Thursday, May 7, 2009

Lessons to learn from Yale and Harvard Endowment Funds

The highly praised asset allocation policies of US universities have produced disappointing results in 2008 and 2009.

If you would like to learn more about the Yale and Harvard endowment funds this book may be of interest to you(click on image):

Diversification of asset allocations have been preached to investors for years. After the dotcom bubble burst at the start of the decade, investors were urged to buy alternative and niche assets to offset volatility in equity markets.

The endowment funds of US universities such as Yale and Harvard were held up as models of how a diversified portfolio of alternative assets could give double-digit returns despite fluctuations in equity markets, and many wealth managers set out to replicate these endowment funds for their clients.

But in the past year, investors have unfortunately found that their alternative asset allocation managers did poorly just like other managers. Both Yale and Harvard endowment funds recorded negative returns of more than 20% last year and Harvard this month announced it would cut a quarter of its in-house investment staff.

The diversification that was supposed to smooth out returns from various assets failed to deliver. This is quite a unique situation where most asset classes revealed that they moved in tandem i.e. bonds (junk), equity, property, commodities and interest rates. And many analysts have hailed this unique situation as a "depression".

Despite these results the mix of assets recommended by most wealth managers at the beginning of this year appears to be similar to those they were promoting a year ago.

According to an investment strategist at a large, Swiss private bank, this is due to the fact that many financial institutions have been too busy trying to sort out their internal mess to revise their investment models. He said: “A lot of people are rethinking their strategies but have not yet acted. The huge restructuring in the asset management and banking industry means asset allocation shifts have had to wait.”

Other wealth managers stand by their asset allocation models insisting that they are investing for the long term regardless of short term market fluctuations.

A white paper published in December by Ben Inker at Boston-based fund manager GMO, titled “When Diversification Failed”, looked to address these issues. Inker argued that following the dotcom bust, investors learnt the wrong lessons about asset allocation.

Observing how Yale and Harvard rode out the downturn with their broad mix of niche assets they rushed to mimic the endowments’ approach, encouraged by quantitative risk models that suggested such broad diversification not only improved returns but lowered risk, therefore enabling them to increase the proportion of risk assets in their portfolios.

What they ignored, according to Inker, was price risk, the risk associated with the valuation of an asset class – whether it is cheap or expensive on a historic basis. Diversifying without taking into account price risk is unlikely to produce the results investors expect. Yale and Harvard performed well during the dotcom downturn partly because they had diversified into niche assets during a period when those assets were cheap.

Inker’s conclusion was that having a well-diversified but static portfolio inevitably exposes investors to the risk of big losses during a sharp downturn, because it ignores the fact that the valuation of various asset classes will be more or less attractive at different times.

Inker said: “Rather than having a static allocation to each class of risk asset, it makes more sense to keep all of them on the menu, but shift the allocations as valuations, and therefore risk/return trade-offs, shift.” He noted that the big problem in the alternative sector is that many assets cannot be traded easily, so investors need to be confident they are being well compensated for the lack of liquidity.

Sally Tennant, UK chief executive of Swiss wealth manager Lombard Odier, said that a more dynamic approach – somewhere between strategic and tactical asset allocation – was called for. She said: “The chief investment officer and the investment engine have a greater burden to make calls that are shorter term.”

This does not mean trying to time markets each month, she said, but perhaps taking a 12 or 18-month view. Tennant said Lombard Odier was also rethinking the role of cash in its portfolios. She said: “It is time we started thinking of cash as an asset class, not a residual, and using it in a more dynamic way.”

This may sound obvious but creates a problem for many wealthy investors who want a reliable, all-weather portfolio they do not have to keep revising. Either they need to be more active themselves in allocating their assets or give more discretion to their wealth manager to do it for them – assuming they trust their adviser’s abilities.

Wealth management executives said trying to mimic Yale or Harvard was unlikely to work for private clients. Tennant said: “Yale and Harvard endowments are there in perpetuity and have a very different tax treatment to private clients, which means they are better placed to weather storms.”

Anthony Rosenfelder, managing director at Veritas Asset Management, echoed Inker’s view that many investors were wrong to try to copy the Yale-Harvard approach following the dotcom bubble. He said: “The lesson many investors took was to reduce their equity holdings and hire alternative asset managers. But getting the right managers was what really counted.”

David Swensen, the chief investment officer of Yale’s endowment, has underlined this point in an interview with the Wall Street Journal. He called funds of funds, which many private clients use to access alternative assets, “a cancer” on the investment world which “facilitate the flow of ignorant capital”.

This might seem a bit rich, given Swensen’s fund fell by a quarter last year. But Nicolas Sarkis, founder of wealth manager AlphaOne Advisers, said much of the negative performance at Yale was accounted for by mark-to-market valuations of illiquid assets.

He said: “Those assets won’t be sold at today’s prices. Mark-to-market valuations for private equity investments, for example, are to a large extent meaningless. The investment horizon is 10 years and unless you sell, you have not lost anything.”

Sarkis said a big problem with conventional asset allocation, revealed last year, was the carving up of the investment universe into buckets of assets such as equities, bonds and hedge funds within which individual securities have little in common. This can create the appearance of a diversified portfolio when securities in different buckets carry similar risks.

Michael O’Sullivan, global head of asset allocation for Credit Suisse’s private bank, said there was growing recognition of this fact. “The distinction between equities and bonds, for example, is becoming less clear. This is simply a spectrum of assets from risk-less to risky.”

Recognising this is likely to make diversification less neat but far more effective.

Ironically, for those investors who tried to copy Yale and suffered last year, sitting tight might be their best bet in terms of recovering losses, as the prospective value of risky assets has become far more attractive (see chart).

Inker said: “Institutions that insist on having static allocations are at least in a position where their target weights make far more sense today than they did in the past few years.”

James Rutter at Wealth Bulletin

Remember to sign up for future updates by filling in your email address and also please subscribe to the RSS feed.