SageCap Blog

November 30, 2010

Permanent Funding for Public Universities

Filed under: Endowments — Laura Vossman @ 7:28 pm

The University of Oregon’s new president has proposed a new model for funding public universities (see WSJ and The Oregonian).  Instead of providing annual direct budget support to the university, the state government would allocate a like amount for 30 years for debt service on new borrowing to fund a permanent endowment of $800 million.  That amount would be matched by private giving, for a combined new endowment of $1.6 billion.  A four percent annual payout from the new endowment would replace the state’s current direct budget support.  More importantly, the new model would provide a stable funding stream that would be more predictable than the state’s annual budget process, particularly in difficult economic times, and could grow to meet the university’s future needs.

The desire for a more permanent and independent source of support is common among state universities.  Direct state government support has funded an increasingly smaller percentage of state universities’ total budgets, offset by tuition increases that are not sustainable.  The University of Oregon’s historical experience is typical – from 1970-2009, the university’s budget increased an annualized 6.6%.  Revenues from gifts/grants and auxiliary operations roughly kept pace, at 6.3% and 6.7%, respectively.  State support increased only 4.0%.  Tuition, as anyone who has been a college student or parent in the last few decades can guess, increased 9.4%.

Some public universities, such as the University of Michigan and University of Virginia, got ahead of this trend and raised substantial endowments decades ago.  Given the current distress state governments are facing, the need is even more compelling today.  Will the University of Oregon plan work?  Here are some things to think about:

  • Greater reliance on endowment support is not a panacea: financial assets can be volatile.  In the market downturn of 2008-09, Harvard and others who rely on endowments for 20% or more of their annual budgets were forced to take significant cuts and scrap some projects.
  • Can the University of Oregon raise $800 in private endowment funds?  Last year’s total giving was $78 million – only a quarter of that was for the endowment, and only a portion of the endowment amount is cash that can be invested today vs. pledges of gifts that may not be received for years if not decades in the future.
  • The University of Oregon projects the annual endowment payout to grow in 30 years from $64 million to $263 million per year (assuming a 9% annual investment rate of return, which it acknowledges could be challenging).  While this sounds like a lot, it represents only a 4.8% annualized increase vs. the university’s historical annualized budget increases of 6.6%.  Unless the university can reign in spending, this creative and ambitious plan may fall short.

October 30, 2010

Fed Should Stop Trying to Manage Economic Growth

Filed under: Great Investors,Multi-Asset Class Investing — Tags: , — Laura Vossman @ 7:32 pm

Jeremy Grantham argues in his recent Quarterly Letter (Night of the Living Fed) (available on GMO’s website with free registration) that the Fed should stop trying to manage economic growth and stick to inflation, or better yet, liquidity:

  • Low interest rates/increased borrowing do not lead to sustainably higher GDP.
  • Lower rates (along with moral hazard) do encourage market speculation.  Higher asset prices may temporarily stimulate the economy through the wealth effect.
  • Using lower rates to stimulate the economy through the wealth effect is dangerous, inflicting financial pain when assets ultimately revert to fair value.  Inflated asset prices tempt municipalities, pensions, and endowments into relying on outsized, unrealistic long-term return assumptions.  Housing bubbles are even more dangerous than financial asset bubbles because they have a broader impact on the real economy and upon bursting, constrain labor mobility.
  • Artificially low rates enable or bail out weak companies that the economy would be better off without.  The Fed overuses monetary tools to ease the pain of even mild recessions.  Using monetary stimulus in this way is harmful, like a forest management policy that never allows periodic fires to clear out some underbrush.
  • The primary beneficiary of the booms and busts in asset prices — as well as high levels of debt to be issued, repackaged and resold, rated, managed, and traded – is the financial industry.

Asset allocation advice:

  • Overweight emerging market and quality US equities.
  • Hold extra cash reserves for dry powder as both stocks and bonds are overpriced on an overall basis.
  • Long-term investors should overweight real assets (especially on weaker prices), as we are running out of everything.  Gold does not count, as it has little utility.

September 11, 2010

Wisdom from Seth Klarman

Filed under: Great Investors,Multi-Asset Class Investing — Tags: , , — Laura Vossman @ 2:08 pm

The CFA Institute recently published its May 2010 annual conference interview with Seth Klarman of Baupost.  Others have posted notes from the interview on the web more contemporaneously.  If you haven’t already heard or read his interview, this is great stuff.

