Tuesday, November 12, 2013

Boring is Best?

James Stewart had a good column in Saturday's New York Times on the superior investment returns that small college endowments have been able to achieve relative to their larger brethren.

Over the past couple of decades, colleges have moved away from investing in publicly-traded stocks and bonds in favor of alternative assets. 

The idea was that investing in private equity and hedge fund vehicles run by sophisticated managers would be able to provide superior returns with less volatility than traditional investment strategies.

This concept was first pioneered by Yale's David Swensen.  Swensen's research suggested that investing in non-traditional asset classes provided superior long term results for patient investors.  In addition, a portfolio of alternative asset investments was less volatile than investments in publicly traded stocks and bonds.

The strong investment results that Yale's endowment produced for much of the last decade was proof that Swensen was onto something, and many other colleges and universities followed suit.

However, as more funds copied Yale's approach, returns have been gradually reduced. 

Here's an excerpt from a piece I wrote on Random Glenings on March 25, 2013:

The Yale Model became the focus of much attention on account of its performance during the tech bubble.  From July 2000 through June 2003, while the S&P 500 fell 33 percent, Yale’s endowment actually gained 20 percent.  Yale’s portfolio continued to perform well until 2008 (returns of 19.4 percent in fiscal 2004, 22.3 percent in fiscal 2005, 22.9 percent in fiscal 2006, 28.0 percent in fiscal 2007 and 4.5 percent in fiscal 2008 – through June 30, 2008).

As the article notes, the tremendous success of Swensen's approach inspired a wide variety of endowments to mimic his approach. Indeed, working with Swensen at Yale became almost a rite of passage for any chief investment officer at prestigious institutions like MIT.

More recently, returns from the Swensen approach have not proved to be as strong as in prior periods.  Indeed, the article notes that a simple 60/40 stock/bond allocation has outperformed many endowment funds that followed the Yale model:

A simple 60/40 portfolio invested 60 percent in an S&P 500 index fund and 40 percent in a fund tracking the Barclays Aggregate bond index would have gained 12.6 percent annually over the last three years and 2.8 percent over the last five years, as compared with 10.2 percent and 1.1 percent, respectively, for the average endowment.  Yale did somewhat better than the average endowment with three-year returns averaging 11.83 percent and five-year returns averaging 3.08 percent. 
What's going on here?

The authors suggest that perhaps too many institutions are investing in the same asset classes, which is dragging down overall returns.  In addition, as they parse through the numbers:

The bottom line here is that Yale’s success has been driven largely by private equity – mostly venture capital – returns.  Outside of private equity, the research suggests that Yale appeared to underperform appropriate risk-adjusted benchmarks.


Stewart's column on Saturday echoed the report that I first published last spring.

Namely, that the combination of high fees, and too many funds flocking to alternatives, has pushed returns much lower than expectations.

Here's an excerpt (I added the emphasis):
...The data released this week shows that small (less than $100 million) and midsize ($100 million to $1 billion) endowments — which typically have smaller allocations to alternative investments — have surged ahead of the largest endowments over the most recent three- and five-year periods. 
Endowments with assets under $25 million reported the highest average three-year return, at 11 percent, while those with assets between $25 million and $50 million reported the highest average five-year return, at 5.5 percent, according to the business officers association.

The largest endowments led over 10 years and longer, and Yale still holds the 10-year crown with annualized returns of 11 percent. But that’s only because the strong performance of alternative assets in earlier years supercharged its results. It’s no secret that since the financial crisis, many alternative assets have been a drag on performance. 

Hedge funds — whose owners typically charge 2 percent of assets under management and 20 percent of any gains and, in some cases, even higher — have performed dismally over the last three and five years, with annualized returns of just 3.88 percent over three years and 5.03 percent over five, according to the HFRI composite index of hedge funds. By comparison, the Standard & Poor’s 500-stock index has had annualized gains of 15.2 percent over three years and 15.34 over five. 

Now, to be sure, I think part of the problem is a matter of size.

An endowment that is less than $25 million in size really doesn't have the access to the top alternative asset managers that an institution like Yale does.  Their recent investment success may more fortuitous than sagacious.

On the other hand, the lesson for most of us may be that simplicity when it comes to investment strategies may be the best course.