How to invest can be reduced to two choices: system player or entrepreneur. System players are happy to harvest the risk-related returns available just by exposing capital to risk in public markets. Entrepreneurs, as in other fields, are not content with market returns and want to create wealth through individual skill. System players depend on the wisdom of crowds. Entrepreneurial investors depend on the wisdom of wizards.
One of the big trends in investing in the last two decades has been that investors who are naturally system players have adopted entrepreneurial investment approaches. A prime example is boards of trustees of American college and university endowment funds collectively moving endowment assets out of public equities and bonds into ‘alternative investments’. Last month the FT reported some new data for the some 800 endowments (data through the fiscal year end of June 2016). This shows a staggering 53% of funds committed to alternatives. The largest category of alternatives is hedge funds (20% of all alternatives) followed by 11% in private equity with the rest accounted for fairly evenly by each of other venture capital, natural resources and direct property.
What’s special about endowments is that they are in ‘drawdown’, just like retirees. But whereas retirees may choose to exhaust the principle, endowment trustees have a duty to keep the capital going or not to run it down below a level it can in time recover from. Since both are funding current spending, the key is that the draw should be increased with inflation and that it should be fairly stable. Similarly the value of the principle should not be eroded by inflation. The key difference between them is the spending rate consistent with either retaining or depleting the capital. Individual endowments, like individual retirees, will set their own constraints on how important it is to avoid cutting the draw as a consequence of how they view the consequences. On average the American endowments are drawing at a rate of 4.3% of capital. But that contributes between 5% of their total spending budget (for poorer endowments) and 16% (for the biggest) so there is more flex in the draw than a retiree, more dependent on the draw, might tolerate.
Maximising draw subject to constraints is not an easy problem to solve. So it was natural that investment consultants would argue that conventional, simple approaches to investing that relied on systematic returns from public markets were less suitable than methods that could meet the return objectives but without the same risk of cutting the contribution to spending or, by making errors in the judgement of the sustainable draw rate, depleting the real purchasing power of the capital. The consultants’ hypothesis was that alternatives did this by mixing more asset classes than are available in public markets and with lower correlations between them than other asset classes. But they also meant replacing evidenced systematic asset-class returns by less predictable returns and correlations, more dependent on individual wizardry to generate the returns within each element of the mix. The consultants may have wanted to be seen as wizards too, conjuring higher fees for themselves.
The FT article was making the point that in the past two fiscal years endowments have not earned enough (-1.9% last year, 2.4% the previous year) to maintain the real value of the capital at their actual draw rates. This is topical because there have been some spectacular shortfalls amongst institutions who had themselves been elevated to wizard status by embracing and championing alternatives early – notably the endowments of Harvard and Yale. Clients of the investment industry, not just in America, are asking the awkward question: are alternatives really a good alternative?
My feeling is this is a little unfair. It is far too short a period to judge whether the draw rate was set too high for the actual sustainable trend of real returns from the overall fund or even whether the draw rate can safely be set higher with rather than without alternatives. But there is something we can do to check whether over a longer period the entrepreneurs are beating the system players. Let’s take 10 years as a good enough window and see how the endowments would have fared if they had stuck to conventional asset mixes using public markets: US and international equities and bonds and maybe a bit of real estate.
A bit of Googling led me to Bogleheads where I found there are about half a dozen so-called ‘lazy portfolios’, based on fixed weights in core public asset classes, associated with respected investment professionals and writers like William Bernstein. The simplest two-asset portfolio can be implemented in real life and is often a default fund of choice for US retirement accounts: the Vanguard Balanced Fund – with the classically-conventional 60:40 US equity: bond mix. Variations add international equities and some break the bonds down between US and international. These lazy portfolios over the past 10 years have all earned around 6% pa with a standard deviation of around12%. This compares with the mean of the endowment funds of 5%.
There is a question to be answered about whether the lower return for endowments came with any significant gain in lower volatility. On the surface, adding wizardry has generated a lot of extra cost, maybe just about recovered in returns earned after fees, but for no obvious gain in utility for the client. After all, a key aspect of investor utility is the ease of living with the adopted strategy. What’s going on in the meeting rooms of boards of trustees and investment committees today tells us that when alternatives go through a bad patch they do not engender the confidence required.
My guess is the same doubt is being expressed by retirees in drawdown in the UK who were talked into elaborate multi-asset class portfolio structures or products, most of whom had far less chance of identifying (or getting access to) the market’s few real wizards and are paying retail product costs far in excess of institutions.
Unfortunately, this does not mean we should return to the old convention. Framing the choice for managing drawdown as one between conventional public-market asset classes and alternatives is in our view a false one, today. This is because the conventional systematic approaches, including all the lazy portfolios, rely on the low correlation between equities and bonds to control the overall portfolio volatility. This has worked well in the past, particularly in the 10-year window I have chosen, because bonds have performed so well. Hence the close bunching of different lazy mixes around a mean of 6% pa. As the Great Moderation in inflation and the subsequent QE experiment reach natural conclusions, the core basis of risk control will not produce the same costless tradeoff between meeting long-term objectives and maximising the safely-sustainable short-term spending rate. Disappointment will be rife.
For the coming years the core asset-class building blocks have to be even simpler than in the past: equities and cash. Dilution, not diversification. The right question for investors to be asking today is can alternatives improve on some risk-adjusted equivalent mix of equities and cash?
We gave up using alternatives in 2007 in the belief that we could approximate the wizardry at much lower cost. Over the period since then, it looks like we were right. The multi-asset class products we used to use (including co-investing in a fund with several Oxford college endowments) have not beaten equities diluted with cash. Moreover, our clients have gained utility because they have more composure. Composure comes from knowing that the early years of draw are funded by the cash and that they have time enough for the equities backing their longer-duration spending liabilities to recover from any periods of weakness. Composure also comes from knowing they are investing right for their type.