General advice:

  • The practice of being fully invested at all times should be revisited: “We are never fully invested if there is nothing great to do.” “Sell fully priced securities so that you are underexposed when things go badly.”
  • The key to long-run equity returns is entry point price.  In a 2008 interview, Klarman noted that “institutional asset allocation models . . . don’t necessarily vary all that much based on price. . . . Clearly, when people are paying higher and higher prices, and there’s more and more competition, that’s probably a less-good time to be doing something.”
  • “Investors need to pick their poison: Either make more money when times are good and have a really ugly year every so often, or protect on the downside and don’t be at the party so long when things are good.”

On today’s environment:

  • Beware the Hostess Twinkie market. (The Twinkie is ”a confection that has made many childhoods slightly better, but is composed of totally artificial ingredients.”) With short-term interest rates at zero and government purchases of securities, the government wants people to invest to move the market higher, creating a wealth effect to restore confidence and get the economy going.  ”I am worried to this day about what would happen to the markets, to the economy if, in the midst of all these manipulations, we realized that they are, in fact, a Twinkie.”
  • Believing that the US will always be a triple-A credit “guarantees that someday the US will no longer be triple-A.  A sovereign deserves to be rated triple-A only if it has valuable assets, a good education system, a great infrastructure, and the rule of law, all of which are called into question by an eroding infrastructure, a government that changes the law or violates it whenever there is a crisis, and a legislature that shows no fiscal responsibility.  There is an old saying, ‘How did you go bankrupt?’ And the answer is, ‘Gradually, and then suddenly.’”

August 31, 2010

Using Valuation for Better Asset Allocation

Filed under: Multi-Asset Class Investing — Tags: , , , , , — Laura Vossman @ 10:17 pm

GMO’s James Montier advocates policy portfolios in which asset class exposures fluctuate according to relative valuations (I Want to Break Free, or Strategic Asset Allocation ≠ Static Asset Allocation) (available on GMO’s website with free registration). Static asset allocations based on modern portfolio theory, he argues, suffer from several flaws:

  • Emphasis on the wrong risk. The most meaningful definition of risk is not volatility, but permanent loss of capital, which comes about in one of three ways: valuation risk (paying too much), business risk (fundamental problems with the asset), or financing risk (leverage).
  • Increasing risk by ignoring valuation. The more overvalued an asset is, the greater the risk of loss.  A static portfolio that is indifferent to valuation, therefore, is careless about loss of capital.
  • Emphasis on the wrong risk (again). As applied, the approach encourages managers to focus on relative returns at the expense of absolute outcomes. Managers focus on whether a security is attractive relative to similar securities, losing sight of whether any are attractive relative to cash.  Measuring and minimizing tracking error becomes more important than avoiding loss of capital.
  • Facilitates ill-advised approaches to reaching for desired returns. When the policy return is less than what is required, the approach has led to unsatisfactory innovations such as increased use of alternative investments (which underappreciated increasing correlations, the impact of valuation, and the effects of other market participants on returns) and risk parity (which as applied today levers inflation-sensitive, interest-rate-sensitive, low-return assets).

Instead, Montier says we should go back to the basics, and follow a valuation-based active asset allocation strategy (buy what is cheap and sell what is dear).  Set a reasonable real return target, and give managers as much discretion as possible.

July 25, 2010

What We Can Learn From Global Macro (Part II)

Filed under: Book Reviews,Multi-Asset Class Investing — Tags: , , , , , — Laura Vossman @ 8:37 am

Last week I wrote about some ideas from or inspired by Steven Drobny’s new book, The Invisible Hands: Hedge Funds Off the  Record — Rethinking Real Money.  This is a continuation of that post:

The Permanent Capital of Institutions Can Be a Big Advantage. Mindful of the potential for investor redemptions, hedge fund managers must invest on much shorter, less patient horizons.  Mark-to-market is less relevant if you have the liquidity to hold to maturity.  Trading (“don’t fight the tape”) vs. investing (betting against market consensus) is a function of horizon.

