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Thursday, September 17, 2009

Morningstar on Harvard and Yale

They come to pretty much he same conclusions I have expressed here before (my bolds my comments in italics)

Are Harvard and Yale Endowments Still Top of the Class?

By Sonya Morris, CFA | 09-17-09 | 06:00 AM

Harvard and Yale recently said that their endowments experienced sizable losses for their most recent fiscal years ended June 2009....
....These results are noteworthy because Harvard's and Yale's endowments have produced results that have been the envy of the investment world. They also have been pioneering practitioners of what are now considered fundamental investment principles, such as diversifying among uncorrelated asset classes and developing a thoughtful long-term asset-allocation plan. Given the sterling reputations of these institutions, many thought that Harvard and Yale would fare much better than the competition amid last year's sell-off. Yet that clearly wasn't the case.
It's important not to make too much of this recent stumble. Last year's extreme market conditions humbled many talented managers, and every investor, even the most skillful ones, occasionally experiences a rough patch. However, the best investors also make a point of learning from their mistakes, and there are lessons to be taken from the endowments' recent underperformance.

Alternatives Aren't a Silver Bullet
Academics theorized that the inclusion of noncorrelated assets in a portfolio would improve diversification and enhance risk-adjusted returns. But the investment managers at Harvard and Yale were among the first to put this theory to practice by including nontraditional assets, such as commodities, real estate, private equity, and hedge funds, in their endowment portfolios. This approach proved very successful for both universities. Indeed, it worked so well that many of their fellow institutions jumped on the alternatives bandwagon. Fund firms also got in on the act by launching a bevy of mutual funds and ETFs that offer exposure to asset classes and hedge fund strategies that were previously unavailable to retail investors, such as commodities, currencies, global real estate, and absolute return strategies.

However, last year confirmed that asset classes tend to correlate during market crises. In other words, when the market implodes, few investments can avoid the downdraft.... .
Does that mean you shouldn't include alternatives in your portfolio? Not necessarily. A modest allocation to a commodity or real estate fund can improve diversification, but don't expect these investments to protect your portfolio from every unexpected turn in the market. Moreover, don't be drawn in by newfangled strategies with fetching back-tested results. The year 2008 proved just how challenging the real world can be.

Liquidity Matters
Many alternative assets held by Harvard and Yale are not readily liquid, and that proved particularly problematic last year. Harvard singled out "aggressive commitments to illiquid asset classes" as one of the factors behind its poor results last year. Private equity proved particularly insidious because not only are these investments difficult to sell, but they can demand additional investments, sometimes at inopportune times. That put private-equity investors in the position of selling their liquid positions at unattractive prices just to meet calls for capital. At the same time, some hedge funds were experiencing problems of their own and consequently limited their shareholders' ability to redeem their investments. This lack of liquidity squeezed many big investors, including university endowments....

Asset Allocation and Time Horizon Must Match

Endowment managers justified including large allocations to nonliquid assets because their time horizons were theoretically infinite. That should enable an endowment to ride out the occasional downturn without having to sell its investments at unfavorable prices....
The ambitious spending demands placed on endowments ultimately caused a mismatch between their asset allocations and their time horizon, which was no longer infinite. Individuals, particularly retirees, can find themselves in similar straits if they don't take realistic account of short- and intermediate-term spending needs in constructing their portfolios. Any money that you plan to spend over the next five years should be set aside in liquid and stable investments such as Treasury bonds, CDs, and bond mutual funds. Also, it's smart to set aside emergency cash reserves to meet unexpected expenses.

I'm not sure I agree with the following conclusion from Morningstar. As I have argued before, if the excess returns at these institutions was largely a premium they for taking more leverage and giving up liquidity, then (to use the flawed but still useful approach of modern portfolio theory) all they did is move along the indifference curve accepting higher risk (and less liquidity) in exchange for higher expected return. Higher risk and higher return perhaps, alpha (especially if you meand both risk and liquidity adjusted return) I'm not so sure.

Also the article conflates the strategy of using alternative investments with the Yale and Harvard strategy. I don't at all see a problem incorporating commodities through a liquid, transparent, unleveraged instrument through etfs (with the caveat that new rules by the cftc may change that view), But that is not the same as the Yale strategy which included private equity, hedge funds, venturecapia both illiquid and both leveraged.

the conclusion of the morningstar article

Focus on the Long Term
Despite large losses last year, Harvard and Yale both hold enviable long-term track records. Harvard has earned annualized returns of 8.9% over the past decade through June 2009, compared with 4.5% for the average world-allocation fund. While we don't yet know Yale's results for fiscal 2009, its 10-year record as of June 2008 was well ahead of Harvard's and was the best among all university endowments. Its estimated 30% loss for 2009, though painful, isn't large enough to derail its impressive long-term performance.
It would be a mistake to throw out an investment process that has produced these sorts of long-term results just because of one bad year. Still, last year serves as an important reminder of the limits of alternative investments and the value of liquidity

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