Alternative Asset Replication in Traditional Vehicles: How Authentic Can It Be?

Journal of Financial Planning: September 2012

When David Swensen began managing the Yale Endowment in 1985 as a young Ph.D. in economics (from Yale, of course), endowment investing was a sleepy backwater within the financial world. Nearly all endowments invested close to the then-standard 60 percent domestic equities/40 percent domestic bonds portfolio. Swensen changed that world and succeeded spectacularly.

Today, mutual funds created to mimic “alternative” investments (usually private equity, other hedge fund strategies, real estate, and commodities) popularized by the so-called “Yale model” are readily available to retail investors and, at least conceptually, provide excellent opportunities for individual investors. They have the added benefits of lower fees than hedge funds, greater transparency, and daily liquidity. But they remain problematic in execution.

Swensen’s innovation was recognizing that an endowment’s perpetual life allowed it to handle substantially more risk and substantially less liquidity than endowments typically employed, as delineated in his 2000 book Pioneering Portfolio Management. Swensen posits that portfolios should be diversified far beyond public securities and should hold dramatically fewer bonds. In 1991, 53 percent of Yale’s endowment was committed to U.S. stocks, bonds, and cash; today, barely 10 percent is devoted to domestic marketable securities with only 4 percent in fixed income.

Yale currently identifies seven major asset classes for investment plus cash (with target allocations in parenthesis): private equity (34 percent), real estate (20 percent), absolute return (17 percent), foreign equity (9 percent), natural resources (9 percent), domestic equity (7 percent), and fixed income (4 percent). Yale’s annual net investment returns have averaged 14.2 percent over the past 20 years.¹ Not surprisingly, the Yale model’s success attracted imitators among endowments, followed by pensions and institutional investment managers, albeit often with less than stellar results.² After seeing that from July 2000 through June 2003, as the S&P 500 fell 33 percent Yale’s endowment gained 20 percent, investment advisers broadly extended Yale’s influence to individual investors. Initially, alternative strategies were primarily accessible through hedge funds, usually in the form of limited partnerships, meaning that investors had to have a lot of money to qualify. Alternative mutual funds—SEC-registered vehicles designed to replicate alternative strategies and developed to meet this demand—make such approaches much more broadly available.

The nearly 25 percent loss to the Yale portfolio because of the global financial crisis in its fiscal year 2009 (compared to an S&P 500 loss of roughly 26 percent over the same period—nearly all correlations tended toward 1) led some to question the validity of the Yale model. A report by the Tellus Institute and the Center for Social Philanthropy boldly called for “a transformation of the Endowment [Yale] Model of Investing.”³ The Yale model received additional scrutiny in a paper questioning whether the model’s success should, in fact, be credited to risk exposure as well as manager skill.⁴

Lessons Learned

One difficult patch is hardly sufficient evidence to discredit Swensen’s work. The idea that a broadly diversified portfolio is a low-risk portfolio is common but wrong.⁵ A well-diversified portfolio has higher average expected return for a lower average risk level, but that is not to say that it is somehow sheltered from significant drawdowns. However, there are crucial lessons to be learned from the Yale portfolio’s performance during the crisis. The biggest is that advisers must consider more than just asset allocation across markets. Liquidity risk cannot be ignored, especially when the portfolio is being used to fund substantial current spending.

It is a good rule of thumb that investors (and especially individual investors) generally need more liquidity than they think. During the crisis, when liquidity was difficult to obtain, alternative assets were frequently liquidated at less than 50 percent of the previous year-end net asset value.⁶ Simply put, institutions with insufficient liquidity in 2008 got crushed. As a consequence, Swensen took pains to point out that he “never took the position liquidity wasn’t important, just that it’s generally overvalued.”⁷

Despite the difficulties the crisis brought (the Yale portfolio did out-perform the S&P 500 during that time), individual investors shifting into alternatives continued apace. Indeed, judiciously used and portioned, alternative investment strategies should provide outstanding opportunities to enhance portfolio strength, especially during the secular bear markets. But doing so effectively is much easier said than done. When Mohamed El-Erian, the former head of the Harvard Endowment, was asked if individual investors could mimic what the top endowments do, he replied, “It would be like advising my son or daughter to drop out of school to play basketball with the goal of becoming the next Michael Jordan.”⁸

Swensen’s own book for individual investors, Unconventional Success, specifically advises them not to try to imitate Yale’s success. A subsequent edition of Pioneering Portfolio Management does make a significant concession, however: “I have come to believe that the most important distinction in the investment world does not separate individuals and institutions: the most important distinction divides those investors with the ability to make high quality active management decisions from those investors without active management expertise.”

Despite the concession, Swensen still rejects the idea that the Yale model can be applied to individual investors. “No middle ground exists. Low-cost passive strategies, as outlined in Unconventional Success, suit an overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions.”

