have started to receive some questions from clients about the merits of underweighting equities relative to their long-term strategic targets. In general, we do not recommend that course of action for several reasons:

1. Forecasting Challenges

It would add material value if we could avoid the very worst months or quarters in equities. Unfortunately, forecasting in investments is unlike forecasting in most other fields. Predicting outcomes over the next month or year is not that difficult in most industries. Most owners and operators of businesses have a good idea of how their company will perform over the next month or quarter. However, forecasting business outcomes over the next ten years is much more difficult, if not impossible, for most sectors. For example, many publicly traded companies provide guidance for the next year but very few provide detailed guidance beyond that. Forecasting in investments is exactly the opposite. The range of annualized returns for monthly or quarterly data points is very wide. If we instead looked at rolling five-year outcomes and annualized those results, the range of IRRs would be considerably tighter. In investments, the longer the time horizon becomes, the easier it is to accurately predict the rate of return. The table below illustrates that shorter periods show a wider range of outcomes, with a 72% spread between the best and worst months. In contrast, longer periods, like five years, have a much narrower range, with approximately a 10% spread.

Range of Annualized Returns at Different Measurement Intervals, 1945-20241

We observe the challenges in short-term forecasting when evaluating managers. One of the methods we use to evaluate equity long/short hedge funds is to decompose the sources of excess returns into three categories: longs, shorts, and value-added from variance in net exposure. Across a growing library of several hundred different managers, we have seen very little evidence of statistically significant value-added from short-term variance in the net by equity-oriented hedge fund managers. We utilize a similar strategy for long-only managers who prefer to hold cash. It is very rare for the managers’ actual realized results to outperform a pro forma portfolio that grosses up their holdings such that they would have been at least 95% fully invested at all times. Even among trend-following managers, who are much more focused on market timing, we have seen mixed results. Short-term forecasting is very difficult.

2. Opportunity Costs

If we instead rely on longer-term forecasts, which are typically more accurate, we encounter a different problem. For an institutional portfolio, the meter is always running. We do not get to call capital when interesting opportunities arise and give it back when there are less attractive options. When we reduce equities, the capital must go somewhere else. The most obvious alternative to stocks when people are concerned about the risk of losing money is bonds or cash. The problem we face as investors is there are not many periods when bonds or cash outperform stocks over reasonable forecast horizons. We have used the S&P 500 and the benchmark 10-year Treasury bond for our analysis below.

Average Relative Results: Stocks vs. Bonds2

Even if the next five or ten years will in fact turn out to be one of these unusual periods when the return on equity is disappointing, it is important to evaluate the alternative use of capital. Revisiting the first chart and assuming the next five years will generally be a bottom-quartile return period for stocks, we can roughly estimate a 5% annualized return. The problem is that the yield to maturity on the 10-year Treasury bond is only 4.2%3. Selling something with an estimated return of roughly 5% to buy something that we should reasonably expect to return 4% is still a long-term expected performance concession. As outlined in Jay Willoughby’s Q4 2024 CIO Commentary and given some of the fiscal challenges the US faces, we think a much higher starting yield to maturity on bonds would be required for investors to consider materially underweighting equities in favor of bonds.

3. Psychology and the Pattern of Returns

For an equity market timing strategy to be successful, investors need to get two calls correct, not one. Those who underweight their long-term strategic targets will eventually need to decide when to return the equity allocation to its normal level. This second decision is key because, in equities, the big days are very important. Since 1945, the annualized return on the S&P 500 is roughly 7.9%4. If we exclude the top 1% return days, the annualized return would be a loss of -1.8%. Market prices tend to overshoot the changes to long-term fundamentals. As a result, equities are often undervalued at the bottoms of drawdowns. Also, markets discount anticipated economic conditions. When sentiment finally improves at the bottom of a drawdown, prices can move back up very quickly. The tables below show the best single day returns for the S&P 500 since 1945. All of them occurred during points in the cycle when uncertainty and volatility were very high. Because the absolute best days and worst days tend to cluster together, mistiming one of the two decisions, even by a day, can be very damaging. The best time to add to equities will often be at the point in the cycle in which doing so feels the most uncomfortable. The average investor who tries to time the market is highly likely to miss at least the first part of the recovery. Missing these big days often locks in long-term underperformance.

