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Learning From US Endowments?

Submitted by Leo Kolivakis on 07/05/2010 19:31 -0400

Michael

Azlen, chief executive of Frontier Capital Management, wrote an op-ed
piece for the FT, Everyone

can learn from US endowments:

The US
endowments of Harvard and Yale have been leaders in diversified
multi-asset class investing for more than two decades. Through this
approach to investing and their exposure to alternative asset classes,
prior to 2008 they had consistently achieved high double-digit annual
returns with relatively low volatility.

The bear market of 2008/09 took
its toll on the endowments:
Harvard and Yale returned -27.3 per cent and -24.6 per cent
respectively for the fiscal year to June 2009, with other large
endowments seeing similar results.

Despite this
setback, the
endowments remain among the best performing investors over five to
10-year periods and the case for their investment philosophy is still
compelling.

The endowment funds have
the advantages of access to some of the top fund managers and a longer
investment time horizon than most investors. But their asset allocation
principles can be adapted to create a more liquid, transparent and
low-cost portfolio suitable for smaller institutions and retail
investors.

Diversification is the key to
endowment-style
investing, first at portfolio level – across asset classes, but also at
the asset class level to ensure capture of risk premium embedded in the
asset class.

Their portfolios have as their
foundation
Professor Harry Markowitz’s Modern Portfolio Theory, which demonstrates
that risk adjusted returns of a portfolio can be improved by
diversification across asset classes with varied correlations. For Yale
and Harvard, this is manifested in a large allocation to alternative
investments: private equity, real estate, commodities, hedge funds and
managed futures. Incorporating alternative assets into a diversified
portfolio has the benefit of further diversification, lower volatility
and increased risk-adjusted returns.

Harvard
and Yale hold about two-thirds of their portfolios in alternative
assets, compared with about a quarter for the average endowment. While
private equity is inaccessible to all but the largest and most
experienced investors, other alternative asset classes can now easily
be built into individual portfolios.

Commodities can
be bought
separately or as a diversified fund; real estate investment trusts can
be used as a long-term proxy for real estate or to supplement existing
real estate holdings; and diversified hedge fund solutions are becoming
available to the wider investment community.

As a
firm believer
in index investing, and due to the overwhelming evidence in favour of
this approach, I would recommend that any investor looking to emulate
the endowments do so passively.

There is little
performance
persistence within the active fund management industry and the higher
fees and trading costs, as well as the high risk of selecting an
underperforming manager, can have a significant negative impact on
overall portfolio performance.

It
is estimated that 30 per cent of all fund management industry assets
are held in passive investments, a number that is expected to grow – in
the institutional as well as the retail markets. While US endowments
have stated they are not planning to change their multi-asset approach
or their belief in the benefits of alternative investments, many –
including Harvard and Yale – are positioning themselves to become more
liquid and are increasing their use of liquid index strategies.

The

growth in indexed assets has facilitated the development of new
techniques to replicate indices, each of which vary in their potential
for tracking error, availability to investors, commission costs,
liquidity and ability to customise. In particular, derivatives such as
futures, forwards, swaps and options are increasingly being used for
index investing. They generally have lower commission costs, allow easy
diversification and can be customised to help minimise tracking error.
Initial investments are often large, however, making them unsuitable
for smaller investors, except through more advanced indexing funds.

We

saw in 2008/09 that the endowment approach is not immune to downturns,
but these are some of the smartest minds in the investment industry
and the high value of their investment proposition is obvious over the
long term. With some modification, their asset allocation can be
adapted to suit all investors.

Endowments
aren't immune to downturns. Back in December 2008, I wrote about how Harvard's

horror will decimate pension funds and how Yale's

yardstick leaves pensions in peril.

Basically, pension
consultants were touting the benefits of alternative investments to
large US public pension funds who got into the game late - and not
surprisingly, they all got slaughtered. The fact is most public pension
funds lack the expertise of the staff at Harvard and Yale endowments and
they can't get into the top funds, be it private equity funds or hedge
funds.

And even these great endowments got clobbered in 2008,
mostly because they didn't realize that everyone was trying to emulate
them, introducing massive systemic risk into the financial system.

what are Harvard and Yale doing now? You can track the latest
news
from Harvard Management Company on their site. Here are some
excerpts from Jane Mendillo, HMC's CIO, given in interviews over the
last year:

