The FT’s Gillian Tett reported yesterday that the “Harvard model” of investing is under the microscope at the Government Investment Corporation of Singapore (GIC), a sovereign wealth fund. The internal debate at the fund carries ” fascinating implications for investors round the world.”
As Tett explains:
The issue at stake revolves around the so-called Harvard or Yale investment model. During most of its recent history, the GIC – like many other sovereign wealth funds round the world – has looked at these huge university endowment funds with envy and admiration. For the Harvard or Yale model seemed to offer an exciting vision for any long-term investment group that wanted to do more than act like a stodgy, old-fashioned pension fund. After all, for 20 years, groups such as Yale earned solid returns, by pioneering a distinctive investment style. This essentially championed the idea of diversifying into illiquid and alternative asset classes, such as private equity, alongside mainstream securities.
But the bloom has fallen from the rose. The soaring successes of Harvard, Yale and other endowments that ventured far afield from conventional pension fund strategies has stumbled recently. Tett quotes Tony Tan, deputy chairman of the GIC, who says: “The whole idea of the endowment model has been very influential [before]. But any reasonable investor would [now] want to take another look at this.”
The Harvard and Yale models weren’t always on the defensive. In happier times, the portfolio strategies of a few choice endowments were things of wonder. What’s changed? Returns, of course, and that’s mostly due to a shift in the trend for betas.
A few years ago, for instance, Yale’s endowment manager David Swensen was celebrated as the new guru du jour. He wrote several books that were widely praised as offering the insights from a financial seer: Pioneering Portfolio Management and Unconventional Success.
In fact, Swensen’s books are quite valuable and worthy of study. At the core of his books are recommendations to focus on a familiar concept: asset allocation. And for good reason, since a fair degree of success or failure flows from strategic decisions, even if the noise of markets in the short term sometimes suggests otherwise.
Earlier in the 21st century, when Yale’s portfolio was reporting returns of 20% to 30% a year, Swensen was considered a genius. Now that Yale and other formerly high-flying endowments are struggling, like most other investors, their so-called models are questioned. That’s unfair in the sense that no one has a secret strategy for asset allocation. Portfolio strategies designed and managed by mere mortals are destined to stumble at times. Why? The future’s uncertain, which means that it’s impossible to consistently hold the ideal asset allocation.
Yet Tett’s article implies that there’s something inherently inferior about the Yale and Harvard models. That may be true, but it’s not obvious from reading her article. As one example, she writes that the Oxford University endowment fund’s one-year losses through June 2009 were less than half as steep as Harvard’s and Yale’s. That’s hardly definitive proof of anything, although it looks like compelling evidence of something on its face. Indeed, by the same reasoning, one could conclude from a few years back that Swensen’s strategy was superior to Oxford’s because the former had superior 12-month trailing returns. That too would be short-sighted.
The larger point in all this is (once again) that asset allocation matters, and that evaluating the merits of any given asset allocation strategy requires a fair amount of effort beyond look at recent returns. Swensen’s previous run of stellar results was largely due to broad portfolio decisions made years earlier, namely, allocating a hefty chunk of Yale’s investments to private equity and hedge fund investments. As it happened, those investments were made early in a period of soaring returns for so-called “alternative” funds. Was it luck? Or skill? Or some of each? Whatever the answer, it’s not conspicuous by looking at 12-month total returns in one period.
But let’s also recognize that Swensen and his team’s particular fund choices were crucial in allocating assets to alternatives. In contrast to the conventional betas of stocks and bonds, fund selection is critical when it comes to buying hedge funds and private equity vehicles. Indeed, it made a world of difference if your hedge fund investments were in Bernie Madoff vs. John Paulson.
By contrast, the stakes tend to be lower in choosing products to represent conventional betas. As one example: You can spend a lot of time and effort trying to figure out which large-cap stock manager will beat the S&P 500 over the next 10 years. But it’s no obvious that this is the best way to channel your analytical resources. All the more so if you own a multi-asset class portfolio. Just don’t try that with hedge funds. If you allocate assets to this realm, you’ll need to do lots of homework. That’s no surprise, since even a modest allocation to hedge funds has the potential to radically alter portfolio results (for good or ill). In short, risk and return are related, all the more so with hedge fund allocations.
Meantime, for all the light and heat in Tett’s story today about assessing the wisdom inherent in the Yale and Harvard models, the primary message is still the same one we’ve heard for years: focus on asset allocation and choose wisely. If you have the talents of a David Swensen, perhaps you should allocate a portion of assets to alternative products. But that’s assuming you have the skills to analyze the funds, which can be devilishly opaque. Even if you have the right stuff, you’ll still need access to the underlying data and inner workings of the portfolios. Swensen and his team had both, but relatively few investors can count on that advantage. The best hedge fund managers are largely closed to all but a select few institutions and wealthy individuals.
That means that for most investors, and perhaps most institutions, focusing on conventional betas is the only game in town. Fortunately, there’s enough action here to keep investors of all types happy. Depending on how you choose to slice and dice the conventional markets of stocks, bonds, commodities and REITs, there are at least half dozen basic choices or as many as 20 to 30. Accordingly, there’s a wide array of returns and risk in so-called plain vanilla index fund choices, as we routinely report on these pages in our monthly updates of asset class returns and in our newsletter.
Should you own something more than conventional betas? Maybe, but it’s not clear that this is a short cut to superior results. And even if you have the analytical skills of a David Swensen, you’ll still need to make informed decisions on your portfolio’s overall asset allocation. Choosing the “right” funds or securities doesn’t matter all that much if the associated market is crumbling.
You can start by considering the true benchmark, the market portfolio, which is the passive mix of all the world’s major asset classes that are available in ETFs and index mutual funds. Each month in The Beta Investment Report, I crunch the numbers on this benchmark and consider the opportunities for second-guessing Mr. Market’s portfolio. As it turns out, beating this benchmark isn’t easy. For the past 10 years through the end of March 2010, for instance, our proprietary Global Market Index cited in the newsletter posted a 3.7% annualized total return vs. a slight loss for U.S. stocks (Russell 3000) and a 6.3% gain for U.S. bonds (Barclays Aggregate).
Can you do better? Of course, but you can also do a lot worse. Ultimately, the answer still revolves around what you do with asset allocation. It’s not always the elephant in the room, but over time it surely casts a long shadow on results. That implies that we should spend more than a trivial amount of time understanding the big-picture forces driving portfolio results and how asset classes interact in terms of risk and return. The literature on this topic is broad and deep, as I’ve discuss in my book, Dynamic Asset Allocation.
On that note, here’s how not to proceed: analyze the most recent returns of several large endowments and draw conclusions about what works, and what doesn’t by favoring the winner. Ah, if it were only that easy!