Tuesday, October 30, 2012

Overweight Duck: The Laden Version of the Endowment Model

Overweight Duck:  The Laden Version of the Endowment Model

In the wake of the poor equity markets of the last decade, many wealthy individuals and small endowments sought the magic of the investment model pioneered at Yale University and emulated at other endowments.  The Yale model uses an assortment of hedge funds, private equity, and other alternatives with only a smattering of conventional stocks and bonds.  For Yale the result has been a serene duck: steady performance without the tumult of the stock market over the span of past thirty years.  Dozens of universities have copied the Yale model with varying degrees of success.  After developing the model for their university endowments, many university CIOs decided that there was more money to be made by forming their own firms in order to offer the endowment model to outside investors.  Instead of being paid $500,000 or more for their services, the CIOs bet they could earn millions in fees and performance bonuses.

Y2K Meeting (1999)

University CIOs generally don’t manage money directly, so their product was going to have to be offered as a fund of funds (a fund that invests in other managers’ funds), which contains multiple levels of fees.  Moreover, few of these ex-CIOs are as gifted as David Swenson, the long-time leader at Yale.  Their strategy is to construct a portfolio of highly diverse managers, so that the ebbs and flows of the managers’ investment performance are as unsynchronized as possible (known as low correlation).  They also employ managers who deliberately hedge certain risks in order to further dampen volatility.  In theory, this strategy should produce a serene duck.  However, in practice, investing in this manner produces an overweight duck that is burdened with excessively high fees.

In recent days, the Endowment Fund run by Salient Partners has severely limited the ability of its investors to withdraw their funds.  It seems there’s been something of a run on the Endowment Fund as some $2.8 billion has been withdrawn in the last 2½ years from what was a $5.2 million fund.  As investors have asked for their money back, the fund has become more and more illiquid, and Salient has been forced to stop withdrawals.

What went wrong?  Just about everything.  First off, investors gave up on good old stocks and bonds just about the time that the financial markets bottomed out.  In other words, they sought refuge in products like the Endowment Fund only after the stock market had been on a long losing streak. As they jumped onto the back of the serene duck, the stock market took off, and the Endowment Fund and similar products were bound to disappoint investors. 

Second, billions of dollars poured into these endowment-type strategies, and as per usual, too much money turned reasonable investments into mediocre ones.  As a result, the alternative managers failed to deliver, and the duck, while serene, started to ride low in the water. 

Third, fees burdened these “endowment” funds.  The Prospectus for Salient Alternative Strategies Fund, which feeds investor money into the Endowment Fund, lists a management fee of 0.75%, a service fee of 1.00%, borrowing costs of 0.32%, and other expenses of 1.62%.  In short, 3.64% of an investor’s money goes to various fund expenses.  The duck is taking on water. However, the expenses thus far haven’t accounted for the cost of investing with the underlying money managers.  These managers add another 1.63% in management fees, 0.38% in performance fees and 2.37% in other expenses.  When you add it all up, the duck is completely underwater, as there are 7.24% in total fees to be paid before Salient’s investors make any money.  If you checked my math, the total is 8.06%, but Salient has graciously offered a rebate of 0.82%.  However, the true burden is even higher as the fund has experienced about 55% turnover in its assets and managers, which probably adds another 2% or 3% in costs to investors.   

Just for this duck to earn 7% for its investors, which would on the low end of expectations, the underlying managers would need to produce an average gross return of 15% or 16%.  They didn’t come anywhere close, and it’s highly unlikely that they ever would over any meaningful period of time.  As a result, investors decided to redeem their capital.

Let’s be clear about two things.  Investors were offered plenty of documentation about the fees and expenses of the Endowment Fund.  This is a product that was going to be ridiculously expensive from the very start.  As per usual, the only ones who made great money on this product were money managers and their service providers.  At its peak, the Endowment Fund was probably throwing off about $140 to $150 million per year to money managers and another $225 million to service providers.  I bet the marketing pitch was compelling and was delivered in some posh settings.  Of course, the fees gave managers plenty of cash for the marketing extravaganza.

While a portfolio that consists of 60% in stocks and 40% in bonds will never be a serene duck, it is a reasonable long-term way for most investors to deploy their capital.  If investors use index funds or exchange-traded funds (ETFs), it can be inexpensive as well.  There’s one shortcoming; investors won’t be able to brag that they’ve got their money invested in “sophisticated” strategies with brilliant hedge fund managers in a serene duck.  On the other hand, a viable strategy is better than drowning water fowl.

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