Modern portfolio theory (the endowment model): It still works.

09 / 25 / 2009
by Charles Skorina | Comments are closed

Charles Skorina looks at people and issues in the world of Endowments, Foundations, Hedge Funds and Alternative Investments.

UC Berkeley hires first chief investment officer

In-house asset management versus outsourcing, the debate continues… the UC Berkeley Foundation just announced that it will outsource its portfolio management to a new standalone management company called, unimaginatively, the UC Berkeley Management Co.

Previously, the UCBF had no CIO as such, just a (huge) board and an investment committee.

The five-member board of the new entity includes such heavy-hitters as Warren Hellman (of the mighty San Francisco-based private-equity firm Hellman & Friedman and “Bluegrass aficionado”) and Laurance R. Hoagland, CIO of the $6.3 Billion Hewlett Foundation.

The new CIO is John-Austin Saviano, whom they plucked from Cambridge Associates. He’ll get $270 K in compensation, which is at the low end of the salary scale for a $ 2.3 Billion dollar asset pool.

Saviano is an MBA from Duke, spent several years at the $4.5 Billion Moore Foundation, and has been specializing in alternative assets:

Brandeis CIO search: I hear the search continues for a CIO at Brandeis. People I know keep getting calls…a tough choice with such a strong pool to draw from.

————————————————–

Modern portfolio theory (the endowment model): It still works.

And now some thoughts from clients, colleagues, and passing strangers about the big economic and investment picture in these interesting times:

There have been heated arguments lately about the “endowment” model of investing and whether, given the sharp drops in returns over the last year, the model is all it’s cracked up to be. David Swenson, the long-time Yale CIO seems to be the poster boy for the strategy, which leans heavily into non-public “alternative” investments that were seldom seen in endowments twenty years ago.

Setting aside for the moment the fact that this model is really just the basic sound portfolio management I was taught at University of Chicago and, that we have experienced over the last thirty years or so one of the greatest run-up in assets prices since our country was founded, the question still remains, is having a relatively large allocation of illiquid assets (private equity, venture capital, real assets, infrastructure) in your portfolio, along with traditional buy-and-hold bonds and stocks, good for institutions in the long run?

My colleague John Legere has some thoughts about this issue in light of the whopping 27% loss just officially reported by Stanford for the fiscal year 2008 (ending June 2009) and the results at a smaller neighboring school, Santa Clara University.

He argues that it’s a cheap shot to say that the “exotic” strategies pursued by Stanford (and its Ivy peers) were too risky, and couldn’t survive a single bad year. But look, over the ten years ending in and including the most recent terrible fiscal year, Stanford still averaged an annual return of almost 9 percent. In fact, the endowment grew by 23% in 2007 alone. You could argue that the “disastrous” 2008 really only wiped out the super-good earnings of the previous year-and-a-quarter or so. And from that angle the strategy still looks pretty good over the longer-haul. And the longer-haul is exactly what an endowment CIO should be looking at.

If you had just bought an S&P 500 index fund and held it over that same ten-year period, you would have lost, on average, over two percent per year! (Most of that loss, admittedly, would have been concentrated in just a couple of bad years, but that’s the whole point about looking at a long horizon). The single-year loss in 2009 would have been comparable to the Stanford strategy, but you wouldn’t have had all those previous fat years to offset it.

Santa Clara University, with its more conservative strategy, posted a significantly smaller loss in fiscal 2009 (although it still lost a painful 20%).

I note that ten years ago — in June, 1999 — Santa Clara had $370 Million. Growing $370 to $540 in ten years implies a straight-line growth rate of just 4.6%. On the same basis Stanford Management Co grew its pool from $5.8 billion to $14.5 billion, implying a straight-line growth rate of 8.7%, close enough to their announced 8.9% ROI. Clearly, SC grew at only about half the rate Stanford managed. This simple metric ignores a lot of financial and accounting detail, including the typical 5% of market value piped into the annual operating budget, but it still tells the story. If you want to grow faster you must either raise ROI or rev up a development effort that’s already peddling as fast as it can.

Of course, this leaves out the important consideration of liquidity. Being heavily into illiquid limited-partnership deals can cause big problems in the short run, even while it enhances returns in the long run. Stanford had to issue bonds to plug the hole in its operating budget last year, and that bond-interest is effectively reducing endowment returns. But it has the borrowing capacity to do it and, over the long run, pulling this emergency lever once or twice in a century might still be a better strategy than relying more heavily on more-conservative and more-liquid public securities.

Another major school, the University of Pennsylvania made a prescient move into U.S. treasuries and dumped financial stocks in 2008, which saved it a bundle over the last year. But that same strategy would undoubtedly have left it far behind the curve if it had been adopted and maintained over the whole past ten years. They timed the market under last year’s extraordinary conditions, and they get credit for doing it well, but that isn’t what we usually expect managers of a permanent endowment to be doing.

As the Great Recession begins to recede and panic subsides, maybe it will be possible to take a more objective look at this whole question. And most likely, as time passes, the “exotic” Swenson-type strategies will turn out to have been the right road all along, at least for the big endowments with the resources to execute them.

All thoughts, comments, and career moves are welcome. To comment or unsubscribe please email me at skorina@sbcglobal.net.