Mar 10th 2011 | from the print edition
THERE can be fashions in investing as well as in the arts. Over the past 25 years many university endowments have moved over to the "Yale model", an investment strategy adopted by the Connecticut-based university in the 1980s. Under the leadership of David Swensen, Yale has invested across a wide range of "alternative assets", from private equity and hedge funds to timber.
The model has worked very well over the long run, for Yale at least. The university's private-equity assets have produced an annualised return of 30.4% since inception; the hedge-fund portion has returned 11.4% a year for the past ten years. The overall portfolio delivered an annual return of 11.8% over the ten years to 2009, easily beating the average endowment.
One idea behind the Yale strategy was that endowments have the luxury of time, since their liabilities (paying for new buildings, academic salaries and so on) stretch far into the future. They can thus afford to invest in illiquid asset classes. Such asset classes may offer a better return simply because other investors (mutual funds, for example) are unwilling or unable to deal with illiquidity.
In addition, the traditional dominance of domestic equities within institutional portfolios put lots of eggs in one basket. There were other sources of return"”the management skills of private-equity houses, the market for distressed bonds"”where the trade-off between risk and reward might be better than could be obtained from the S&P 500 index.
But the model came into question in 2008 and 2009, when the financial crisis hit. In the year to June 30th 2009, the Yale endowment fell by 24.6% and Harvard's portfolio fell by 27.3%, losing the latter a whopping $10 billion (there has been a modest recovery since then). The illiquidity of the portfolios counted against them.
The broader question is whether what worked for Yale and Harvard, for a time, can be a successful strategy for a much broader range of universities over a much longer period. Yale, in particular, has a first-mover advantage; by being an early investor in private equity it was able to get access to the best-managed funds. Later endowments found that some of these funds were closed to new money and were forced to settle for less talented managers and more modest returns.
Another problem is that diversification means more than simply a willingness to invest across a wide range of asset classes. It also requires taking a separate stance from the herd. Some asset classes (particularly illiquid ones) can be subject to a "rowing boat" effect. Mortgage-backed securities were a classic example. Everyone rushes into them, so the price rises sharply and investors pat themselves on the back for their shrewdness. Then something happens to change sentiment. As everyone tries to rush out of the asset, the boat capsizes. The additional returns achieved during the boom turn out to be illusory.
Martin Leibowitz of Morgan Stanley has analysed the characteristics of endowment portfolios over the past ten years. He looked at three portfolios: a classic 60/40 US equity/Treasury bonds split; a Yale-like portfolio with seven separate asset classes; and a portfolio with international diversification but without the illiquid private-equity, hedge-fund and real-estate portions. What is remarkable about these portfolios is how closely correlated they all are with the S&P 500. Even the Yale-like portfolio had a correlation of more than 0.9 (where 1 is a perfect fit).
Another way to measure relationship with the market is "beta". An asset with a beta of more than 1 rises more than the market in bull phases (or falls more when the market drops); an asset with a beta of less than 1 moves less violently.
Sadly for the Yale-like portfolio, its beta rose sharply in the third quarter of 2008 when the market was in turmoil as Lehman collapsed. The beta then fell again as the market recovered in 2009 and 2010. In short, the benefits of diversification were highly diluted. In beta terms, endowment portfolios traded like a traditional 60/40 fund in the boom and then were more volatile in the bust.
Those results ought to weigh on the minds of those planning to follow the Yale example. After all, institutional investors are able these days to invest in the main asset categories for very low fees of just a fraction of a percentage point. Handing over an annual fee of 1-2%, plus a 20% performance fee, to an alternative-asset manager throws away that advantage. As 2008 showed, the asset managers get rich but the investors still get clobbered.
Economist.com/blogs/buttonwood
from the print edition | Finance and Economics
The Economist welcomes your views.
Want more? Subscribe to The Economist and get the week's most relevant news and analysis.
Advertisement
Over the past five days
Over the past seven days
Advertisement
Subscribe to The Economist's free e-mail newsletters and alerts.
Subscribe to The Economist's latest article postings on Twitter
See a selection of The Economist's articles, events, topical videos and debates on Facebook.
Advertisement
Read Full Article »