Alternative Investing: Harvard, Yale and Retail Investors

Institutional investors often identify seven major asset classes plus cash as part of a multi-asset portfolio: private equity, real estate, absolute return, foreign equity, natural resources, domestic equity, and fixed income.  And given the success of endowments such as Harvard and Yale who use of what maybe called panoramic and risk taking models (the terms, panoramic and risk-taking are from Bob Rice’s recent book on Alternatives) and have averaged 20% or better returns over the past 20 years, have tempted other endowments, pensions and institutional investment managers to follow Harvard and Yale’s lead, often with less than stellar results.

Seeing the 20% or more return both over a 20 year period and from June 2000 thru June 2003 when the S&P 500 dropped 30%,  wealth management advisers started using the panoramic and risk-taking model (hereafter referred to as the P&R model) for their individual investors.  Initially, alternative strategies wealth managers were using primarily hedge funds, usually in the form of limited partnerships.  This meant investors had to have a lot of money to qualify.  Alternative mutual funds—vehicles that are designed to replicate alternative strategies and developed to meet the growingdemand—have started to make the alternative approach in general broadly available.

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During the global financial crisis when the most prominent endowments lost 20%, 25% or more, (the S&P 500 lost 26% percent over the same period) some investors started to question the validity of the P&R model.

One difficult patch is hardly sufficient evidence to discredit the work of endowments and others that have earned so much over the years.  However, the idea that a broadly diversified portfolio is a low-risk portfolio has been proven wrong. 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.  This means there are crucial lessons to be learned from the performance of the P&R model during the credit crisis. One of them is that advisers must consider more than just asset allocation across markets.  And liquidity risk cannot be ignored, especially when the portfolio could or is being used to fund current spending.

It is a good rule of thumb that individual investors generally have more liquidity than they think. During the crisis, when liquidity was difficult to obtain, alternative assets were frequently liquidated at less than 50% of the previous year-end net asset value. Simply put, institutions with insufficient liquidity in 2008 got crushed.

Despite the difficulties the credit crisis brought, individual investors continue to move into alternatives. Indeed, when judiciously used, alternative investment strategies can provide opportunities to enhance portfolio strength, especially during 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.”

The use of the mutual fund structure itself for alternatives suggests however, a potential dissonance.  A crucial virtue of the P&R model is its 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 P&R model is better diversification. Commodities exposure can be obtained via low-cost ETFs.  REITs make real estate investment accessible.  Moreover, some alternative strategies like long/short equity lend themselves to replication in a mutual fund format. But not all alternative strategies do.  For example, besides those that exploit illiquidity, strategies requiring a significant use of leverage 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 compared to more “vanilla” mutual fund offerings could present hurdles for such funds. Perhaps most significantly, a significant part of the endowment/pension fund model advantage stems from its ability to uniquely align incentives with managers and the extensive resources available to the manager to select and monitor the best managers. These advantages will be difficult to replicate in the retail space.

These issues make the general underperformance of alternative mutual funds understandable.  A Lipper analysis in 2013 found that less than 10% of the long/short equity funds outperformed the S&P 500 on a risk-adjusted basis during the past three years.  Lipper notes that absolute return funds declined 1.3% for the 12 months ending March 2013 and none of those funds as of the end of March 2013 had the necessary risk-adjusted which could minimize the S&P 500 volatility.  And alternative mutual funds, such as absolute return funds, have at times struggled to achieve non-correlation.
Prominent and highly successful hedge fund managers are increasingly entering the mutual fund space. While many of their strategies have been used successfully by hedge funds in the past, 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 hope that the strategies that endowment and pension funds use so successfully in their respective contexts can be effectively adopted by mutual funds.