Understand the Motivations of Other Market Participants.  Exits from crowded trades can have severe consequences for liquidity and/or price.  One manager notes “what other people believe will happen is just as important as the eventual outcome.”  For example, uncertainty about paper currency will drive demand for hard assets; money flows will drive price.  For any asset, know who is the buyer of last resort (if it’s you, don’t count on liquidity).

Inflation is the Biggest Long-Term Risk to Institutional Capital. One manager suggested highly leveraged real estate could be an effective hedge, as “you could inflate away all the debt.”  Real assets with utility (real estate, farmland) are particularly attractive long-term assets.  Several managers say the best way to implement commodities exposure is through a combination of indices enhanced for yield management, active managers with a long bias and downside risk management, and physical assets (which match a long horizon well and offer both current cash flows and capital gain).

Portfolio Construction. Take individual positions based on expected return; manage risk at the level of aggregate portfolio exposures.  Explore options-based hedging, such as costless risk collars at shorter/cheaper maturities — a protective put hedging a long position allows you to mitigate losses while staying in the trade to benefit if there is a reversal.  If you invest through external managers, hire managers who manage risk well (and if you can’t find enough good hedge fund managers, government bonds may be the next best bet).  A portfolio of hedge funds should be diversified across 15-25 managers.  A concentrated fund of best ideas can be a bad idea if it makes the manager more in love with the ideas and less willing to cut losers.

The Macro Environment Will Be More Important Going Forward. One manager notes that long-only stars of prior decades operated in an environment where “investors did not require a macro compass.”  The traditional institutional approach of long-term strategic asset allocations, relative benchmarks, and asset class buckets could use some retooling.

July 18, 2010

What We Can Learn From Global Macro: Take-Aways from Drobny’s The Invisible Hands

Filed under: Book Reviews,Multi-Asset Class Investing — Tags: , , , , , — Laura Vossman @ 9:15 am

What can or should institutional investors learn from global macro hedge fund managers about portfolio management?

Steven Drobny‘s last book, Inside the House of Money (2006), explained the history and practice of global macro investing through extensive interviews with prominent managers.  His latest book, The Invisible Hands: Hedge Funds Off the  Record — Rethinking Real Money (April 2010) is again told through detailed interviews of the managers themselves, and focuses on why global macro was one of the few successful strategies during the market crisis of 2008-09.

Drobny notes that historically the investment approaches of institutional investors have been somewhat reactive.  Most pension funds, endowments, and foundations invested almost exclusively in bonds until they got whacked by inflation in the 1970′s.  The 60/40 or 70/30 stock/bond policy portfolio worked fairly well in the 1980′s and 1990′s, in a macro environment favorable to equities.  After the tech bust of 2000, many investors added much greater proportions of alternative investments that had served the largest US endowments well.  In 2008 almost everyone fell hard.  Will we learn the right lessons?

Focus on Risk, Not Returns. Several of the global macro managers observed that they manage portfolios to target risk levels (e.g., maximum drawdown), while institutions manage toward target returns.  This may follow from the requirement to generate a return vs. merely preserve wealth (though obviously long-term returns are higher if severe losses are avoided).  Unlike a truly wealthy individual, some endowments and pension plan sponsors and/or beneficiaries may want or need more return than they can safely afford.  Institutions need to carefully define their investment objectives — real or nominal return objective, the most can you afford to lose, how much liquidity do you need, do benchmarks/peer returns matter.  Importantly, you can’t have it all (e.g., absolute return in down markets; relative return in up markets).

Cash is an Essential Asset. Jim Leitner (Falcon Management) notes that “when other assets have negative returns forecast over the next 6 or 12 months, there is no reason to not hold a low return cash portfolio.”  Price, not long-run assumptions, determines return.  Most institutions have followed long-term strategic policy asset allocations based on long-term risk/return expectations.  This approach is supported by academic studies showing that consistently timing markets correctly is a rare skill, and the penalty of being out of the market at the wrong (bull market) times outweighs the reduction in long-term returns from a stable asset allocation through bad markets as well as good. Institutional investment approaches may also reflect their typical group decision-making structure — i.e., even if they had the correct market insight, they would not be able to act on it in time.  Some institutions do adjust asset allocations at the margins, taking some risk off when markets appear expensive, mitigating but not avoiding loss when that insight is correct.  The global macro managers do note that tactical asset allocation and managing for absolute return would be difficult for an institution with size, though even the largest can always keep some dry powder.