Highest Single Day Returns for the S&P 500, 1945 – 20245

Conclusion

While equity market volatility can be unsettling, maintaining a long-term perspective on equities is crucial for achieving optimal investment outcomes. Predicting short-term market movements is highly challenging, and the costs of missing key recovery days can be significant. By sticking to a long-term strategy around equities, investors can avoid market-timing pitfalls and benefit from the growth potential of owning stocks. Our tactical adjustments to equity exposure tend to be small because we understand how difficult it is to do this well. We tend to be biased to overweights because that improves our odds of generating good returns.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

Executive Summary

• Hedging inflation in endowment and foundation portfolios is challenging because many hedging instruments have proven largely ineffective for two reasons:
  1. Low reliability: they do not reliably respond to inflation in the way theory suggests.
  2. High opportunity cost: they supplant productive core portfolio allocations and underperform when inflation is benign.
• Many “classic” hedging allocations such as real estate, real assets, and gold fall in this camp, suffering from unreliability and/or high net cost.
• Other strategies, including portfolio duration management and inflation swap overlays, have shown efficacy with carefully managed implementation.

The Challenge of Hedging Inflation

Of all the risks faced by endowment and foundation (E&F) investors, inflation is among the most challenging to hedge. Over time an actively managed portfolio consistently focused on equities, taking prudent advantage of private investments and appropriately diversified, has the best chance of delivering a robust real return over inflation. However, as we’ve been reminded over the last few years, spikes in inflation can make this goal harder to achieve. An inflation hedging allocation seeks to mitigate these periodic challenges.

The theory is straightforward – two types of assets should work as hedges:

1. Those with intrinsic value that will make their prices grow with inflation. For most portfolios, the investable version of such assets is commodities, including gold, and some commodity-like real assets such as timber.
2. Those with the ability to increase their cash yields in line with inflation. These assets include rent-generating real estate, infrastructure real assets such as toll roads or utilities, and inflation-indexed securities such as the US Treasury’s TIPS.

Of course, the reality is anything but straightforward for two basic reasons. First, the economy hardly sits by passively when inflation emerges (or recedes) – consumers, producers, and government all react, impacting demand, supply, interest rates, and fiscal policy in ways that can overwhelm the theoretical responses of inflation hedges, making them less reliable. Second, inflation hedges have meaningful opportunity cost as they generally underperform when inflation is benign and also supplant part of the core elements of an investment portfolio, costs which can outweigh their benefits.

Which Classic Strategies Have Worked?

So, if inflation hedges are unreliable and costly, how does one decide which (if any) to employ? One approach is to assess reliability and opportunity cost practically by modeling an investable hedging strategy and observing whether it would have added value to the type of portfolio E&Fs actually employ. Let us first look at the impact of the classic hedging strategies mentioned above: commodities, including gold; real estate and real assets; and TIPS. We focus on practical liquid implementations that i) are accessible to typical E&Fs and ii) can be added to or removed from a portfolio as inflation risks warrant.

We look at rolling 1-year periods, both inflationary and non-inflationary, during the past 40 years*. We choose 1-year periods because the response of hedges to inflation1 can take time, and shorter periods, such as a quarter-year, may not show a relationship, while longer multi-year periods often incorporate both an increase and subsequent decrease in inflation, again muddying the relationship. For each asset, first, we check reliability by observing the correlation of returns with inflation – is there evidence that the asset responds to inflation as hoped?

If there is a meaningful correlation, we will then check the cost/benefit: the excess return generated by the hedged portfolio vs the unhedged portfolio. To assess this cost/benefit correctly, the core portfolio must be representative – what core investment do we forgo and replace with a hedge? E&Fs are endlessly diverse in many dimensions, but at a high level share a fundamental investment goal: funding their missions reliably and effectively over the very long term. Parsing this goal leads to common requirements for their portfolios:

• Funding requires ready liquidity for distributions, while their long-term horizon often permits prudent but meaningful high-potential illiquid private investment.
• Continued effectiveness requires, at a minimum, growth with inflation net of distributions, while reliability requires volatility management via diversification.

