Many years ago I taught a course in a not for profit MBA program on investing for not for profits. In the course we examined the "Yale model" which was admired for impressive results by adding large amounts of alternative investments" such as venture capital and hedge funds. At the time I taught that most endowments --particularly those with smaller staffs than Yale --would be much better off with a simple indexing strategy. In fact in more recent years the Yale endowment's performance fell behind simple indexing.
Despite the fact that this "sophisticated strategy" of incorproating alternative investments proved more volatile, riskier, less liquid and more expensive..many endowments persist in following this strategy
I incorporated into the class a unit on "what happened to endowments in the 2008 financial crisis which highlighted the results for endowments during that period--the very types of markets where hedge fund investors claim they will outperform. Many endowments suffered large losses on their portfolios which included hedge funds and other alternative investments. Some of these were both leveraged and included derivatives connected to the real estate industry. Many of the endowments didn't really understand the investments but were no doubt impressed by the presentations of the managers and recommendations of their consultants . The consultants have an incentive to regularly bring in new "creative" strategies to justify their fees.
Not only did the endowments and pension funds find that they had large losses they found that they did not have liquid investments. Many of the funds they invested in had long "lock up" periods meaning the money could not be withdrawn at will. This led many of the endowments with the need to sell their more liquid and conservative investments to meet liquidity needs.
It seemed in recent years that some other major pension funds had soured on the high fees and middling results of hedge funds and moved most if not all of their portfolios to low cost indexing. Calpers the largest pension fund in the US. Already in 2015 it announced a move to indexing its massive portfolio. The Illinois state pension fund one of the largest in the country did the same as did other major pension funds
The experts at some of the largest pension funds were moving to catch up with individual investors who were already moving large portions of their portfolios to indexing, But the trend is far less extensive than the massive movement of individual investors to passive investing.
It seems that for many pensions and college endowments "they never learn". Every time there is a new "alternative investment" some of the endowments and pension funds become investors.. Often this is the result of recommendations of "expert consultants" or the slick presentations of Wall Street salespeople. Neither group has an incentive to recommend indexing..such a strategy would literally put them out of business.
And the results are not surprising: some of these exotic investments will prove to be more volatile than conventional instruments and rather than the hedge funds providing some actual "hedge" against negative market movements...they magnify the losses.
This time around the big movements in volatility based products and the huge losses on derivative products hit some pensions and endowments with big losses including Harvard (again !) and the state of Hawaii. I wont be surprised if we see more names added to the list.
WSJ (my bolds)
Pensions and Endowments Gambled on Market Calm, Then Everything Changed
More recently, some of these investors also made big, unpublicized wagers seeking to benefit from what had been an unusually long period of low volatility, according to pension-fund consultants and others who deal with these intuitions. The strategies, often involving the writing of complicated options contracts, were for years a source of easy money. Markets hadn’t been so calm since the 1950s.
Among those making such bets were Harvard University’s endowment, the Employees’ Retirement System of the State of Hawaii and the Illinois State Universities Retirement System.
More recently, the army of consulting firms that advise pension funds, such as Wilshire Consulting, has recommended some public-pension-fund clients write put contracts. As recently as 2013, hardly any public pension funds used this strategy, according to Wilshire Consulting President Andrew Junkin. He estimated more than 60 of the nation’s more than 6,000 pension funds now do.
A growing number of Wall Street firms have been selling volatility-related strategies to pension funds and other big investors. Neuberger Berman’s U.S. Equity Index PutWrite Strategy sells puts on stock indexes. Part of the value of a put relates to the volatility of underlying stocks. By selling the puts, the fund aims to generate steady income in stable markets.
In a document prepared for an Illinois pension, the firm argued that behavioral biases in financial markets mean investors “ultimately overpay for protection.” The Neuberger Berman options products have attracted about $3 billion over the past two years.
But the strategy suffers losses when stocks fall. So far this month, the fund has lost 4.37%, through Feb 12, though that tops a loss of 4.52% for its benchmark, a mix of puts on stock indexes and compares with a 5.90% loss for the S&P 500 through that date.
The Neuberger Berman products have outperformed their benchmarks in recent years and the firm notes the price for the puts rises when markets tumble, making the fund a lower-risk way to invest in stocks
Given the large volume of trading in these instruments more and more endowments are taking it seems quite likely there will be more stories like this in the future.
And despite the fact that the massive money flow from active to passive investing by individual investors ..some were drawn to the short volatility trades because of thei large profits due to leverage...and suffered massive losses when things reversed,
And the NYT reports that despite the moves by Calpers and some others there are still plenty of endowments allocating significant assets to "alternative investments" despite their dismal record compared to a basic index allocation:(my bolds)
It’s official: Returns for college and university endowments for the 2017 fiscal year are in, and while they averaged a respectable 12.2 percent for the year, over the last decade they have underperformed funds offering a simple 60-40 or 70-30 stock-fixed income allocation.
With their average returns dragged down by the weak performance of hedge funds, venture capital and private equity, you would think endowments would be fleeing these so-called alternative investments, which are costly and mostly illiquid, as some large pension funds have done.
On the contrary, endowments are holding firm, or even adding to these holdings. Last year, alternative investments accounted for an average of 52 percent of endowment assets — over 60 percent in the largest endowments — the same percentage as two years ago, according to the annual Nacubo-Commonfund study of endowments.....
Five-year averages suggest the magnitude of the gap: The average endowment had annualized five-year returns of 5.9 percent. A 60-40 mix returned 8.2 percent, and a 70-30 mix returned 9.2.
Not surprisingly an official from Vanguard quoted in the article was puzzled (to say the least) at the persistence of he use of "alternatives".
The best explanation is that "hope springs eternal as an official of the Commonfund group that surveys endowments noted:
We’re not seeing any changes in portfolio alignment or investment philosophy even though the indexes have clearly outperformed both managed funds and hedge funds. There’s still this belief that alternatives will provide some measure of outperformance.”
He noted that endowments of more than $1 billion, which tend to have high allocations to alternatives, did on average outperform the 60-40 mix (but not the 70-30 mix) over the most recent five-year period.
Jeff Schwartz, Markov’s president, agreed. “We’re talking about true believers in the value of alternatives,” he said. Many endowment managers, he added, “aren’t completely objective.”
Among those strong unobjective believers include the managers of endowments at the largest endowments in the country at Ivy League Universities such as Harvard,Yale and Columbia. There may be much that is impressive about the level of the academics at those Universities. But individual investors would be much smarter investors if they keep it simple rather than following the lead of those investment managers.
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