On risk:
Speaking to NACUBO members, Jane Mendillo discussed her views on
positioning today's endowment portfolio for the future: "We must learn
and capitalize on the past, seek out new opportunities through
innovation, build competitive strength,
manage our risk and minimize our costs."
On
diversification: "In terms of our
strategic vision, there were a few adjustments as well. We have
sharpened our focus to concentrate on the "best of the best" investments
and relationships for inclusion in the Harvard portfolio. Our bar is
very high. We are committed to
diversification, but not for diversification's sake—every strategy must
add value. We are looking to expand our sights beyond existing asset
classes and working across disciplines on cross-sectional investment
themes. We know the value of
being an early adopter of new strategies, as we were with asset classes
like private equity and timber. We will look to add weight in areas
where we have specific competitive or knowledge advantage."
On managing
liquidity risk: "Finally,
we have taken actions to increase liquidity and reduce leverage across
the portfolio. The University's reliance on the endowment has grown, and
so we need to be aware that we must be positioned to meet that need.
The flexibility that comes as a result of these combined actions will
also position us to invest in new themes coming out of the financial
crisis."
On rebuilding
Harvard's portfolio: "There will be many opportunities to
generate value through prudent and creative investment strategies in the
coming months and years. However, we must be realistic about HMC's
ability to fully reshape the current portfolio in the short term. It will take
substantial time and effort to
regain all of the market value lost as a result of the global economic
crisis."(read full
interview
)

Harvard Management Company proceeds to add
value
is by adopting a hybrid

investment approach:

In the September 2009 Harvard
Management Company Endowment Report Message from the CEO, President and
CEO Jane L. Mendillo describes the benefits of the hybrid
model as Harvard sees them. We couldn’t agree more so we’d like to
share her eloquent description:

“While we
have made many changes in recent
times, we continue to employ a ‘hybrid model’ – a unique
approach to endowment management. We use a mix of internal and external
management teams that focus on specific investment areas. We believe
this gives us the best of both worlds – top-quality investment
management by our internal team and access to cutting edge capability
from specialized teams around the world…we will use the mix of internal
and external managers that best represents our conviction regarding
opportunities and gives us access to the best possible strategies.

The benefits of the hybrid
model and both broad
and deep:

Harvard’s partnerships with investment
management teams
around the world provide diversification, insight, and perspective
that goes beyond what could possibly be achieved through our
relatively small team in Boston;

Our internal investment
management team…is our eyes and ours on the markets – constantly
attuned and responsive to changing conditions, and frequently ahead
of the curve in recognizing market inefficiencies and ways we
might profit from them;

In
addition to this close feel for the markets, our internal
management approach gives us increased control, total transparency
and greater nimbleness in the face of changing market
conditions…Finally, our internal team in extraordinarily cost
effective – with total expenses equal to a fraction of the costs
of employing outside managers for similar asset pools with similar
results.”

While the scope, scale and range of the Harvard Endowment investments
far exceeds those available to Essential Investment Partners and our
clients, the shared philosophy of combining internal and external
management to greatest effect is an important tenet in successful
investment management.

Yale's

endowment, run by investment titan David Swensen, takes a different
approach, focusing almost exclusively on finding the best external
managers. In a recent article, Larry Swedroe asks, Is

David Swensen Lucky or Good?:

The success
of the Yale Endowment Fund raises an interesting question: Why haven’t
other similar endowment funds, run by other very smart people with
large resources at their command, generated these kinds of returns? In
other words, is Yale’s success a result of manager skill, a result of
exposure to risk or perhaps a lucky random outcome?

Peter
Mladina and Jeffery Cole sought to answer
that question in their study “Yale’s Endowment Returns: Manager Skill
or Risk Exposure?,” which was published in the summer 2010 edition of
the Journal of Wealth Management. The following is a summary
of their findings:

For their public equity
holdings, the returns are fully explained by exposure to risk factors
and not manager skill. The endowment’s exposure to small-cap and
value stocks provided the excess returns over the Wilshire
5000 (the chosen
benchmark). A similar result was found internationally. While the
endowment beat its benchmark (MSCI
EAFE Index), the outperformance was explained by exposure
to emerging market stocks and the same Fama-French risk factors. In
other words, the benchmarks were wrong.

The private equity
managers they hired added value. It’s important to note that
private equity is the one asset class or investment category in
which there is some evidence of persistence in performance.
(Though this isn’t true for hedge funds.)

The
implication is that the endowment’s
private equity exposure — venture capital in particular — has been the
unique source of its excess return.

The authors found
the same
results when they studied the last 10 years of the period. Thus, they
concluded that Yale’s returns can be explained by consistent exposure
to diversified, risk-tilted, equity-oriented assets and extraordinary
outperformance in private equity (and venture capital in particular).
Outside of private equity, the endowment appeared to underperform
risk-adjusted benchmarks.

The authors
concluded that any disciplined investor with a high risk tolerance
could replicate Yale’s results using publicly available index funds and
some degree of leverage. They added that they saw value in Yale’s
broad diversification across asset classes with relatively low
correlation.

