Monday, July 5, 2010

Learning From US Endowments?

Michael Azlen, chief executive of Frontier Capital Management, wrote an op-ed piece for the FT, Everyone can learn from US endowments:

The US endowments of Harvard and Yale have been leaders in diversified multi-asset class investing for more than two decades. Through this approach to investing and their exposure to alternative asset classes, prior to 2008 they had consistently achieved high double-digit annual returns with relatively low volatility.

The bear market of 2008/09 took its toll on the endowments: Harvard and Yale returned -27.3 per cent and -24.6 per cent respectively for the fiscal year to June 2009, with other large endowments seeing similar results.

Despite this setback, the endowments remain among the best performing investors over five to 10-year periods and the case for their investment philosophy is still compelling.

The endowment funds have the advantages of access to some of the top fund managers and a longer investment time horizon than most investors. But their asset allocation principles can be adapted to create a more liquid, transparent and low-cost portfolio suitable for smaller institutions and retail investors.

Diversification is the key to endowment-style investing, first at portfolio level – across asset classes, but also at the asset class level to ensure capture of risk premium embedded in the asset class.

Their portfolios have as their foundation Professor Harry Markowitz’s Modern Portfolio Theory, which demonstrates that risk adjusted returns of a portfolio can be improved by diversification across asset classes with varied correlations. For Yale and Harvard, this is manifested in a large allocation to alternative investments: private equity, real estate, commodities, hedge funds and managed futures. Incorporating alternative assets into a diversified portfolio has the benefit of further diversification, lower volatility and increased risk-adjusted returns.

Harvard and Yale hold about two-thirds of their portfolios in alternative assets, compared with about a quarter for the average endowment. While private equity is inaccessible to all but the largest and most experienced investors, other alternative asset classes can now easily be built into individual portfolios.

Commodities can be bought separately or as a diversified fund; real estate investment trusts can be used as a long-term proxy for real estate or to supplement existing real estate holdings; and diversified hedge fund solutions are becoming available to the wider investment community.

As a firm believer in index investing, and due to the overwhelming evidence in favour of this approach, I would recommend that any investor looking to emulate the endowments do so passively.

There is little performance persistence within the active fund management industry and the higher fees and trading costs, as well as the high risk of selecting an underperforming manager, can have a significant negative impact on overall portfolio performance.

It is estimated that 30 per cent of all fund management industry assets are held in passive investments, a number that is expected to grow – in the institutional as well as the retail markets. While US endowments have stated they are not planning to change their multi-asset approach or their belief in the benefits of alternative investments, many – including Harvard and Yale – are positioning themselves to become more liquid and are increasing their use of liquid index strategies.

The growth in indexed assets has facilitated the development of new techniques to replicate indices, each of which vary in their potential for tracking error, availability to investors, commission costs, liquidity and ability to customise. In particular, derivatives such as futures, forwards, swaps and options are increasingly being used for index investing. They generally have lower commission costs, allow easy diversification and can be customised to help minimise tracking error. Initial investments are often large, however, making them unsuitable for smaller investors, except through more advanced indexing funds.

We saw in 2008/09 that the endowment approach is not immune to downturns, but these are some of the smartest minds in the investment industry and the high value of their investment proposition is obvious over the long term. With some modification, their asset allocation can be adapted to suit all investors.

Endowments aren't immune to downturns. Back in December 2008, I wrote about how Harvard's horror will decimate pension funds and how Yale's yardstick leaves pensions in peril.

Basically, pension consultants were touting the benefits of alternative investments to large US public pension funds who got into the game late - and not surprisingly, they all got slaughtered. The fact is most public pension funds lack the expertise of the staff at Harvard and Yale endowments and they can't get into the top funds, be it private equity funds or hedge funds.

And even these great endowments got clobbered in 2008, mostly because they didn't realize that everyone was trying to emulate them, introducing massive systemic risk into the financial system.

So what are Harvard and Yale doing now? You can track the latest news from Harvard Management Company on their site. Here are some excerpts from Jane Mendillo, HMC's President and CEO, given in interviews over the last year:
  • On risk: Speaking to NACUBO members, Jane Mendillo discussed her views on positioning today's endowment portfolio for the future: "We must learn and capitalize on the past, seek out new opportunities through innovation, build competitive strength, manage our risk and minimize our costs."
  • On diversification: "In terms of our strategic vision, there were a few adjustments as well. We have sharpened our focus to concentrate on the "best of the best" investments and relationships for inclusion in the Harvard portfolio. Our bar is very high. We are committed to diversification, but not for diversification's sake—every strategy must add value. We are looking to expand our sights beyond existing asset classes and working across disciplines on cross-sectional investment themes. We know the value of being an early adopter of new strategies, as we were with asset classes like private equity and timber. We will look to add weight in areas where we have specific competitive or knowledge advantage."
  • On managing liquidity risk: "Finally, we have taken actions to increase liquidity and reduce leverage across the portfolio. The University's reliance on the endowment has grown, and so we need to be aware that we must be positioned to meet that need. The flexibility that comes as a result of these combined actions will also position us to invest in new themes coming out of the financial crisis."
  • On rebuilding Harvard's portfolio: "There will be many opportunities to generate value through prudent and creative investment strategies in the coming months and years. However, we must be realistic about HMC's ability to fully reshape the current portfolio in the short term. It will take substantial time and effort to regain all of the market value lost as a result of the global economic crisis."(read full interview)
Harvard Management Company proceeds to add value is by adopting a hybrid investment approach:
In the September 2009 Harvard Management Company Endowment Report Message from the CEO, President and CEO Jane L. Mendillo describes the benefits of the hybrid model as Harvard sees them. We couldn’t agree more so we’d like to share her eloquent description:

“While we have made many changes in recent times, we continue to employ a ‘hybrid model’ – a unique approach to endowment management. We use a mix of internal and external management teams that focus on specific investment areas. We believe this gives us the best of both worlds – top-quality investment management by our internal team and access to cutting edge capability from specialized teams around the world…we will use the mix of internal and external managers that best represents our conviction regarding opportunities and gives us access to the best possible strategies.

