We now know investing like Yale isn’t easy

By Len Costa

Published: October 28 2008 03:29 | Last updated: October 28 2008 03:29

When financial institutions teeter, liquidity is in short supply and correlations between asset classes converge in unexpected ways, even sophisticated investors can be forgiven for questioning some of the fundamental tenets of money management.

“Our protection is supposed to be diversification,” said one member of the Institute for Private Investors, a peer networking organisation for ultra-wealthy families, during a recent IPI meeting in New York. “It didn’t protect, and it feels awful.”

A key, differentiating feature of the global credit shock is that it originated in the world’s most advanced financial system. As Martin Wolf recently pointed out in his column, this is a problem of complexity, not backwardness.

Complexity also turns out to be a key feature of private investor portfolios: illiquid and opaque alternative managers – largely hedge funds, but also private equity, venture capital, real estate and commodities funds – today account for 46 per cent of the average IPI member’s portfolio, up from 28 per cent in 1999.

Unfortunately, portfolios laden with alternative investments have in many cases not performed.

Martin Leibowitz, managing director of research at Morgan Stanley, examined the risk and return characteristics of a hypothetical endowment model portfolio with a 40 per cent allocation to alternatives between 2003 and 2007. Although the portfolio outperformed a traditional one with 60 per cent in stocks and 40 per cent in bonds, he discovered that it did not materially reduce volatility. In fact, the performance of US equities explained 94 per cent of the endowment portfolio’s overall return.

Mr Leibowitz found similar results between 1993 and 2007, and also discovered evidence that both strong and weak equity markets reduced the relative return of the hypothetical endowment portfolio.

This is unexpected. Over the past decade, the shift into alternatives was inspired in large part by the stunning record of David Swensen, chief investment officer for Yale University. His treatise, Pioneering Portfolio Management, published in 2000, opened many private investors’ eyes to the power of alternatives.

Now, investors are grappling with the fact that investing like Yale isn’t easy. A good many hedge funds, it seems, were not truly hedged. And, as the past few months have shown, risking substantial illiquidity in the quest for outperformance can come at a high cost. In addition, most private investors cannot count on the advantage enjoyed by top endowments: the sizeable cash inflows from alumni and donors, which add to total return over long periods. As Jim McDonald, president and chief executive of Rockefeller & Co, says, major ongoing streams of contributions enable top endowments to tap illiquid investments earlier, stay in them longer and tolerate losses with greater fortitude.

Endowments also enjoy unparalleled access to top-tier funds and are tax-exempt organisations. Conversely, private investors typically pay taxes on their hedge fund investments, may not have access to the top managers, and therefore need to scale a higher hurdle to realise value.

According to an analysis by one IPI member, private investors seeking a target pre-tax return of 10 per cent would need the typical hedge fund to return 14.5 per cent and typical fund of funds to return 17.1 per cent just to overcome the fee burden.

In a survey of IPI members completed last week, more than three quarters of respondents said that “few” to “none” of their absolute return managers have produced positive returns in this down market.

Even so, wealthy investors are not about to abandon hedge funds – or the endowment model – whole-scale. According to the IPI survey, roughly half of respondents plan to hold their hedge fund, private equity, and real estate investments steady.

Some investors and advisers are happy with the performance of their alternative investments and are increasing their allocations.

Mark Green, chief investment officer at Oxford Financial Group, says the absolute return hedge funds recommended by his company have helped his clients reduce volatility during this turbulent time. He expects investing with hedge funds to become less burdensome.

“Investors are going to have more leverage over their managers than they have had in some time.”

Investors and advisers would do well to keep an eye on opportunities outside of the alternatives space. With many traditional asset classes now beaten down to attractive levels, boring once again looks beautiful.