The implication is striking: If Yale,
with all of
its resources, can’t identify the future alpha generators, what are the
odds you can? This is why I believe that active management is the
triumph of hype, hope and marketing over wisdom and experience.

there a lot of hype, hope and marketing in active management? Yes and
no. I believe there is a tremendous amount of fluff out there, and most
active managers aren't worth the fees they're charging. This goes for
long-only, hedge fund and private equity managers.

But guys like
David Swensen aren't stupid. They're constantly thinking years ahead
when building their portfolios, and they are cementing relationships
with the top money managers of the future in all asset classes. I wish anyone best of luck trying to replicate their returns over the
long-run (silly conclusion from authors).

Interestingly, most Canadian pension
funds have adopted Harvard's hybrid approach or moved assets internally
to lower costs, increase transparency and control risk. They have the
internal expertise to do this, and some are competing just fine with
external managers. Net of fees, they are better off managing assets
internally.

I happen to think that you can gain a lot by
partnering up with top talent. And top talent is not only found in the top
100 hedge funds or private equity funds. In the environment we're
heading in, you might want to selectively build relationships with
smaller, nimbler, hungrier managers who are better paced to capitalize
on opportunities as they present themselves.

But given the size of
large endowments and even larger pension funds, it's not really worth
the hassle to find smaller managers, so most stick to internal
management or allocating to bigger, well known brand names. This is
especially true of large pension funds worried about reputation risk.

It's

too bad because what I find lacking in today's environment is
investment shops that are willing to think outside the box and explore
taking on new risks, new investment themes, or just new ways of
thinking strategically but being nimble enough to take sizable tactical
positions when opportunities arise. Everyone is reducing risk and
hunkering down, but when everyone is doing the same thing, they're
guaranteed to deliver mediocre results.

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Wed, 11/10/2010 - 06:08 | 715567 cheap uggs for sale

Mon, 07/05/2010 - 23:17 | 453769 BobWatNorCal

What level of regulatory scrutiny do endowments face?

Mon, 07/05/2010 - 21:02 | 453659 RockyRacoon

The bear market of 2008/09 took its toll on the endowments: Harvard and Yale returned -27.3 per cent and -24.6 per cent respectively for the fiscal year to June 2009, with other large endowments seeing similar results.

Well. So much for those returns. Let's see how my 100% allocation in gold and silver bullion did... I don't need no stinkin' fund manager.

Mon, 07/05/2010 - 21:18 | 453669 maddy10

Most fund managers work with 'Golden numbers' and 'golden ratios' anyway

You can never go away from gold,eh?

Mon, 07/05/2010 - 20:48 | 453653 traderjoe

Ahh, more of the siren song stuff from Leo:

(1) use top 100 managers - but are past returns predictive of future results? As they got to be top 100, can they still deliver alpha? Or,

(2) find young small managers that are about to become top 100 - if that were so easy, wouldn't everyone do it?

Most of this alpha stuff and lust for private equity and hedge funds (with 2/20 fees) and good returns over only one market cycle is more of the call to buy into the Matrix. "We'll get you good returns as we pay ourselves big bucks because we are smarter than you are." Smarter x2.

Mon, 07/05/2010 - 21:13 | 453668 Leo Kolivakis

There is strong evidence of performance persistence, especially in private equity. But that's no guarantee because TPG lost big on Wamu's failure. In hedge funds, we saw Citadel and Farralon Capital Management, two of the top multi-strategy hedge funds, get hit in 2008. There are simply no guarantees. And while smaller managers who deliver true alpha are hard to find, if you have the right team, process, and a few smart quants who can quickly sift through the pile of crap, you'll find some gems out there.

Mon, 07/05/2010 - 21:22 | 453673 traderjoe

Ahh, the proverbial search for that diamond in the rough. Which in someways is responsible for the creation of the entire wealth management system that I referred to as the Matrix. CNBS, Bloomberg, 10000 mutual funds, etc. - all trying to deliver that one nugget of information that proves they know what's going to happen next. Creating the large monster that syphons off the wealth of the middle-class on the promise that one day they might be rich too. Where are the customers yachts?

Mon, 07/05/2010 - 21:32 | 453679 Leo Kolivakis

"Where are the customers yachts?"

Parked in marinas, with the rest of the banksters yachts. :)

Tue, 07/06/2010 - 00:37 | 453844 hungrydweller

Hardly.

Mon, 07/05/2010 - 19:49 | 453578 Leo Kolivakis

My apologies, got jammed and triple posted this one.

Mon, 07/05/2010 - 21:27 | 453678 El Hosel

...."but these are some of the smartest minds in the investment industry and the high value of their investment proposition is obvious over the long term."

The only thing obvious about their proposition is that they had better invest in bear type investments if they want to have any returns as the "no growth recession" rolls on.

Learning From US Endowments?

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