To achieve these requirements, a typical TIFF client portfolio might have an illiquid budget of 10-35%, with the balance in liquid assets, and about 2/3rds of assets in growth-driving equities with the balance in volatility-reducing diversifying investments. For this exercise, we assume a core portfolio of 45% liquid equity2, 20% private equity3, and 35% fixed income4.

Commodities and gold

A broad basket of commodities5 has a correlation of about 0.64 over this period, indicating that statistically about 40% of its return is explained by inflation and that it has some promise as an inflation hedge. In contrast, gold6, perhaps the most “classic” inflation hedging instrument, has a correlation of approximately zero. While there is little doubt that gold has some inherent inflation hedging power, this inflation response has generally been overwhelmed by all the other market forces driving its value. We do not rule out gold as a hedge but cannot call it reliable.

Having established that commodities have some reliability, we test adding commodities to the portfolio. Commodities are volatile but have very little correlation with equities, so they replace part of the core portfolio’s non-equity diversifying allocation, 10% of it for our test.

Commodities Hedged Portfolio Annual Excess Return vs Annual CPI

We observe the high volatility and limited reliability of the hedge, particularly in years when inflation is not extreme: while about 40% of commodity return is explained by inflation, 60% is due to market forces unrelated to inflation. However, in the most inflationary (and deflationary) years the relationship between commodities and inflation is more apparent. Across all observed periods, the commodity hedge generates approximately 0.75% additional return for each 1% rise in inflation—a significant contribution when endowments and foundations typically target a 5% real return. Commodities do not make sense to us as a permanent hedging allocation, but they can be valuable if selectively employed when inflation risks are emerging.

Real estate and real assets

Both liquid real estate7 and liquid real assets8 have correlations with inflation of about 0.1, indicating that inflation explains almost none of their returns. Some of their unreliability stems from factors noted above, such as the fact that in a dynamic economy, they may be unable to increase rents and other cash flows in line with inflation to the extent theory suggests. But the bigger factor degrading their hedging power is interest rate sensitivity. Real estate and real assets are inherently illiquid, but they are made liquid and readily investable via securitization in real estate investment trusts (REITs) and similar real asset structures. These structures are companies that borrow (typically 50% of assets or more) to grow and achieve equity-like returns and are negatively impacted by the rising rates that generally accompany inflation.

TIPS

A broad TIPS index9 has a correlation of approximately zero. This observation seems counterintuitive for an instrument indexed to inflation, but again, the reason is interest rate sensitivity. TIPS are bonds with duration, and on average their inflation indexing benefit is offset by their sensitivity to rising rates during emerging inflation.

What Other Strategies Can Help?

Short Duration

Since rising rates often accompany inflation, one approach could be simply to reduce the interest rate sensitivity (duration) of the portfolio. We model this strategy by exchanging longer-duration diversifying assets for cash-like very short-duration treasuries10:

Duration Hedged Portfolio Annual Excess Return vs Annual CPI

Similar to the commodity hedge, there is much volatility in most years as the return of interest rate exposure is, in general, not highly correlated with inflation; however, the relationship is again clearer in more extreme inflation regimes. Reducing portfolio duration when inflation-driven interest rate increases are anticipated clearly makes sense, but it’s equally important to increase duration again ahead of interest rate reductions. The cost/benefit is moderate on average, as even if replacing the full 35% longer-duration allocation with cash (illustrated in the plot above), the portfolio’s return increases by 0.5% for every 1% increase in inflation. Similar to commodities, shortening portfolio duration makes sense as an inflation hedge when applied selectively when risks are disproportionately towards higher inflation and rates.

Illiquid Real Estate / Real Assets

Another possibility is to replace some of the core portfolio’s private equity allocation with private real estate or real assets. In illiquid form, these assets can be held directly without leverage and, therefore, with much less interest rate sensitivity. While private asset data is too sparse for the statistical analysis we have done here for liquid assets, we do believe that directly held real estate and assets demonstrate reliability against inflation.  However, we also believe that for the typical endowment portfolio their opportunity cost is too great. The upside potential of private equity is too high to forgo for inflation hedging when there is a limited illiquid asset budget available. And unlike liquid hedges, an effective private asset hedge cannot be employed periodically but instead must be committed to and left in place through complete inflation cycles.  Private asset hedges can make sense for the largest endowments with very substantial illiquid allocations, particularly those with ancillary needs for real estate investment (such as universities and hospitals) and the very large scale necessary to consistently outperform in these sectors.

