Endowment Model 2.0.

04 / 27 / 2010
by Charles Skorina | Comments are closed

Wanted: Endowment Model 2.0

CIOs and greener pastures

Public pensions seeking hedge funds

The Endowment Model – time for a tune-up?

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A Correction:

Last week we heard from the CEO of Morgan Creek Capital Management who reminded us that he is Mark Yusko and not, as we carelessly wrote, “Mike” Yusko.  We regret the error.

Apologies also to Mike Yusko of Gateway Honda in Port Richey, Florida, who had nothing to do with any of this.

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Endowment CIOs head for greener pastures

Up on the Hudson, the entire endowment management team at Rensselaer Polytechnic Institute decamped last week, and RPI announced that it was outsourcing its $800 million fund to High Vista Strategies in Boston.

This move, after cooking unannounced for six months, saw CIO and Treasurer Wale Adeosun and his two managing directors Mark Larkin and Travis Angevine pull out of Troy, NY, heading for New York City where all three will join Chesapeake Asset Management in mid-town Manhattan.

Mr. Adeosun, hired in 2004, was RPI’s first (and, apparently, last) in-house chief investment officer.  He was hired away from the $5 billion MacArthur Foundation in Chicago, where he was a managing director for equity.

The market meltdown on his watch pummeled RPI, leading to layoffs of about 5% of their staff.  With RPI in straitened circumstances, its president, Dr. Shirley Ann Jackson, has received some criticism for her generous salary.  According to Business Week last February, she was the fourth-highest-paid college president in the nation, earning $1.3 million.  Mr. Adeosun, according to IRS filings as of June, 2008, earned $944,000, including benefits and deferred compensation.

We note in passing that RPI floated a $561 million bond issue last week, raising cash to refinance existing debt and unwind five interest-rate swaps.  S&P lowered its outlook from “stable” to “negative” on the school’s $746 million debt, saying that their financial ratios “continue to deteriorate,” and expressed concern about the school’s reliance on its endowment to pay for expansion projects.

High Vista now manages $3.6 billion, including the RPI endowment.  It was founded in 2004 by Daniel J. Jick, André Perold and Brian Chu.  They manage institutional money and claim to combine the traditional endowment model with a focus on risk management and asset protection.  CEO Dan Jick spent 23 years at Goldman Sachs before leaving to start High Vista.  Mr. Perold is the George Gund Professor of Finance and Banking at the Harvard Business School; Brian Chu worked at Vulcan Capital and Highfields Capital.

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Chris Brightman, CEO of the University of Virginia Management Company, left that job four weeks ago, and surfaced almost immediately in Orange County as a strategist with Research Affiliates LLC of Newport Beach, California.  Official word is that he resigned “for personal reasons.”

Chris was recruited in 2004 from UBS Asset Management where he had been executive director and head of equity strategy.

On his watch the endowment grew from $2.5 billion to $4.4 billion.  Of course, there was that little hiccup in between, when the endowment dropped a billion dollars in 2008/2009, but over five fiscal years it still grew by an annualized 6.5%, far exceeding their 2.9% policy benchmark.  They were heavy in private equity, which hurt them in the short term and drew some criticism.  But PE still gave them an annualized 6.4% through Chris’ tenure, even after losing a third of its value in FY 2009.  In a recent report, UVIMCO indicates that, as commitments are called in, private equity could climb to a peak of 45% of their portfolio until distributions begin to exceed new commitments.  That will be more than their 35% target, but still (barely) within their 15% – 45% allocation band.

In his new job, Chris will be working for Research Affiliates founder Robert Arnott and CIO Dr. Jason Hu.  RA acts as an investment advisor to hedge funds and claims over $46 billion is being managed using their strategies.  They have developed an innovative index methodology, which they patented in 2009.  Mr. Arnott has written some influential and cutting-edge research papers on indexing and other topics with people like the late Peter L. Bernstein (Economics & Portfolio Strategy) and Cliff Asness (Co-founder of AQR).

Back at Thomas Jefferson’s university, John Macfarlane will be directing investment strategy as chair of the investment committee while UVA conducts a national search for Chris’s replacement.  Chris’s total compensation in FY 2008 was $2.5 million per government filings.