The benefits of the hybrid model and both broad and deep:

  • Harvard’s partnerships with investment management teams around the world provide diversification, insight, and perspective that goes beyond what could possibly be achieved through our relatively small team in Boston;
  • Our internal investment management team…is our eyes and ours on the markets – constantly attuned and responsive to changing conditions, and frequently ahead of the curve in recognizing market inefficiencies and ways we might profit from them;
  • In addition to this close feel for the markets, our internal management approach gives us increased control, total transparency and greater nimbleness in the face of changing market conditions…Finally, our internal team in extraordinarily cost effective – with total expenses equal to a fraction of the costs of employing outside managers for similar asset pools with similar results.”
While the scope, scale and range of the Harvard Endowment investments far exceeds those available to Essential Investment Partners and our clients, the shared philosophy of combining internal and external management to greatest effect is an important tenet in successful investment management.
Yale's endowment, run by investment titan David Swensen, takes a different approach, focusing almost exclusively on finding the best external managers. In a recent article, Larry Swedroe asks, Is David Swensen Lucky or Good?:

The success of the Yale Endowment Fund raises an interesting question: Why haven’t other similar endowment funds, run by other very smart people with large resources at their command, generated these kinds of returns? In other words, is Yale’s success a result of manager skill, a result of exposure to risk or perhaps a lucky random outcome?

Peter Mladina and Jeffery Cole sought to answer that question in their study “Yale’s Endowment Returns: Manager Skill or Risk Exposure?,” which was published in the summer 2010 edition of the Journal of Wealth Management. The following is a summary of their findings:

  • For their public equity holdings, the returns are fully explained by exposure to risk factors and not manager skill. The endowment’s exposure to small-cap and value stocks provided the excess returns over the Wilshire 5000 (the chosen benchmark). A similar result was found internationally. While the endowment beat its benchmark (MSCI EAFE Index), the outperformance was explained by exposure to emerging market stocks and the same Fama-French risk factors. In other words, the benchmarks were wrong.
  • The private equity managers they hired added value. It’s important to note that private equity is the one asset class or investment category in which there is some evidence of persistence in performance. (Though this isn’t true for hedge funds.)

The implication is that the endowment’s private equity exposure — venture capital in particular — has been the unique source of its excess return.

The authors found the same results when they studied the last 10 years of the period. Thus, they concluded that Yale’s returns can be explained by consistent exposure to diversified, risk-tilted, equity-oriented assets and extraordinary outperformance in private equity (and venture capital in particular). Outside of private equity, the endowment appeared to underperform risk-adjusted benchmarks.

The authors concluded that any disciplined investor with a high risk tolerance could replicate Yale’s results using publicly available index funds and some degree of leverage. They added that they saw value in Yale’s broad diversification across asset classes with relatively low correlation.

The implication is striking: If Yale, with all of its resources, can’t identify the future alpha generators, what are the odds you can? This is why I believe that active management is the triumph of hype, hope and marketing over wisdom and experience.

Is there a lot of hype, hope and marketing in active management? Yes and no. I believe there is a tremendous amount of fluff out there, and most active managers aren't worth the fees they're charging. This goes for long-only, hedge fund and private equity managers.

But guys like David Swensen aren't stupid. They're constantly thinking years ahead when building their portfolios, and they are cementing relationships with the top money managers of the future in all asset classes. I wish anyone best of luck trying to replicate their returns over the long-run (silly conclusion from authors).

Interestingly, most Canadian pension funds have adopted Harvard's hybrid approach or moved assets internally to lower costs, increase transparency and control risk. They have the internal expertise to do this, and some are competing just fine with external managers. Net of fees, they are better off managing assets internally.

I happen to think that you can gain a lot by partnering up with top talent. And top talent is not only found in the top 100 hedge funds or private equity funds. In the environment we're heading in, you might want to selectively build relationships with smaller, nimbler, hungrier managers who are better placed to capitalize on opportunities as they present themselves.

But given the size of large endowments and even larger pension funds, it's not really worth the hassle to find smaller managers, so most stick to internal management or allocating to bigger, well known brand names. This is especially true of large pension funds worried about reputation risk.

It's too bad because what I find lacking in today's environment is investment shops that are willing to think outside the box and explore taking on new risks, new investment themes, or just new ways of thinking strategically but being nimble enough to take sizable tactical positions when opportunities arise. Everyone is reducing risk and hunkering down, but when everyone is doing the same thing, they're guaranteed to deliver mediocre results.

***Feedback from US consultant****

A US consultant shared this with me:

I have been a consultant to pension plans and endowments for over 10 years and serve on the board of a multi-billion pension.

Endowments get higher returns by taking more long term investments that do not have liquidity. Most pension plans need much more liquidity to make payments especially now. These are not good comparisons.

Alternatives have much higher fees which are harder to justify for public plans. Nevertheless I have pushed for modest (10%ish) alternative allocations for pension plans because of the diversification benefits.

My only comment is that endowments and pension funds are both focusing much more on liquidity these days. And as far as diversification benefits of alternatives, it remains to be seen if this holds up as well in the next 10 years. If a protracted period of deflation ensues, I doubt diversification benefits will be there, and alternatives may even hamper your portfolio (RE and PE will get hammered and few hedge funds will outperform broader market).

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