Inflation Swaps

An inflation swap is a derivative contract in which the payer pays an agreed-upon fixed rate at the outset of the swap while the receiver pays a rate equal to the inflation that is actually experienced during the swap’s duration. The fixed-payer rate is thus effectively the prevailing breakeven inflation rate for the period. If realized inflation proves higher than this breakeven, the payer receives the difference, while if it comes in lower, the payer pays the difference. This instrument is purpose-built for inflation hedging and has several advantages.  First, it is liquid and can be put on and taken off on a daily basis.  Second, it has no direct interest-rate exposure, not only to rate duration but also to short-term rates. Third, while this market breakeven rate changes continuously, it is not very volatile (~2% annual volatility over the past ~25 years that this swap has been implementable**) compared to the core portfolio or the other hedges described above, which all have annual volatilities in the teens. This low volatility means an inflation swap can be added to the portfolio in large notional size without increasing overall portfolio risk. For illustration, consider 1-year swaps11, which pay out based on realized inflation over 12 months:

Inflation Swap Hedged Portfolio Annual Excess Return vs Annual CPI

We observe very high correlation (~0.9) with inflation as hoped. At a size consistent with the swap’s very low volatility (~75% of portfolio NAV), the portfolio, on average, gains a respectable ~0.65% for every 1% increase in in inflation. However, the swap is not a panacea because, as expected of any liquid market hedge, it is, over time, fairly valued: when inflation risks are high, the price of insurance goes up. During this period, these swaps post a gain in ~55% of rolling years and a loss in the other ~45%. Over very long periods, we expect a 50-50 track record. We believe inflation swaps can be very effective but, like other hedging tools, must be employed selectively when risks are elevated.

Conclusion

TIFF’s approach to managing against inflation reflects these real-world observations. TIFF has largely eschewed gold as well as liquid real estate and real assets, and while we do not rule out private real estate and real assets as attractive investments per se, we have not deployed illiquid capacity to them for the purpose of inflation hedging, keeping the illiquid allocation focused on private equity. We will periodically employ the strategies supported by our observations:

• We may add passive broad commodity baskets, as well as maintain long-term investments in active equity managers who themselves will take on commodity exposure (e.g. in the metals and mining industry)
• We may shorten the portfolio’s duration
• We may employ inflation swaps, either directly or in the form of short-term TIPS, which are effectively an inflation swap combined with a duration-reducing short-term treasury note

A common theme is that these hedges are not effective as “set and forget” permanent allocations; rather they must be managed and deployed periodically with an eye towards current inflation risks. TIFF implements these strategies for its clients selectively when warranted based on real time pricing and data around inflation expectations.

We find inflation hedging as challenging as does the rest of the investment world. Ultimately, we believe the best defense is a good offense: to maintain focus on generating long-term excess real return via an actively managed, equity-oriented portfolio with a prudent private investment allocation.  We believe that running up the score with this approach, combined with some modest, carefully employed hedging, gives our clients the best long-term protection against inflation.

The materials are being provided for informational purposes only and constitute neither an offer to sell nor a solicitation of an offer to buy securities. These materials also do not constitute an offer or advertisement of TIFF’s investment advisory services or investment, legal or tax advice. Opinions expressed herein are those of TIFF and are not a recommendation to buy or sell any securities.

These materials may contain forward-looking statements relating to future events. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” the negative of such terms or other comparable terminology. Although TIFF believes the expectations reflected in the forward-looking statements are reasonable, future results cannot be guaranteed.

* Why 40 years? Beyond that time, the forms of inflation hedges that typical E&F investors can practically access were much less available, and data for them is sparse. For instance, TIPS were only introduced in 1997. More importantly, we believe the response of the economy and policy makers to inflation is meaningfully different since the devastating inflation of the 1970s and the massive response of the Volcker Fed wound down in the early 1980s.

** The inflation swap is equivalent to a position owning a TIPS and selling short a nominal treasury of exactly equal duration. The swap exists as a liquid instrument because of the introduction of TIPS in 1997.