By the way, if you’re looking for a nice country place in historic Albemarle County, we note that Chris’s handsome old house, Blandemar Farms Estate, is on the market for $2.8 million.  If he gets the asking price, he’d have a 30% gain over what he paid in 2005.  A guy can dream.  We wish him luck with that and with the new job.

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Coming to hedge funds everywhere – Public pension money:

We speculated in the last letter that the underfunding crisis among public pensions may push them toward higher allocations to hedge funds.  To wit.

The Ohio School Employees Retirement System will boost its direct hedge fund investments by 50%, according to Pensions & Investments.

The $9.5 billion public pension plans to increase the size of its direct hedge fund investing program to 9% from 6%, with a hard-cap target of 15%.  Most of it will go to the thirty funds already in their roster, but they say they will consider adding new managers.  OSERS consultant Askia will be the go-between.  That’s a quarter-billion of new business to the hedges.  Eventually, perhaps as much as $900 million.

And: The Chicago Public School Teachers is issuing a new RFP in search of female or minority-owned hedge funds-of-funds.

CPST dipped their toe into hedges (via fund of funds) for the first time last November, evenly splitting $140 million between K2 Advisors and home-town Mesirow Advanced Strategies.  They announced a 2% allocation, which means they have room for another $40 million.  They seek to put 25% of the total HF cap into minority funds, which is $25 million.  Needless to say, that’s a very small niche.  Roxanne Martino, who runs Aurora Investment, is an obvious candidate, as both a woman and a Chicagoan.  The only other large female-headed hedge FOF I can think of is Jane Buchan’s PAAMCO in Irvine, California, who probably has her presentation memorized already.

Last time, we pointed out that Illinois‘ public pensions are the worst of the worst among the underfunded.  If the pressure is on anywhere, it’s here.  And CPST in particular, got more bad news recently.  By statute, the Chicago public school system was required to make a whopping contribution to the pension next year: $587 million.  But in Chicago everything is…negotiable.  The gang in Springfield cut that amount by two-thirds.  That’s $400 million that the pension won’t be seeing anytime soon.  Of course, the Chicago school system itself is stone broke and in political chaos, so the result isn’t unexpected.

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In Search of Endowment Model 2.0:

I talk to institutional CIOs and their outside fund managers every day, and they all seem to be worried about two things in this uncertain, post-meltdown era.  First: liquidity.  Second: protection against big downside risk.

The chagrin, as they say, flows downhill – via boards and presidents to the guys running the money.  You can argue that they’re fighting last year’s battles, but these are the things that bit them, and they don’t want it to happen again.

Most CIOs run some version or variant of the revered Endowment Model and none of them are ready to throw it out unless something clearly better comes along.  But the EM has revealed at least two vulnerabilities: First, the institutions often found themselves fresh out of the liquidity they absolutely had to have to fund the institutional mission.  Second, those non-correlated asset classes which are at the heart of modern portfolio theory (and its stepchild the EM), didn’t work as advertised.  Instead of some zigging while others zagged, they all held hands and jumped together.

As one board member of a major endowment said to a client of mine:  “Sure, we saw storm-clouds coming, but, given the allocations we had, we didn’t know what

do about it.”

Others have remarked that if the EM were a car it would have a hundred-thousand miles on it by now and maybe it could use a major tune-up.

I’m reading Steve Drobny’s new book, The Invisible Hands, and the fund managers he interviews are also focused on these two points.  Steve is the co-founder of Drobny Global Advisors and previously wrote Inside the House of Money, which I also liked.

Some of the comments from these front-line traders and portfolio managers reminded me of my time at Chemical Bank in Chicago, monitoring our commodity and FX trader-clients on the Chicago Mercantile Exchange.  All the good ones, I noticed, kept a healthy cash cushion to exploit opportunities.  They were also very disciplined about cutting their losses and getting out when the market turned.

So there you are: liquidity and downside protection.  What could be simpler?  But these trading-floor precepts don’t seem to scale up to institutional portfolios.

A trader in the pit can simply write a stop-loss on a position.  Why, I naively asked myself, couldn’t a billion-dollar institutional portfolio do the same thing?  And then I answered my own question.  Portfolio insurance – the wholesale version of a stop-loss – was tried and it failed spectacularly.

