Hal Holbrook had a wonderful supporting role in the Watergate saga All the President’s Men, a 1976 Alan J. Pakula film based upon the book of that name by Pulitzer Prize winning reporters Bob Woodward and Carl Bernstein of The Washington Post. Holbrook played the conflicted, chain-smoking, trench-coated, shadowy source known only as “Deep Throat” (over 30 years later revealed to have been senior FBI-man Mark Felt). Woodward’s meeting with his source when the investigation had bogged down is a terrific scene.
Sadly, Holbrook’s iconic line – “Follow the money” – was never spoken in real life and doesn’t appear in the book or in any Watergate reporting. Still, Woodward insists that the quote captures the essence of what Felt was telling him. “It all condensed down to that,” Woodward says. More importantly, it provides a profound truth. Indeed, when asked 25 years later on ”Meet the Press” what the lasting legacy of Watergate was, legendary Post editor Ben Bradlee replied with the words of screenwriter William Goldman, if not Mark Felt: ”Follow the money.” It provides good guidance for reporters generally and really good guidance when one is looking at the financial advice business.
With this important touchstone at the forefront, it’s crucial to recall that the financial advice business generally builds products and portfolios for marketing purposes rather than investment purposes. For the industry as a whole, “results” relate to sales far more than to what investor-clients end up getting. Accordingly, the idea is to play to people’s hopes, fears and prejudices rather than speak the (less marketable) truth. Moreover, if something can be positioned as new, novel or complex — and thus offering a plausible justification for a high fee — so much the better.
CalPERS, the highly influential California public employee pension agency, announced in September that it would no longer invest its dollars via hedge funds. That decision is not altogether surprising in that the annualized rate of return of the hedge funds in the CalPERS portfolio over the past decade was only 4.8 percent. The behemoth pension plan sponsor was careful to note that not all hedge funds are bad, but that “at the end of the day, judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size,” the hedge fund investment program “is no longer warranted.”
In essence, CalPERS recognized and acted upon what should be apparent to everyone: hedge fund returns have simply not lived up to their hype. As Victor Fleischer famously put it, “hedge funds are a compensation scheme masquerading as an asset class.” Continue reading
With a new report out from the Yale Endowment, now is a good time to do a heat check on how the so-called “Yale Model” of investing is doing. I have written about the Yale Model numerous times (see here, here, here and here, for example). It emphasizes broad and deep diversification and seeks to exploit the risk premiums offered by equity-oriented and illiquid investments to investors with an investment horizon that’s sufficiently long – in Yale’s case, essentially forever. It has worked exceptionally well for Yale. For others…not so much. Continue reading
For many years now, institutional investors have consistently tried to follow the lead of the Yale Endowment and its talismanic leader, David Swensen, by investing heavily in illiquid alternative investments such as private equity via hedge fund vehicles. Indeed, the so-called “Yale Model” has been perhaps the primary investment innovation in the institutional space over the past 25 years. But the times they are a-changin’.
Universities that routinely spend 5 percent of their endowment assets per year or more have learned that doing so during periods of poor market performance can have serious implications later on, similar to the “sequence risk” faced by retirees taking systematic withdrawals from investment portfolios. Less than stellar portfolio returns over the past decade have thus created some very difficult issues for these endowments, especially those unwilling or unable to curb spending.
William Jarvis, Managing Director of the Commonfund Institute (which sets out to support endowments with respect to their investments), argues that being an endowment fiduciary in this environment requires active management. Really.
The role of the fiduciary is to think in the longest terms – intergenerationally at the least, in perpetuity if possible – on behalf of yet-unborn generations of beneficiaries.
Pure indexation represents an abdication of that responsibility, given that reasonable means exist to obtain access to managers who can diversify the portfolio and enhance risk-adjusted performance over time. It is not active management but rather the siren song of indexation that leads, over the long term, to underperformance. A better way exists, for those thoughtful fiduciaries who choose to take that path.
Given the factual context, that’s an astonishing claim. As a reminder, consider the following.
- As Charley Ellis has pointed out, “research on the performance of institutional portfolios shows that after risk adjustment, 24% of funds fall significantly short of their chosen market benchmark and have negative alpha, 75% of funds roughly match the market and have zero alpha, and well under 1% achieve superior results after costs — a number not statistically significantly different from zero.”
- The institutional subset of endowments doesn’t do any better. On November 6, preliminary data was released concerning endowment performance for the fiscal year ending June 30, 2013, during which endowments averaged 11.7 percent return. Over that same period, the S&P 500 gained 23.42 percent. Over the ten years ended June 30, 2013, endowments averaged 7.1 percent per annum, as compared with 7.17 percent for the S&P 500. Moreover, until this past year, more than 90 percent of endowments with less than $1 billion in assets underperformed in every time period since such records have been kept. Zero alpha there, at best.
- The bloom is off the hedge fund rose too. The HFRX Global Hedge Fund Index gained just 3.5 percent in 2012 and has returned just 1.7 percent per annum over the past 10 years. The S&P 500 has outperformed the HFRX for ten straight years, with the exception of 2008 when both fell sharply. More significantly, a standard 60/40 portfolio has delivered returns of more than 90 percent over that same period compared with a meager 17 percent after fees for hedge funds. That’s negative alpha.
In other words, according to Mr. Jarvis, it is imperative as a matter of fiduciary duty for endowments to keep doing what, in the aggregate, endowments have been unable to do and what hasn’t been working for decades. Einstein may not have actually made the claim, but it is insane to keep doing the same thing repeatedly and expecting different results. Rather than following Mr. Jarvis, most endowments would be wise to follow the advice of Yale’s David Swensen, the intellectual talisman of endowment investing: those without Yale’s access and expertise shouldn’t try to emulate its investment strategies.
Matthew C. Klein of Bloomberg View has a new piece up on the “Yale Model” of endowment investing. The Yale Model is so-called because of the influence of David Swensen, long-time head of the Yale Endowment. Swensen’s book, Pioneering Portfolio Management, is essential reading for institutional money managers and especially endowment managers. The Yale Model is widely imitated by endowments, pensions and other institutions. Many advisors who work with individual investors claim inspiration from the Yale Model too. Here is Klein’s conclusion.
A few institutions have done very well buying exotic assets, paying high fees for the world’s best money-managers and using the proceeds to fund a significant chunk of their operating expenses. (Even the Yale endowment, however, has underperformed the S&P 500 over the past five years.) Most, however, will never be able to accomplish this. Instead, they will buy overpriced boondoggles and pay high fees to have their money managed by mediocre traders. These institutions would be better off putting their assets into index funds that charge low fees and track liquid markets.
I wrote about the Yale Model in-depth here. It’s a lengthy piece with a lot of supporting detail. My conclusion follows.
The available evidence provides a pretty good case for the idea that the Yale Model is past its peak due to overcrowding. A more traditional approach may simply make more sense, even if such an approach is decidedly less “sexy,” especially for those who don’t have Yale’s access and expertise.
Is the Yale Model Past It?
It is axiomatic in the investment world that as an asset class becomes more popular, it suffers from both falling expected returns and rising correlations. In other words, good trades get crowded and their advantages tend to disappear. This crowding happens because success begets copycats as investors chase returns. Mean reversion only tends to make matters worse. In effect, it results in “investing while looking in the rearview mirror” or, as per the title of William Bernstein’s fine new book, Skating Where the Puck Was.
The evidence suggests that this overcrowding is precisely what has been happening with respect to the Yale Model. Continue reading