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Friday, April 2, 2010

An Alternative to Alternatives : Some Are Having Second Thoughts...But Not Yale

 The WSJ recently published a very interesting article about the way some institutional investors are rethinking the way they approach "alternative investments. I think it shows a very enlightened rethinking of the use of these type of investments. Many endowments and other institutions( as I have commented upon here) and elsewhere rushed into the "yale model" with very heavy weightings towards these type of investments. Many individuals and advisors to individuals jumped into this type of investing in these categories as well as evidenced by many aritcles in both the popular press and in publications aimed at financial advisors as well. The trend was even evidenced in two books (pictured here)



that had the misfortune to come to press just at the time many institutions and individuals regretted having made the choice to invest like Harvard and Yale.

Many investors who ventured into alternatove investments overlooked or held several misconceptions about these investments particularly private equity and hedge funds:

  • Diversification: many touted hedge funds and private equity funds as "diversifiers" to a portfolio that would go up when stocks went down. This would be the case because the hedge funds had the capability to go short and many engaged in "market neutral strategies".

    In fact, many of these fund proved to be highly correlated to the overall market including the "market neutral " strategies. Scott Patterson's The Quants gives a great description of the demise of many quantitative long/short "market neutra:" funds.

    Even today's NYT report on the eye popping compensation of hedge fund managers illustrates the high correlation between the overall market and hedge funds. Of the top ten earners among hedge fund managers only 3 had up years in both the down market of 2008 and the up market of 2009. One of the top 10: Ken Griffin of Citadel was down 55% in 2008 and up 62% last year  

    From the WSJ: my bolds, my comments in blue

An Alternative to 'Alternative' Assets 


Public pensions are increasingly asking a question that has haunted investors since the financial crisis: When is an alternative investment really more of the same?
So-called alternative investments like private equity and real estate that were supposed to help investors buffer losses in case of market declines in fact fell along with stocks in 2008.
Now some public funds are reconsidering how to categorize their investments. Rather than focus on the type of investment, such as stocks or bonds, they are looking at lumping holdings based on how they might perform under various economic conditions, such as slow economic growth or high inflation.....

The discussions come as investors of all sizes have been rethinking the value of asset allocation and how to do it. The idea of trying to minimize risk by spreading funds across different types of assets has been an investing chestnut for decades. Studies have shown that a portfolio's volatility depends 90% on asset allocation. But when stocks big and small, global and domestic, all fell along with other assets in the fall of 2008, the basic premise disappointed....

If funds conclude investments like private equity or real estate don't add much diversification to a portfolio of stocks, or that they all belong in the same risk category, funds may have less demand for these managers.
There doesn't yet appear to be a widespread movement toward a more situation-based way of thinking about asset allocation. But some consultants who advocate the change say the issue is bubbling up now that funds have some peace from crisis mode to consider it. (Consultants often benefit when a fund changes asset-allocation strategy; the consultant may get hired to help execute the change.)..... also focuses investors on the liquidity of their portfolios, something some found in short supply during the financial crisis.

Liquidity is one issue motivating Calpers to explore a new approach. "Calpers's portfolio did not have meaningful exposure to assets that could have been a hedge in times of financial crisis and provide adequate liquidity to the fund," the fund's chief investment officer, Joseph Dear, said in a report for an investment-committee meeting held Monday....

Mr. Burns(of alaska's fund) said his staff started rethinking the asset classifications in 2008, when it noticed amid the financial crisis that its fixed-income portfolio no longer correlated with relevant interest rates as it historically had done. That caused them to question other assumptions.
In their research, managers came across Denmark's ATP fund. In 2008, that $112 billion pension fund moved from allocating investments based on asset type to what drives risk, a spokesman confirms. For example, it put private and public equities into one category called corporate earnings, which usually perform badly during economic downturns.

I think the above shows that some pension managers are rethinking hedge funds and private equity as "alternative asset classes". As noted private equity and hedge funds are assets that are exposed to the same economic factors as traditional equity funds. The difference is that hedge funds include the additional risks related to leverage and limited liquidty. And compared to index instruments I would add a third additional risk factor, what I call manager or "alpha risk" which I would define as the risk the specific manager in control of your assets underperforms the general category that should move in tandem with corporate earnings and economic growth. Of course the high fees are another negative. In my view adding all these risks and costs I find it  difficult to see a strong rationale for including "alternative investments" in a portfolio, institutional or individual.

also in the same day's wsj a report tha Yale has no intentions of changing its investment policy

Yale Sticks With Investment Model

Anyone expecting a mea culpa from Yale University's investment chief can forget it.

..."Some observers questioned the University's investment philosophy, which rests on the principles of diversification and equity orientation," the report said. But it maintained that Yale's approach still lowered risks and diversified returns.
The endowment in fact increased its allocations to illiquid, or hard to sell, assets that caused some funds trouble when markets cratered, such as private equity and real estate, according to the report, which wasn't signed by any single individual....

... Yale's endowment declined by 24.6% for the fiscal year that ended June 30, and many other schools with similar approaches, like Harvard University, also faced double-digit declines. That caused some observers to question Mr. Swensen's philosophy; some, like Harvard, are now reducing their exposure to real estate and are trying to increase liquidity....
, the target allocation to private equity was increased from 21% to 26%, the report says. That compares to an 8.3% actual allocation of the average educational institution, the report..
    Liquidity is a concern for endowment managers, the report acknowledged. But it said some illiquid assets can be used to create liquidity, for example as collateral for loans.

    In other words, in extremis when the actual investments can't be turned into cash Yale will borrow against them.

    Meanwhile, the "need to provide resources for current operations as well as preserve purchasing power of assets dictates investing for high returns," the report said. "Hence, 96 percent of the Endowment is targeted for investment in assets expected to produce equity-like returns

    Well nobody ever accused Swensen of not holding strong beliefs. And he certainly has more experience and manages far more money than I do. But 96% in growth assets is a massively aggressive allocation for a portfolio which, must generate earnings on a consistent basis to meet Yale's annual expenses.

    Furthermore Swensen is comfortable relying upon investments that use significant leverage and can be illiquid in order to get what he calls equity like returns. A small proportion of the assets allocated to earn "equity like returns" are invested in simple equity vehicles like low cost unleveraged index instruments. Yale writes that these :equity like returns will come ...

    through holdings of domestic and international securities, real assets, and private equity."
    In the 2009 fiscal year, the endowment provided 46% of Yale's $2.56 billion operating income.
    The increases in less liquid asset classes were offset by, among other things, a 5 percentage point drop in the target allocation in foreign equities to 10% and a 2.5 percentage point decline in the domestic equity target to 7.5%
    So while some are rethinking whether hedge funds are really an "alternative " that adds diversification to a portfolio and whether the loss of liquidity is worthwhile (along with the leverage and high fees). Yale has lost no faith in its strategy of large allocation s to these "alternatives" and reliance on active managers to provide superior investments. Label me skeptical.  In fac,t as I have noted before, in both his book on institutional investing: Pioneering Portfolio Management and his book aimed at individiual investors: Unconventional Success Swensen does not suggest others should try to "be like Yale " in investment strategy.