Friday, January 18, 2013

Beware of the Sophisticated Approach: It Isn’t Better; It’s Different

Beware of the Sophisticated Approach:  It Isn’t Better; It’s Different

Among investors, there’s an ongoing debate about the relative efficacy of the traditional investment model versus the endowment model.  The traditional model of roughly 60% stocks and 40% bonds works extremely well in bull markets, but subjects investors to a bumpy ride under less favorable conditions.  The endowment model draws from a wider array of investments, including private equity, various hedge fund strategies, and natural resources.  It produces more consistent returns, although it is prone to collapse under extremely stressful financial conditions

In the past decade, the endowment model appears to have beaten the traditional model rather handily, as the largest university endowments chocked up 9.5% to 10% returns, and pension plans returned 6% to 7%.  The conclusions seem obvious.  First, we should all be clamoring to invest using the endowment model.  Second, sophisticated investing is superior to pedestrian investing.  Third, the folks running endowment funds and the money managers they employ must be smarter than the people relegated to operating in the traditional world of stocks and bonds.

Screwing Up (1996)
Unfortunately, all too many people from individual investors to state treasurers have drawn these conclusions.  They’ve moved toward the endowment model because those trailing 10% returns look so darn tempting.  Alas, you can’t invest in prior returns.  You only get what your investments earn in the future, and I’m pretty sure the two models will not produce as large a gap in the next ten years.  Moreover, I don’t think the gap – 10% for the endowment model versus 6.5% for the traditional model – is as large as it appears.

Let’s first examine a big misperception about the endowment model.  I want to thank Café Carolina in Cary, and Shawn Wischmeier, the CIO of the Margaret A. Cargill Philanthropies, for helping me to think about this.  Shawn has managed pension plans for Indiana and North Carolina and now oversees a major endowment.  The combination of Shawn’s insights and Café Carolina’s caffeine led me to conclude that the major endowments, particularly at the elite universities, really only have one insurmountable advantage not enjoyed by anyone else: wealthy alums.  Harvard lists $909 million in future pledges on its balance sheet.  Yale has $544 million of these commitments, and Princeton enjoys $344 million.  As these endowments invest, they have a high degree of certainty that there’s a cushion of cash waiting in the wings.  Since the cash is still in the alums account, the low returns on the cash don’t pull down reported performance at Harvard, Yale, or Princeton.


Traditional pension plans don’t have loyal alums eager to contribute to their universities.  Rather they have angry taxpayers, who prefer to give as little as possible.  As a result, universities and the endowment model, in general, can seek out less liquid investments which pay higher returns.  They know there’s cash waiting in the wings, especially if times get tough.  Of course, if times get really tough, even well-heeled alums slow down the giving, as the big universities learned in 2009-2010.  Nonetheless, it is easier to make esoteric investment decisions knowing that your principal benefactors are the top 1% of all Americans and not the median household.


If an individual decides to commit all her savings money to the endowment model, there’s no one else to make contributions.  When times get tough and there’s not much cash lying around, she’s going to have to liquidate some assets to make ends meet.  And, selling illiquid assets in a distressed market usually produces huge losses.  It’s not like she can start a capital campaign and ask her friends and relatives to help make up the temporary shortfall because she invested in the endowment model.  So if you’re going to pursue all manner of private equity, hedge funds, and commodities, you’d better set aside a big slug of cash.  Of course, if you’ve got 10% or 20% of your assets in cash, you’re not going to earn 10% on all of your money.


As pension plans scramble to look more like endowments, and the endowments search for new places to generate average long-term returns of 10%, guess what happens?  The 10% returns disappear.  All that capital chasing private equity and hedge funds washes out the extraordinary long-term opportunities.  That’s not to say that they won’t earn an outsized return, of say 20%, in any given year.  They’ll certainly issue a press release trumpeting their windfall if that happens.  The long-term double-digit return is unlikely to come to anyone but the luckiest or most gifted of investors or the entrepreneur who actually creates value.


For those of you still reading this post and still intent on investing like an endowment, there’s still the matter of fees.  The endowments and pension plans pay wholesale fees, and you have to pay retail.  In addition, most of us can only assemble an endowment-like portfolio with the help of an advisor or a fund of funds.  As a result we’re going to lose 1.5% to 2.5% of our investment in the endowment model merely for the privilege of investing. 


You still think 10% is possible?  The Yale Endowment, probably the gold standard of the endowment model, doesn’t think it’s possible.  How do I know?  They’ve said so.  Yale estimates that its portfolio will grow by 6.2% after inflation with about a one in three chance that it will generate a 21% return, and a one in three chance that it will lose 15%.  Even after adjusting for inflation, Yale’s not counting on 10% and neither should you.  Moreover, Yale seems ready for a rocky ride.  Are you?

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