I’ve written at least two significant pieces on endowment investing:
- Alternative Investments, Illiquidity, and Endowment Management
- The Forever Fund
- Oh, toss in one more: Managing Illiquid Assets
Recently, Cathleen M. Rittereiser, Founder of Uncorrelated, LLC, reached out to me to show me her whitepaper on endowment investing, The Portfolio Whiteboard Project. This was partially in response to Matthew Klein’s excellent article, Time to Ditch the Yale Endowment Model. which came to conclusions similar to my articles above.
The Portfolio Whiteboard Project, which seeks to take a fresh look at endowment investing came to some good conclusions. If you are interested, it is worth a read. The remainder of this piece expresses ways that I think their views could be sharpened. Here goes:
1) Don’t Think in Terms of Time Horizon, but Time Horizons
2008-9 proved that liquidity matters. The time horizon of an endowment has two elements: the need to fund operations over your short-term planning horizon, and the need to grow the purchasing power of the endowment.
Choose a length of time over which you think you have a full market cycle, with a boom and a bust. I like 10 years, but that might be too long for many. As I said in Managing Illiquid Assets:
For a pension plan or endowment, forecast needed withdrawals over the next ten years, and calculate the present value at a conservative discount rate, no higher than 1% above the ten-year Treasury yield. Invest that much in short to intermediate bond investments. You can invest the rest in illiquid assets, because most illiquid assets become liquid over ten years.
I include all risk assets in illiquid assets here. The question of illiquid vs liquid assets comes down to whether you are getting compensated for giving up the ability to easily sell. There should be an expected premium return for illiquid assets, or else, invest in liquid risk assets, and wait for the day where there is a return advantage to illiquidity.
2) Look to the Underlying Drivers of Value
Hedge funds aren’t magic. They are just limited partnerships that invest. Look through the LPs to the actual investments. It is those actual investments that will drive value, not the form in which they are held. Get as granular as you can. Ask: what is the margin of safety in these endeavors? What is the likely return under bad and moderate conditions?
3) Ignore Correlations
It is far more important to focus on margin of safety than to look at diversification benefits. Correlation coefficients on returns are not generally stable. Do not assume any correlation benefits from risky investments. Far better to segment your assets into risky and safe, and then choose the best assets in each bucket.
4) On Leverage & Insurance
Unless they are mispriced, borrowing money or getting insurance does not add value. Same for all derivatives, but as we know from the “Big Short,” there are times when the market is horribly wrong.
Away from that, institutional investors are not much different from retail — they borrow at the wrong time (greed), and purchase insurance at the wrong time (fear).
5) Mark-to-Market Losses Might Matter
Mark-to-Market losses only don’t matter if endowments don’t face a call on liquidity when assets are depressed.
6) Insource Assets
The best firms I have worked for built up internal expertise, rather than outsource everything. The idea is to start small, and slow build up local expertise, which makes you wiser with relationships that you have outsourced. As you gain experience, insource more.
7) Thematic Investing is Usually Growth Investing
Avoid looking at themes. Unless you are the first on the scene, themes are expensive. Rather, look at margin of safety. Look for businesses where you can’t lose much, and you might get good gains.
8) Look to the Underlying Value of the Business, or Asset Class
Cash flows are what matter. Look at he likely internal rate of return on all of your investments, and the worst case scenario. Buy cheap assets with a margin of safety, and don’t look further than that. Buying safe assets cheap overcomes all diversification advantages.
Those are my differences on what was otherwise a good paper. I can summarize it like this: Think like a smart businessman, and ignore academic theories on investing.
By David Merkel, CFA of Aleph Blog