This post will continue next week. . . in the meantime, comments from absolute return managers, long-only money, and interested bystanders are welcome!

July 11, 2010

The Endowment Model — Some Misguided Praise and Some Misplaced Blame

Filed under: Multi-Asset Class Investing — Tags: , , — Laura Vossman @ 2:27 pm

I share Heidi Moore’s assessment (CNNMoney.com, July 8th) of Michael Azlen’s recent  FT.com post, “Everyone can learn from US endowments.”  But her criticism of Harvard and Yale is misplaced.

Azlen does appear to have learned nothing from 2008-09.  (His firm, by the way, is not a hedge fund as Moore states, but a sponsor of index funds and asset allocation products built on index funds.)  He essentially makes the same argument he did in 2007 – i.e., small investors can replicate the success of Harvard and Yale using index funds and the magic of diversification.  There are two flaws to this strategy:

  • The market crisis of 2008-09 demonstrated that correlations across asset classes rise dramatically in difficult markets.  The myriad of asset classes one could have purchased pre-2008 collapsed to two: (1) US Treasurys and (2) everything else.  In a liquidity crisis, most liquid assets will be oversold.  Thus the free lunch formerly known as diversification offers little protection in a market downturn, especially if you are relying exclusively on liquid assets.
  • Harvard’s and Yale’s past success in alternative investment strategies is largely due to their early adoption of that approach – i.e. they bought assets few others were buying and as a result got them cheap.  By the time an asset class is so popular that mutual funds spring up to receive the hoards of capital being thrown at it, those assets are no longer cheap but expensive.  Publicly traded “alternative” investments behave a lot more like stocks than the private market version of the underlying asset – e.g. REITS (publicly traded real estate) have long been shown to be more highly correlated to public equity than to private real estate.  This does not mean passive strategies are bad:  Yale’s CIO David Swenson regularly tells small investors they should invest through passive vehicles.  Just don’t kid yourself into thinking you will achieve the same returns as Harvard or Yale.

The rest of Moore’s article argues that Harvard and Yale should take less credit for success and more credit, along with pension funds, for causing the market crisis.  Here I get off the train.

First, Harvard’s and Yale’s longer-term returns (e.g. 10-year, including the downturn of 2008-09) outperformed virtually everyone.  Capital  invested with them ten years ago would be worth more money today than if you had had anyone else invest it for you.  Did Harvard and others experience liquidity problems during the crisis due to leverage and illiquid holdings?  Yes.  That is one element of the so-called endowment model that many are reworking today.

Recall though, that during the boom years many endowment managers urged caution, warning that high returns year after year were not sustainable and that we should be prepared for lower long-term returns.  It was Congress and the beneficiaries of endowment spending (especially those desiring new buildings) that cried, “Spend it up!”  Many projects envisioned in rosier times have now been caught short, true.   But those projects would never have made it to a drawing board but for the prior investment success.  Ultimately the volatility has been disruptive, but a more conservative investment strategy would not have provided the shiny new buildings either.

Finally, endowments and pensions should not be lumped together for purposes of allocating blame for the market crisis.  Endowments are a tiny fraction of total institutional investor capital, and they are predominantly equity players.  Pensions, along with banks and insurance companies, are much larger and invest more heavily in fixed income assets — it is here that many investors took on too much risk for a little extra yield through various products Wall Street happily sliced and diced for them.

June 27, 2010

What Will Peak Oil Do to Agriculture

Filed under: Environmental Investing — Tags: , — Laura Vossman @ 4:12 pm

How will higher and more volatile oil prices affect agriculture?