On Black Monday in 1987, the stock market had its biggest one-day drop in history, and the institutional money watched their portfolio “insurance” crumble.  Sixty billion dollars of equity assets had been “dynamically hedged” by, e.g., short-selling index futures on the S&P 500.  Heads we win; tails we don’t lose (much).  What could possibly go wrong?

It’s The Fallacy of Composition:  What works for an individual portfolio can’t work when everybody is trying to leave through the same exit.  Selling all those futures contracts at once created a demand for liquidity that couldn’t be met without driving down prices even further.  The underlying assumptions, based on historical experience, didn’t hold when a really big asset bubble burst.  Sound familiar?  One of the Finance Gods – William Sharpe himself – said: “We learned in the 1987 crash that if everyone wants the upside, and no one wants the downside, then everyone isn’t going to get what they want.”

I recite this ancient history for those readers too young to remember it.  My point is that everyone wants a magical formula to make downside risk go away.  Or as one anonymous interviewee says in The Invisible Hands, “Everyone wants noncorrelation, but only when markets are down.”

Dr. David F. Swensen, CIO of the Yale endowment, and his disciples argue that properly-implemented MPT will produce the best risk-adjusted returns that rational minds can devise.  And the best downside protection we can get in the real world, consistent with those returns.  If we have a bad year, and the correlations crash, then we just wait for a reversion to the mean.  If you’re Yale and can wait, theoretically, forever; then, from the point of view of eternity, all will be well.  However, if you’ve got hard-wired liabilities and payouts that can’t be adjusted – like pensions; and no big time contributors to help you out except broke state legislatures – then you have a problem.

If the Endowment Model gives birth to Endowment Model 2.0 then some combination of theorists and practitioners will have to do the midwifery.  Since EM is the stepchild of modern portfolio theory, then maybe we have to wait for the Nobel-chasers to produce a Post-Modern Portfolio Theory.

Then again, maybe we don’t.  A literal PMPT has been proposed which supposedly incorporates the insights of behavioral finance.  It assumes, for instance, that people don’t look at risk as mathematically symmetrical.  Downside risk and upside risk are entirely different things to actual investors.  Who knew?  These and other works in progress from the financial labs are described in a paper published in January by Scott Welch of Fortigent LLC in Maryland.  Much of it is way above my pay-grade, but it’s a pretty good read: “When Bad Things Happen to Good Portfolios: Rethinking Risk and Diversification”

See:  http://www.imca.org/cms_images/file_1344.pdf

While we wait for the textbooks to be re-written, we can also look around to see if individual CIOs are tinkering with the EM.

Writing over a year ago in the Financial Times, Whitney Kvasager pointed to the example of Nathan Fischer, a working CIO at the Lumina Foundation in Indianapolis.  Mr. Fischer’s portfolio looked a bit like what some of the PMPT guys seem to be pushing: A few broad categories of assets based on how they behave in terms of risk, returns and diversification.  He has growth drivers, inflation hedges, deflation hedges, and diversifiers.  No hard target allocations and no traditional index benchmarks (since none of them fit his silos).  So, no time and money spent on frequent rebalancing and chasing index-like returns, which he thinks aren’t very meaningful.  Heresy all around.

I note that Mr. Fischer recently left Lumina, which is now out-sourcing its $1.2 billion portfolio.  Nothing to do with his performance, which was better than most.  So that particular experiment is over.  But others including the Dutch and Canadian pension plans are tinkering with the model right now, and we’ll hear about it in due course.

Nolan Bean, a VP at Fund Evaluation Group advocates an approach almost identical to Mr. Fischer’s in this paper published last June:  “Time to Replace Modern Portfolio Theory.

And that’s without even a cautious question mark.  A bold man.

You can read it here: http://www.feg.com/news-insights/2010-FEG-Investment-Forum/documents/TimetoReplaceModernPortfolioTheory.pdf

Jim Leitner of Falcon Management (who lunches with Dr. Swensen as a member of the Yale investment committee since 2004) is interviewed in both of Steve Drobny’s books, in which he had something to say about managing downside risk:

“The investment process [in endowments, foundations, and pension plans] seems to be driven by a need to generate certain returns rather than a need to avoid absolute levels of loss on deployed capital.”

