As I am MBA bound in mid-August, I thought it was a good idea to present Bloomberg's recent article (http://www.bloomberg.com/apps/news?pid=20601109&sid=aQn_Cxyu99xY) on how the market rout of the past two years has affected Universities throughout the world. Most University endowments lost 20-30% from their peaks in (roughly) June 2008, and I believe the results achieved by the endowments will have prolonged effects on North America. It is well documented that we are past the industrial revolution and that we are well into the technological revolution. For North America to continue its lead on the world stage, we must continue to grow our technological lead, because this is where the future lies. At its most basic level, future growth will come from investment in the educational infrastructure of our society. These investments are designed to help spur innovation, eventually leading to impactful changes on our society (scientific, commercial, etc). Simply put, this is a requirement for the success of our society.
As pointed out in the article, many of our higher educational institutions that produce these breakthroughs have been forced to cut back on funding - postponement of the construction of buildings, lowering of professor salaries, halting program expansions, shrinking programs and research projects, etc. Furthermore, these cuts will be long-lived, because Universities generally derive a large chunk of their funding from endowments. However, to protect from outlier year's returns affecting funding, universities generally smooth the asset values of their endowments over three years to attain an average from which to draw a percentage of said funds for spending purposes. While this approach works the majority of the time, a problem really arises in times of distress where the endowment suffers multiple down years. Universities have already cut back on spending to compensate for an inevitable decline in their income stream; however, this decline will almost certainly be semi-permanent in nature. In fact, the larger and more prominent endowments are predicting that they will not be able to achieve their peak endowment size for anywhere from ten to fifteen years. To me, this means restricted growth in University funding, which may translate into slower long-term growth in our society - something that we cannot allow to happen.
While few organizations saw the market correction coming, I believe most endowment's investment strategies have actually aggravated their losses in this downturn. To understand how this occurred, you must understand that endowments were founded on the Prudent Man Rule, which basically states that they must manage their assets as a "prudent man" would, focusing on capital preservation primarily, followed by the earning of a respectable return. By that definition, most endowments have failed miserably over the past two years. As the purpose of an endowment is to fund long-duration liabilities (the maintenance and growth of the income stream of a University into perpetuity), the natural thing to do is to match those liabilities with long-duration assets. The first iteration of endowment investment strategy involved their assets being invested in long-term government bonds and high-quality corporate credits. This continued until equities started becoming a viable institutional asset class (again) in the 1950's and 1960's. During that time-period, Modern Portfolio Theory was created which was then incorporated in the endowment world - most famously by David Swensen, Yale's endowment manager. Swensen pioneered the use of MPT in endowment asset management starting in 1985, and focused on diversification as a way of achieving higher alpha. However, he did not simply diversify based on credit rating or sector. Swensen diversified into unconventional and uncorrelated asset classes such as hedge funds, real estate, venture capital, private equity, commodities, and timberland. Yale's endowment benefited handsomely from this approach to asset management for years, generating double-digit returns (http://www.yale.edu/investments/Yale_Endowment_08.pdf) which other endowments envied and eventually imitated. Although, this approach was like a double-edged sword, as the common link amongst all those investment asset classes is that they are illiquid and have high frictional costs. For example, hedge funds often have lock-up periods of two or more years. Private equity funds have lock-up periods of 7 to 10 years. Real estate and timberland can be notoriously illiquid, especially at the wrong time and price. Endowments embraced these asset classes and increased their portfolio weightings throughout the 1990's and 2000's. The additional alpha generated from investing in unloved and uncovered areas helped produce +15% returns for most endowments over this period. However, when the liquidity-seeking panic selling began in mid-to-late 2008, endowments were caught offside, losing billions in the process. These funds are not nimble and cannot turn their strategies on a dime. Their actions affect the market because, in essence, they are the market, and this is especially true when you consider that the size of the market for these strategies can be small. They are also inefficient, resource intensive, volatile, hard to enter and exit, and expensive to enter and exit. Furthermore, as the Bloomberg article pointed out, these areas have been slow to rebound, and it is very difficult to say whether or not they will reach the level of popularity they achieve pre-credit crisis. Some of these endowments are now stuck in these illiquid investments, and have been forced to raise cash for funding requirements via debt issues (Harvard issued $2.5bn in debt in 2008). In short, the acceptance of illiquidity has now caused long-term structural issues in terms of asset and liability matching. These funds, supposedly conservative in nature, are having a difficult time meeting their mandates - providing stable streams of income to match their Universities funding requirements.
As they say, hindsight is 20-20, which is why I believe it is actually hard to fault these managers for pursuing such strategies. The investment world is complex and competitive. These managers had the proverbial gun to their heads and were involved in a dual - the pursuit of the highest alpha. The truth is that if they did not pull the trigger in employing these alpha-seeking strategies, somebody would come along and pull the trigger at their expense. Furthermore, it is hard to fault them for being unable to change what has worked for so long. As humans, we are susceptible to hindsight bias. Seeing a competing manager consistently earn +15% returns with low volatility for years will often fool us into believing that that strategy is sustainable. This is clearly not always the case, and certainly brings into question the wisdom of maintaining an investment policy of effectively static portfolio weightings in asset classes over the long-term.
It makes one wonder whether straying from the essence of the Prudent Man Rule was so wise? Does the pursuit of return trump the pursuit of capital preservation? Although my investing career has been relatively short, the longer I am in this game, the more I think that capital preservation is the essence of investing. Wealth accumulation is, after all, path dependent. Simple arithmetic tells us that losing X% requires us to produce a return greater that X% for us to simply get back to even, and more importantly, it robs us of the time (read: opportunity cost) that our funds could be employed in an investment producing positive returns.
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