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A Lesson in Liquidity?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
I want to follow-up on my last post on Harvard's mea culpa. Last week, James B. Stewart reported in the WSJ that Ivy League Schools Learn a Lesson in Liquidity:
Just
a year ago, in the midst of the subprime meltdown, many of the nation's
top universities and colleges were reporting significant gains. This
year, the University of Pennsylvania is being hailed for Ivy
League-leading results—with a decline of 15.7% for its fiscal year ended in June.
Results
from other schools are still trickling in, but Harvard University has
said it is expecting to report a drop of 30%, and Yale University about
25%. Considering the size of these endowments, these are staggering
losses in absolute terms—many billions in the case of both Harvard and
Yale.
Students soon will be heading back to larger classes,
curtailed extracurricular activities and cheaper dining-hall fare. But
the results are also of more than academic interest to investors like
me, who have to some degree modeled their portfolios on the diversified
asset-allocation model pioneered by Yale's chief investment officer,
David Swensen. What I refer to as the Ivy League approach for
individuals calls for diversification along similar lines as the large
university endowments—equities (domestic and foreign), fixed income,
and real assets (which includes commodities and real estate), but with
a much higher allocation to so-called nontraditional asset categories:
emerging-market equities and debt, energy and commodities. Yale
allocated just 10% to U.S. equities and 4% to fixed income, with 15% in
foreign equities and 29% in so-called real assets as of June 30, 2008.
The
major difference is that most individual investors didn't qualify or
otherwise couldn't invest in the hedge funds and private equity and
venture-capital partnerships that make up a large part of university
endowments. At Yale, 25% of the endowment was in what the university
calls "absolute return," mostly hedge funds, and 20% was in private
equity.
The irony is that turned out to be a huge advantage for
individual investors this past year, when, in the midst of
unprecedented market turmoil, many endowment managers learned the true
meaning of "illiquid." The exits for most private equity and
venture-capital funds slammed shut. Existing positions yielded no cash
flow even as investment partnerships made new demands for funding. Many
investors were forced to sell their liquid investments into weak
markets to fund cash needs and to meet prior commitments to investment
funds. Asset allocations went wildly out of balance, overweighted to
illiquid partnerships as the value of equities plunged. It's a wonder
that last year's results weren't even worse.
Liquidity
turned out to be the Achilles' heel of the Ivy League model. But what
about its core premise—diversification? True, nearly every asset
category declined at some point in 2008, even those that were supposed
to be uncorrelated, like equities and high-quality corporate bonds.
But
for individuals who followed a diversification strategy—and who weren't
forced to sell anything at distressed prices—those values have
rebounded sharply, with many of the nontraditional categories, such as
emerging-market equities and commodities, outperforming U.S. stock
indexes. By sticking to liquid alternatives to private
partnerships—such as mutual funds, exchange-traded funds, and
real-estate investment trusts and publicly traded stocks and
bonds—individual investors should have done far better than even the
University of Pennsylvania.
Penn, too, found itself in quite a
few illiquid partnerships. But it notched its league-beating return
with some old-fashioned market timing. Chief Investment Officer Kristin
Gilbertson recently told The Wall Street Journal that in early 2008 she
started reducing the portion of the endowment in public equities to 43%
from 53% and put about 15% in Treasurys. It turned out to be a shrewd
move, and by endowment standards, which rarely stray from predetermined
asset allocations, a bold one. The highly liquid Treasurys were one of
the few assets to hold their value over the period and also enabled the
university to meet capital calls from private-equity firms.
Market
timing can be difficult, but I suspect some degree of it will
increasingly be worked into endowment-allocation models. It will
probably take years for the lessons of 2008 to be absorbed. But you can
be sure that liquidity will gain new respect.
I
think that in the environment we are heading in, there will be a
premium placed on liquidity. Long gone are the days where you tie up
your money for ten years in private equity or accept lock-ups of three
years with some hedge fund (some are stupid enough to do this).
Investors are thinking long and hard about their liquidity needs as their pension plans mature. Some pension funds are eying commercial property,
but the majority are standing pat. Mr. Gilbertson's shrewd move into
Treasuries saved Penn's endowment fund from serious losses in 2008
and I happen to think that these type of portfolio shifts will be
required if you're going to make money in the next decade. But market
timing is a double-edged sword because if you're wrong, you risk
seriously underperforming your policy portfolio. Again, focus on what
Harvard's Jane Mendillo said, you have to stay liquid and be nimble.