Alternatives for the Masses

Financial advisers and their clients have not been deterred by Swensen’s warnings. The Morningstar & Barron’s 2011 Alternative Investment Survey of U.S. Institutions and Financial Advisors reports that approximately 65 percent of advisers indicate that alternative investments are at least as important as traditional investments. Those concerned about liquidity dropped from 60 percent in 2009 to 40 percent, coinciding with the launch of many new liquid alternative products.
All alternative mutual fund categories have seen tremendous inflows over the past five years. Alternative funds saw the second most net inflows of any fund asset class last year (only behind taxable bonds), adding $12.2 billion.⁹ In the first four months of 2012, alternative funds added another $3.5 billion, with total fund assets estimated at $73 billion as of April 30. A study by Cerulli Associates notes that asset managers anticipate alternative mutual funds, which have a 2.8 percent market share today, will make up an astonishing 10 percent of all mutual fund assets in 5 years and 15 percent in 10 years.¹⁰

The use of the mutual fund structure itself for alternatives suggests an inherent dissonance. A crucial virtue of the Yale model is the ability to exploit illiquidity, following a growing body of research that supports the idea that illiquid assets provide the potential for higher return. But strategies requiring less liquid investments (for example, distressed debt) will be difficult to implement via mutual fund structures, which require daily liquidity.

That said, the other primary virtue of the Yale model is better diversification. Commodities exposure can be efficiently obtained via low-cost ETFs. REITs make real estate investment readily accessible. Moreover, some alternative strategies, like long/short equity, lend themselves to replication in a mutual fund format. But not all do. For example, besides those that exploit illiquidity, strategies requiring a significant use of leverage (for example, market neutral) will be difficult to employ as there is a cap on leverage in ’40 Act funds.

These are not the only difficulties. The high fees commanded by the alternative mutual funds as compared with more “vanilla” mutual fund offerings also present a hurdle for such funds. Perhaps most significantly, Swensen is clear that Yale’s investment advantages stem largely from its ability to uniquely align incentives with managers and the extensive resources available to him to select and monitor the best managers.¹¹ Those advantages will be difficult to replicate.

These issues make the general underperformance of alternative mutual funds readily understandable. A recent Morningstar analysis found that only about 10 percent of the equity-based alternatives funds examined outperformed the S&P 500 over the past five years.¹² Only one receives Morningstar’s “best-of-breed” gold rating.¹³ Morningstar also notes that managed futures declined 1.0 percent year-to-date through May and long/short equity funds and multi-alternative funds added just 55 basis points (bps) and 49 bps, respectively, while the S&P 500 was up over 5 percent.¹⁴ Alternative mutual funds have also struggled to achieve non-correlation.¹⁵
Prominent and highly successful hedge fund managers are increasingly entering the mutual fund space. While many of their strategies have been successfully used in the past by hedge funds, there is no guarantee that the transition of these strategies into the mutual fund world will prove as successful. As a class, alternative mutual funds cannot be said to have been successful to this point. Still, we can hope that the strategies that Swensen has shown to be so successful in the endowment context can be effectively adopted by the mutual fund world. Only time will tell. 

Robert P. Seawright, J.D., is the chief investment officer of Madison Avenue Securities and the author of the Above the Market blog.

Endnotes

1. 2011 Yale Endowment update. www.yale.edu/investments/Endowment_Update.pdf.
2. 2011 National Association of College and University Business Officers NACUBO-Commonfund Study of Endowments. www.nacubo.org/Research/NACUBOCommonfund_Study_of_Endowments.html.
3. Humphreys, Joshua. 2010. Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in the Shadow Banking System, A Study of Six New England Schools. Center for Social Philanthropy and the Tellus Institute.
4. Mladina, Peter, and Jeffery Coyle. 2010. “Yale’s Endowment Returns: Manager Skill or Risk Exposure?” Journal of Wealth Management (Summer).
5. Considine, Geoff. 2009. “Not Without Risk.” Financial Planning (September).
6. McGrady, Colin, and Brad Heffern. 2009. “Secondary Pricing Analysis, Interim Update, Summer 2009.” Cogent Partners.
7. Golden, Daniel. 2009. “Cash Me If You Can.” PUC-Rio online article (April).
8. Faber, Mebane T., and Eric W. Richardson. 2009. The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Hoboken, New Jersey: John Wiley & Sons Inc.
9. Zoll, Adam. 2012. “These Alternative Funds Have Delivered.” Morningstar (June 20).
10. Maxey, Christopher. 2012. “Alternative Mutual Funds See Continued Growth.” Morningstar Perspectives (June 5).
11. 2009 Yale Endowment update. www.yale.edu/investments/Yale_Endowment_09.pdf.
12. Zoll, ibid.
13. Maxey, Daisy. 2012. “Morningstar Rates 40 Alternatives Funds, Will Expand to ETFs.” Wall Street Journal (June 21).
14. Maxey, Christopher, ibid.
15. Horejs, Mallory. “Long-Short Equity Handbook.” Morningstar. http://advisor.morningstar.com/uploaded/pdf/Alt_Long-ShortEquity.pdf.