  • Higher production cost. Highly mechanized, industrial-scale farm operations will be more expensive to run.  Fertilizer inputs will be more expensive, particularly if natural gas prices also increase.  Farm profit margins may be squeezed, putting downward pressure on farm land prices (but see discussion below of biofuels, which will likely push prices up, allowing farms to maintain or enhance margins).  Smaller-scale, less energy-intensive, and organic operations may be less impacted, improving their competitive position.
  • Higher transportation cost. Consumer food prices will be higher.  Local producers will improve their competitive position, possibly leading to more diversified farming on a local and regional basis.
  • More competition from biofuels. Higher oil prices will improve the competitive position of biofuels.  Increased biofuel demand will reduce food supply, as productive capacity (e.g. land) and possibly food crops (e.g. corn) are diverted to produce biofuel stock, putting upward pressure on food prices.
  • Possible Offset: Technology. Can we continue the pace of technology advances and yield improvements of the past several decades?  Private agricultural research will have to shoulder more of the load, as governments face increased funding constraints.  Consumer acceptance is also a constraint, as health and environmental concerns fuel resistance to developments such as GMO and reliance upon herbicides, pesticides, growth hormones, additives and preservatives.
  • Wildcard: Government Policy. Government policies such as price setting, production subsidies, import tariffs, export subsidies, supply management programs, conservation programs, research programs, biofuel policies, and food aid programs all impact supply, demand, and price levels, often in conflicting ways.

For a good primer on the economics of food prices, see Patrick Westhoff’s The Economics of Food: How Feeding and Fueling the Planet Affects Food Prices.

June 3, 2010

Using Scenarios to Build Better Buy-and-Hold Asset Allocations

Filed under: Multi-Asset Class Investing — Tags: , , , — Laura Vossman @ 11:32 pm

For institutional investors or others with long-term horizons, is there a better approach to asset allocation than the strategic “set-and-forget”?  Fred Dopfel of Barclays (now Blackrock) offers a new framework in The New Policy Portfolio.

Dopfel compares four asset allocation approaches, two strategic and two tactical: (1) “Naive” uses a static asset allocation, set based on expectations reflecting a benign investment environment; “Strategic, But Hedged” uses a static asset allocation, optimized for both benign and difficult market scenarios; (3) “Prophetic” is a tactical investor with perfect timing; and (4) “Myopic” is a tactical investor who can’t (and doesn’t try to) time the market but does adjust asset allocations to reflect current market conditions.

Naturally the hypothetical “Prophetic” will outperform the others.  But of the other three approaches, based on modeled results, “Strategic, But Hedged” substantially outperforms the other two.  This is consistent with studies Dopfel cites, showing that strategic portfolios outperform tactical ones unless you have a rare level of market timing skill.  Incorporating scenarios into the strategic allocation better accounts for uncertainty and fat tails than the naive normal distribution approach.

How will this work in the real world?  Over the next few months I plan to build a strategic allocation based on a normal base case, a high inflation scenario, and a deflation scenario.  I’m curious how much this allocation will differ in practice from the naive allocation, its relative performance in historical periods, and how it does in the future.

May 31, 2010

Book Review: Why Your World is About to Get a Whole Lot Smaller

Filed under: Book Reviews,Environmental Investing — Tags: — Laura Vossman @ 3:02 pm

Jeff Rubin, former chief economist for CIBC World Markets, has been a believer in peak oil since about 2000. After laying out the peak oil case in the first chapter, most of his book elaborates on the economic consequences of a world where oil is increasingly more expensive and less available.

Historically cheap and plentiful oil has led to an economy that is highly geared to oil.  Cheap oil made globalization possible, which led to an extended period of low inflation, which led to easy credit and excess liquidity, which resulted in high financial leverage.  Low inflation and cheap money are possible only when oil is cheap.  When oil gets expensive (e.g., from 2004 to 2008), it not only slows economic growth directly, but pushes inflation up, resulting in tightening credit, which further slows growth.  In 2006-08, rising interest rates collided with subprime mortgages, leading to economic crisis.  Oil supply constraints will continue to act as a brake on the economy until and unless we transition to an economy less levered to oil.

What does Rubin think this this transition will look like?

  • Our overdeveloped services sector will get smaller, as we get back to basics.  Local manufacturing will grow, leading to a possible revival of the U.S. rust belt.
  • Increased demand for locally grown food and higher food prices overall.  Possible resurgence of family scale diversified farms.
  • Less travel, especially by air or auto.  Increased reliance on rail and waterways.
  • Reversal of globalization, reversal of specialization.  Economies and trade will be more regional with more generalists (smaller markets, broader focus).
  • Rejuvenation of local communities — more cohesive, more distinctive, and a return to human scale.

At least some of this is not so grim.  In addition, Rubin notes we have the perennial promise of creativity and innovation to solve problems we face.

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