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Thursday, August 20, 2009

The "Yale Model of Investing."..and the Penn Experience

As the school year begins and students and faculty see the impact of portfolio losses on campus life, the WSJ has a good piece on the "Yale Model". As the article notes the experience of these endowments has some valuable lessons for individual investors as well. As the author rightly notes it is not enough to position a portfolio for high returns or even high "risk adjusted returns". It is crucial to be cognizant of the liquidity of one's investments because precisely when market volatility is greatest and market losses are greatest is the time when one will want to have access to cash to meet immediate funding needs. At that time liquidity becomes crucial for at least an adequate portion of the portfolio to meet current cash needs. For that reason all portfolios should have what I call a "bucket " of highly liquid holdings such as treasury bills. Otherwise one will find that some of the portfolio is totally illiquid (see below) and as a consequence liquidate large amounts of positions that are long term holdings but have short term losses simply before they are most liquid: listed stocks for instance because hedge funds and private equtiy positions can t be liquidated.

article is below, my bolds and my comments in italics

Ivy League Schools Learn a Lesson in Liquidity .

Just a year ago, in the midst of the subprime meltdown, many of the nation's top universities and colleges were reporting significant gains. This year, the University of Pennsylvania is being hailed for Ivy League-leading results—with a decline of 15.7% for its fiscal year ended in June.

Results from other schools are still trickling in, but Harvard University has said it is expecting to report a drop of 30%, and Yale University about 25%. Considering the size of these endowments, these are staggering losses in absolute terms—many billions in the case of both Harvard and Yale.

Students soon will be heading back to larger classes, curtailed extracurricular activities and cheaper dining-hall fare. But the results are also of more than academic interest to investors like me, who have to some degree modeled their portfolios on the diversified asset-allocation model pioneered by Yale's chief investment officer, David Swensen. What I refer to as the Ivy League approach for individuals calls for diversification along similar lines as the large university endowments—equities (domestic and foreign), fixed income, and real assets (which includes commodities and real estate), but with a much higher allocation to so-called nontraditional asset categories: emerging-market equities and debt, energy and commodities. (Of course as I have pointed out several times, Swensen's own book for individuals Unconventional Success specifically advises against several of these asset classes for individuals and advises not to try to "be like Yale) Yale allocated just 10% to U.S. equities and 4% to fixed income, with 15% in foreign equities and 29% in so-called real assets as of June 30, 2008.

.The major difference is that most individual investors didn't qualify or otherwise couldn't invest in the hedge funds and private equity and venture-capital partnerships that make up a large part of university endowments. At Yale, 25% of the endowment was in what the university calls "absolute return," mostly hedge funds, and 20% was in private equity.

The irony is that turned out to be a huge advantage for individual investors this past year, when, in the midst of unprecedented market turmoil, many endowment managers learned the true meaning of "illiquid." The exits for most private equity and venture-capital funds slammed shut. Existing positions yielded no cash flow even as investment partnerships made new demands for funding. Many investors were forced to sell their liquid investments into weak markets to fund cash needs and to meet prior commitments to investment funds. Asset allocations went wildly out of balance, overweighted to illiquid partnerships as the value of equities plunged. It's a wonder that last year's results weren't even worse.

Liquidity turned out to be the Achilles' heel of the Ivy League model. But what about its core premise—diversification? True, nearly every asset category declined at some point in 2008, even those that were supposed to be uncorrelated, like equities and high-quality corporate bonds.

As we have noted before Harvard's situation was even more adverse than Yale's . The are reported to have shopped around some of their private equity positions to third parties and found bids at 50% of book value. Declining to seel at those distressed prices and in search of liquidity Harvard wound up issuing debt.

But for individuals who followed a diversification strategy—and who weren't forced to sell anything at distressed prices—those values have rebounded sharply, with many of the nontraditional categories, such as emerging-market equities and commodities, outperforming U.S. stock indexes. By sticking to liquid alternatives to private partnerships—such as mutual funds, exchange-traded funds, and real-estate investment trusts and publicly traded stocks and bonds—individual investors should have done far better than even the University of Pennsylvania.

Penn, too, found itself in quite a few illiquid partnerships. But it notched its league-beating return with some old-fashioned market timing. Chief Investment Officer Kristin Gilbertson recently told The Wall Street Journal that in early 2008 she started reducing the portion of the endowment in public equities to 43% from 53% and put about 15% in Treasurys. It turned out to be a shrewd move, and by endowment standards, which rarely stray from predetermined asset allocations, a bold one. The highly liquid Treasurys were one of the few assets to hold their value over the period and also enabled the university to meet capital calls from private-equity firms.

Market timing can be difficult, but I suspect some degree of it will increasingly be worked into endowment-allocation models. It will probably take years for the lessons of 2008 to be absorbed. But you can be sure that liquidity will gain new respect.

Here is where the author draws the wrong conclusion, For Penn in my view it is better to be lucky than right or put another way Penn was right for the wrong reasons. In my view (check Taleeb's great book Fooled by Randomness) what is perceived as investing skill is oftentimes luck, Penn would be foolish to take as a lesson from their experience that they have particular skill in market timing (or that anyone does). And they and other endowments would be making a big mistake if "market timing...were increasingly worked into endowment allocation models"

I do agree that "liquidity will gain new respect". Hopefully such respect will be expressed in a permanent allocation to a "bucket" of highly liquid investments with minimal market risk, even if that may bring down the "expected return" of the portfolio. After all if there is anything that should have been learned from the recent market meltdown is the limitation of measures from MPT (modern portfolio theory) such as "expected return of a portfolio

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