The Evolution of Investing by Not For Profits
For years probably dating from the 1990s up through the 2008 financial crisis the “gold standard for not for profit investing was the “ Yale model” defined by the FT :
Definition of Yale model
An investment model developed by David Swensen, the chief investment officer at Yale, that relies on modern portfolio theory and invests heavily in alternative or non-liquid investments.
The Yale model calls for a high allocation to equities, diversifying the portfolio, avoiding market timing and investing in private markets that can increase earnings potential. Also known as the endowment modell. [1]
Yale's 2006 annual report can be found here
It actually shows a relatively low allocation to stocks vs the average of endowments: 14.9% to foreign equities vs.the endowment average of 21.4% and 4% to domestic stocs vs. the endowment average of 19.6%
The Yale endowment had several advantages vs. others in implementing this strategy It got into many of the alternative asset funds particularly venture capital early before the area became overinvested. The prestige of having the endowment as an investor let them invest with lower fees than other investors. And the fund established structures so that their funds were separated from the overall investment portfolio preventing any liquidity issues. It also had a large highly skilled staff.
Not surprisingly many many other endowments hastened to copy the Yale Model and hold large allocations to alternative investments often without the qualified personnel to properly screen the prospective investtments.
The results were far from impressive. As investment advisor and author Rick Ferri wrote in Forbes the returns were worse that a simple index portfolio
The Added Risk In the Yale Mode
Probably second to the Yale Endowment in its reputation of sophistication and quality of in house staff would be the Harvard Endowment. Yet the endowment had a nightmare year in 2008, not only with a 20%+ loss but also a liquidity crisis as they found that not only were many of their securiiteis marketable some of the - under the terms of the structure- could demand more cash for investments from investors.
After replacing leadership for the endowment and putting Janet Medillo in charge the endowment continues with a very high allocationf to alternative investments But according to Medillo it now places a greater emphasis on liquidity.
The Move to Indexing
After all these difficulties with alternative investments poor performance, high fees and low liquidity some of the largest institution investors in the world announced that they were giving up on these instruments and moving to indexing. The country’s largest pension fund Calpers was probably the first to make the change in a big way. And many others followed giving the impression of a lage scale move out of the “Yale Model
Several major state pension funds have shifted to indexing but the biggest move was by Calpers the California state pension fund.
How big a deal is this? Well, we're talking about nearly 1.7 million public employees and an investment portfolio of $258 billion as of June 30. On that date, 35% of the portfolio was in passive investments and 65% was actively managed.
On Sept. 16, the Calpers board adopted a lengthy set of "investment beliefs," from which I will quote here briefly, specifically from No. 7 of a total of 10 beliefs:
"Calpers will take risk only where we have a strong belief we will be rewarded for it
“Sub-beliefs:
· An expectation of a return premium is required to take risk; Calpers aims to maximize return for the risk taken
· Markets aren’t perfectly efficient, but inefficiencies are difficult to exploit after costs
· Calpers will use index tracking strategies where we lack conviction or demonstrable evidence that we can add value through active management
· Calpers should measure its investment performance relative to a reference portfolio of public, passively managed assets to ensure that active risk is being compensated at the Total Fund level over the long-term”
But the bottom line is simple enough. Expect the percentage of Calpers assets held in indexed, passive investments to rise, and rise dramatically. Consequently, actively managed assets will decline.
It will probably take such a massive pension system months to make a move, but once it does the eventual goal is likely a flip to 65% passive and 35% active — maybe more, maybe less. It's a hard row to hoe after decades of paying active managers, but Calpers has clearly taken on a new direction.
1. The sixth-largest pension fund in the world, second in the U.S. behind the federal employees plan, just endorsed passive investments — index funds — over paying active managers to attempt to "beat the market."
2. Cost is the reason why. High active management fees greatly diminish the likelihood of beating the benchmarks.
Seems some people clearly didn’t get the message from the Calpers decision. Greed and the prospect of “beating the market” through an exotic alternative investment strategy led to investment losses that are probably unprecedented for major investors. Even investors with Madoff didn’t wind up with zero.
More from the WSJ article linked above:
Though private-equity investments regularly flop, industry consultants and fund investors say this situation could mark the first time that a fund larger than $1 billion has lost essentially all of its value…..
EnerVest’s collapse shows how debt taken on during the drilling boom continues to haunt energy investors three years after a glut of fuel sent prices spiraling down.
I would think that many of those invested in the fund didn’t understand the amount of leverage in the fund. Some form of leverage is involved in virtually every major investment disaster. No unleveraged investment goes to zero.
The strategy is described as follows:(my bold)
EnerVest Ltd., a Houston private-equity firm that focuses on energy investments, manages the fund. The firm raised and started investing money in 2013, when oil was trading at more than double the current price of about $45 a barrel. But the fund added $1.3 billion of borrowed money to boost its buying power. That later caused it trouble when oil prices tumbled...
The strategy isn’t as risky as staking wildcatters or borrowing heavily to buy entire oil companies, but profits are usually lower. To juice returns, however, funds managed by EnerVest and rivals that shared the strategy borrowed money as if they themselves were oil companies, encumbering all of the funds’ assets with the same debt.
Doing that eliminates a key protection for private-equity investors, which generally finance each investment independently so that soured deals don’t put good ones at risk. The use of fund-level debt effectively cross-collateralizes assets, meaning that good investments can be pulled down by bad ones.
Institutional investors were drawn to these so-called resource funds because they typically pay out steady streams of cash as soon as they make their first investments, unlike other private-equity investments that can take years to bear fruit, said Christian Busken, who advises endowments and other big energy investors as director of real assets for Fund Evaluation Group LLC.
A number of prominent institutional investors are at risk of having their investments wiped out, including Caisse de dépôt et placement du Québec, Canada’s second-largest pension, which invested more than $100 million. Florida’s largest pension fund manager and the Western Conference of Teamsters Pension Plan, a manager of retirement savings for union members in nearly 30 states, each invested $100 million, according to public records.
The fund was popular among charitable organizations as well. The J. Paul Getty Trust, John D. and Catherine T. MacArthur and Fletcher Jones foundations each invested millions in the fund, according to their tax filings.
Michigan State University and a foundation that supports Arizona State University also have disclosed investments in the fund.
The WSJ noted another loser
Orange County Employees Retirement System, already has marked its investment down to zero, according to a pension document.
If there is a single pension fund in the country that should have implemented a policy of investing only in simple unleveraged investments it is Orange County. The highly leveraged strategies of treasurer Robert Citron led to a default on bonds and a 1994
The bottom line is the one that Calpers concluded: alternative investments are not worth the additional risk....and that is' conventional " hedge funds and private equity funds which were the alternatives Calpers had invested in. How much more could the case be made against alternative investments when they involve complex leveraged strategies. But it seems there is always someone who lets his greed and overoptimism lead to venturing into exotic investments In this case the results were as bad as possible...the investment going to zero.