“We began thinking [after 2008] about purchasing a portfolio of bonds using leverage to mitigate the downside volatility of a real money [i.e., institutional] portfolio oriented toward the Endowment Model with more than 90 percent of its risk in equity-like investments.  We ran some simulations and discovered that even a tiny 5 percent leveraged allocation to long U.S. government fixed income would, over time, generate more absolute return, better ratios of return-to-worst-drawdown, and less significant absolute worst drawdown levels.”

As for liquidity, Mr. Leitner argues forcefully that there is a big opportunity cost to not having cash on hand when infrequent but wonderfully lucrative bargains present themselves.  He thinks, in fact, that some of them appeared over the last year, when many institutions were in no position to swoop.  Leitner makes the point that a Swensenian 1% to 2% “illiquidity premium” pales in comparison to the huge returns available in 2008 to those lucky few (like Buffet) who had cash on hand to buy distressed assets at the bottom.

Somehow, over the last decade, cash came to be generally regarded as the least useful of all institutional assets.  By definition, everything else earned more, so why hold more than the barest minimum?  In fact, why not use leverage to hold even less than zero!  Harvard cleverly managed to hold negative cash for many years.  Minus 5% according to their reports from 1995 to at least 2005.  Only now, in 2010 are they showing a positive 2% cash balance.

What opportunities did they have to pass up in 2008 and 2009 because they had no tactical reserve of cash?  Maybe some bright lad in the B-school could write a paper on that.

I certainly don’t have any answers in my pocket; I’m just talking to people and raising questions.  But a lot of smart guys are thinking through this problem, and I would not be surprised to see some new practices emerge from their work.

I had the pleasure of interviewing Steve Drobny about his book last week, and will have more to say about our conversation in an upcoming letter.

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Singapore vs. Yale:

Gillian Tett filed a provocative story in the Financial Times two weeks ago.  At least, it provoked a couple of thoughtful responses in the blogosphere.

In “Singapore’s Lesson from Harvard Model,” she reported that a debate has been bubbling inside GIC, Singapore’s sovereign fund, about the merits of the Harvard/Yale endowment model as seen through Asian eyes.  Tony Tan, deputy chair of GIC told her that “Any reasonable investor would now want to take another look at this.”  She concludes, rather ominously, that “in a world where more wealth is moving to the emerging markets – and away from America – the question of where the future intellectual leadership for the investment business will be found is becoming ever more fascinating.”

See: http://www.ft.com/cms/s/0/edccd72a0in-11df-9046-00144feab49a.html

Justin Fox, editor of the Harvard Business Review, writing on his blog, responded here: http://blogs.hbr.org/fox/2010/04/why-the-yale-model-of-investin.html

Fox makes a couple of good points.  First, Dr. Swensen is a smart guy who never expected that his model would be static.  On the contrary, “his approach calls for constant thinking and retesting of assumptions and changing of allocations.  Owning hedge funds and private equity and timber in exactly the proportions that Yale’s endowment did over the past decade is almost certainly not a winning investing strategy for the coming decade.  That’s why Yale’s endowment isn’t going to follow it.”  He also points out that the Swensen model works pretty well, as long as it’s run by Swensen.

And, James Picerno, writing on his Capital Spectator blog, had an interesting take here: http://www.capitalspectator.com/archives/2010/04/back_to_the_fut.html

Mr. Picerno notes that it’s not just an allocation to alternatives that distinguishes the best endowments.  It depends crucially on just which funds you get into and when.  And Yale and Harvard had entree to the cream of them, plus the talent and information to judge which among these rather opaque vehicles were worth having.

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Parting ShotPosition Wanted?

Mr. Timothy Geithner, a noted public servant, was interviewed on CNN the other day.  He told Fareed Zakaria that he’d gone to work for the government right out of grad school and conceded (rather wistfully, I thought) that he’d “never had a real job.”

See: http://www.realclearpolitics.com/video/2010/04/25/geithner_i_never_had_a_real_job.html

It occurs to me that someone out there might have a spot for this promising young man.  Give him a chance to test himself in the private sector.  Just call the number below, and I would be glad to convey your offer to Mr. Geithner.  My usual fee schedule will apply.