Follow the Money

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.

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Yale Model in the News

The “Yale Model” (or “endowment model”) of investing has been in the news again this week — see here and here, for example. Accordingly, my work in that area is worth noting again.

 

• Is the Yale Model Past It?
• Smaller Endowments Better Off with Fewer Alts
• More on the “Yale Model”
• Updating the Yale Model
• Checking in on the “Yale Model”
• Yale Model Heat Check

Yale Model Heat Check

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.

Checking in on the “Yale Model”

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’.

Say What?!

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.

1. 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.”
2. 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.
3. 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.

Private equity funds fail to make the grade for Yale endowment

The Financial Times has published a new article on the so-called “Yale Model” of investing. I recommend it, in no small measure because I’m quoted a fair amount. This one, for example:  

“The evidence is pretty clear that unless you have the ability and the resources that Yale does, it is problematic to expect that you could get the level of performance that Yale has.”

 

I encourage you to read the entire article.

Private equity funds fail to make the grade for Yale endowment

Worth Reading

As regular readers are well aware, I don’t frequently offer links to articles, largely because there are others who do it so well (such as Joe Calhoun for Real Clear Markets, Tadas Viskanta for Abnormal Returns, Barry Ritholtz and Josh Brown, among others). But there are four pieces that I want to highlight today, particularly in light of my recent work on the so-called “Yale Model” of investing (see here, here and here).

• Beating the Market Has Become Nearly Impossible
• You’ll never be a Yale superman
• Is Yale a Model?
• Time to Ditch the Yale Endowment Model

I also want to commend Michael Mauboussin’s fine offering on outcome bias which, coincidently, came out the same day I wrote about it (much less comprehensively). It should be read along with his excellent book, The Success Equation, which I also heartily recommend.

• Outcome Bias and the Interpreter

Happy reading.

Updating the Yale Model

The so-called “endowment model” of investing – often called the “Yale Model” because it was pioneered by David Swensen at Yale – remains the most prominent institutional investment approach out there. That approach may still be working for Yale (although some would disagree), but in the aggregate it is not.

Data from 831 U.S. college and university endowments and affiliated foundations, representing over $400 billion in endowment assets, shows that the average return for U.S. college endowments was minus-0.3 percent in the 12 months ended in June 2012 (the most recent period for which data is available).   Longer-term returns are not a lot better.  College and university endowments returned an average of only 1.1 percent annually over the past five fiscal years and 6.2 percent over the past decade, net of fees. There is no way to sugarcoat those numbers.  They aren’t very good.  Moreover, Swensen himself concedes that the “average endowment” runs a 28 percent likelihood of losing fully half of its assets (in real terms) over the next 50 years based on its asset allocations and a 35 percent risk of a “spending disruption” over the next five years.

It should not be surprising, then, that The Portfolio Whiteboard Project brought together a group of next generation institutional investment leaders and asset managers to update the Yale Model by considering afresh what an asset allocation model for the future might look like. The end result (memorialized via a noteworthy “white paper“) was significant and insightful in unanticipated ways, suggesting that institutions do need to go back to the drawing board, but not just for the reasons initially thought.

More on the “Yale Model”

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?

Confessions of an Institutional Investor

My friend Josh Brown (The Reformed Broker) just published an interesting piece, Confessions of an Institutional Investor. Here’s a taste.

“I’ve seen complexity fail over multiple investment cycles in these types of portfolios, but as Keynes told us, ‘Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.’  Somehow simplicity has become the exception while complexity is now the rule.

“I believe that meeting long-term spending needs for institutional portfolios and controlling risk can be accomplished through simplicity.  That’s not to say that it’s easy, just less complex.  A complicated portfolio relies on the hope of being smarter than your investing peers and the markets while taking on added risks.  We all know hope is not an investment strategy.”

Josh concludes by asking, “What do you think?” I’m glad he asked.  What I think is linked below.

• Is the Yale Model Past It?
• The Active Management Challenge