Finally, please take the time to listen to my interview with Steve and the crew at Two Beers With Steve Podcast. It is an informal discussion on pensions where I share some of my thoughts on the pension crisis and its long-term implications.
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Great article. Thanks Leo
pivot,
You make an excellent point here:
"Point is, if you have found a good investment opportunity, it shouldnt matter whether its liquid or illiquid, but you should always keep TRUE liquidity in mind when structuring an overall portfolio, especially when you have cash needs."
BUT, how do you really know illiquid asset classes have bottomed? You have to be sure the global economy has bottomed and that the risks of a double-dip have subsided.
It is easy to throw billions in real estate and private equity now claiming that the "worst is behind us" but if you are wrong, you are stuck waiting out the cycle - and it could be a long cycle.
this is too simplistic and i disagree that lock-ups are going away. like every investment and/or asset class, there are good times and bad times to get in. just as you are likely not being properly compensated for buying a HY bond when spreads are +200 over UST, you have likely not been earning much premium for illiquidity over the past several years (just levered equity beta, for which you really don't need a lock-up).
and I agree that 40%+ is too high an allocation to illiquid investments (targeting a % allocation for illiquids is close to impossible given all the moving parts in a portfolio and the uncertainty of cash flows), but that does not mean that 10% or 5% is not accretive to a portfolio of traditional, liquid assets.
Point is, if you have found a good investment opportunity, it shouldnt matter whether its liquid or illiquid, but you should always keep TRUE liquidity in mind when structuring an overall portfolio, especially when you have cash needs.
Dear 11,
Diversification failed in 2008. Period. Correlation matters most when a systemic crisis hits, but most pension funds were caught with their pants down.
Leo
hi leo,
i thought that one of the most importanat words you used here in this column was nimble. if you're aware and nimble and liquid enough, you can avoid being eviscerated and even profit by getting turned around in a timely fashion.
another great column. besides liquidity, correlation can also be a deadly trap. so deadly.
what makes correlation so beautiful, and deadly to the hapless, is that it's dynamic, not static. correlations change. whenever someone presents you with an average correlation, you're getting the same quality of information that enabled the hapless person to drown in a river whose average depth is 6".
economic shocks, events, and circumstances can cause everything you have to correlate against you. the Nobel laureates at LTCM experienced this first hand. they used diversified average correlation as one of their panaceas. then the russian bond market blew up and suddenly everything they had was correlated against them. by the time they realized the problem, they were already dead. too little liquidity and too much leverage.
liquidity could help you avoid this trap if only you have active effective risk management and objective non-discretionary loss containment strategies.
average correlation kills.
I was driving home at average 65 mph last week, the police stopped me and ticketed me for speeding, what?!
absolutely couldn't agree more
The endowments in are an even deeper hole considering that their nominal losses do not take into account currency depreciation; and I am talking in terms of Gold, not the flawed and misleading DXY. We are entering an era where currency depreciation will ensure that nominal gains, even those which were heretofore considered significant, will only mean that you have just broken even in terms of purchasing power. The fallcy of using the constantly shrinking scale of fiat money to measure "growth" in the economy or in their portfolios will be obvious to all, i.e., the emperor will be naked for all to see. Most investors - even small ones - will begin to evaluate the growth in their portfolios in real terms such as Gold. Furthermore, the present economic crisis is centered on Gold far more than most people imagine - a Perfect Storm for Gold, if you will. Hence, in hindsight, IMO, the best investment for the next decade will have been Gold itself. Yes, John Paulson will beat 'em all again.
good points...daily reckoning called out gold
in 2000 as the investment of the decade but they
have backed off that for poor reasons....it is
still not too late to get on the gold train....
once the manipulations are knocked out gold will
appreciate substantially more....it is significantly
under priced from many perspectives....
but the more important point is to price other
assets in terms of gold which is the only money
anyone has....everything else is a chimera....
to see how other assets price in terms of gold
i would use runtogold.com which keeps a running
tally of these things....this lets you know what
is cheap and expensive.....the frn is total piece
of crap...