Monday, May 7, 2012

More on Yale, Alternative Investments and Individual Investors

As we've noted in a previous post, the Yale Endowment has taken a very aggressive position in using alternative investments in its portfolio's asset allocation. For the year ended June 30, 2011, alternative investments in total (absolute return hedge funds, private equity, and real assets comprised 81.5% of the portfolio!  Liquid investments (domestic equity, foreign equity, and fixed income) net of cash comprised 18.5% of the portfolio.

This statement appears in the annual report, "...the actual (2011) allocation produces a portfolio expected to grow at 6.3% (real) with a risk of 15.4%.  Disclosures in the report don't provide expected returns by asset class, nor do they suggest the distribution of expected portfolio returns for which 6.3% might be a measure of central tendency.  I confess to being surprised that the portfolio's expected real rate of return was not higher given the preponderance of alternative assets.

This, in turn, made me start thinking about other studies of expected return and about the gross distortions being introduced into financial markets by the Fed's enabling policy of spreading liquidity around  like Halloween candy. 

Vanguard's Capital Markets Model recently ran simulations on the expected average annualized returns for a 50/50 equity-bond portfolio.  Their results returned a nominal portfolio return centered in the range of 4.5%-6.5%, or in real terms an expected range of 3.5%-4.5% over the next decade.  These are pretty meager returns for most investors, especially when compared to historical returns over the Great Moderation. 

So, the Yale Endowment portfolio is expected to outperform the Vanguard investor's simulated, balanced portfolio by 180-280 basis points over the investment horizon.

Reading the Endowment's report for the period ended June 30, 2011 doesn't clear up some of the obvious questions.  Performance numbers are given in nominal terms. Yale's domestic equity portfolio returned 24.5% for the year, underperforming their benchmark index return, as opposed to the expected return, by 7.8%.  The foreign equity portfolio by contrast returned 18.6%, outperforming its benchmark index return 7.0%. 

The absolute return hedge fund asset class, 17.5% of the portfolio, returned 12.7% for the year.  From previous annual reports, one can read that this class is expected to return 12-13% per annum, and so this was right in line with expected returns.  Historically, absolute return funds as a class have produced a 10.2% annual return, so Yale's 2011 performance was better than the long-term historical  average performance of the asset class.  Given Yale's' assumption about correlations between absolute return and liquid equities being zero, and the variance of absolute return being about one-third that of equities, absolute return funds lowered the overall portfolio variance as well as raising its returns.  Almost a free lunch!

So, in this persistent, distorted low rate environment, ordinary investors are forced to chase yield and return. If investors are seeking to lower risk, they don't have the options that the Yale Endowment does, rather they have to fly to Treasuries and bid up their prices to the point where their risk may increase rather than decrease.  Talk about distorted market signals! 

Liquid investments, like domestic public equities, generally offer lower returns because this liquidity comes at a premium. However, in the low rate environment against a risky economic background, investors tend to pay too much for this liquidity, thereby depressing the likelihood of higher future returns.  Again, market prices are distorted from long-term, economic cash flow related valuations. 

Finally, corporations flush with cash focus on stock buybacks and dividend increases rather than on productive investments for the future, which don't offer the easy returns fostered by this low rate environment.  Berkshire Hathaway analysts have suggested that instead of more cash flow reallocation to insurance businesses within the portfolio, investments like Burlington Northern Santa Fe should be keeping their cash flows and making long-term investments to grow and maintain their economic moat in the future.  However, the promise of almost eternal low rates pushes even astute managers to take the easy road to short term gains. 

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