Over the past five years, investors have been searching for investment characteristics that hardly exist in today’s economic and political environment: income and stability. At one extreme, investors want yield. However, the Federal Reserve has set short-term interest rates at near zero and purchased enough long-term bonds through its program of quantitative easing so that yields on quality fixed-income investments have been anemic. Meanwhile, those investing in stocks still remember the massive swoon in stock prices in 2007-2008 that chased many of them out of the market.
Money managers have had an easy answer to this conundrum: alternative investments. By stirring together a rich mix of private equity, real estate, hedge funds, and commodities and then adding a modest dash of emerging market or high-yield bonds, investment advisers are promising to deliver more consistent returns with lower risk than the stock market. It is an appealing formula, and I must confess that I was extremely attracted to this recipe at one point in my career. The method is sometimes known as the Yale or endowment model. Indeed, the pioneers of this model of investing had great success in building value for their respective foundations and universities. David F. Swensen, the chief investment officer at Yale University since 1985, is rightfully lauded for developing the model, and right here in North Carolina Eugene J. MacDonald successfully implemented the model on behalf of Duke University.
However, as more institutions sold stocks and bonds in favor of the endowment recipe, the investment results couldn’t be replicated on a wide scale. As both Swensen and MacDonald have frequently advised would-be practitioners of the endowment model, one of the keys is to find and maintain long-term relationships with top quartile money managers. Their advice is extraordinarily difficult to achieve because top-notch managers aren’t readily apparent or available to a broad swath of investors.
The last great frontier
Nonetheless, most money managers continue to beat the drums for alternative investments as the magic elixir. There’s a good reason. The management fees and profit incentives charged for private equity, real estate and hedge funds are far more lucrative to portfolio managers than old-fashioned stocks and bonds. At a time when investors are using more index funds and ETFs, which tend to drive down fees, the endowment model has opened up a vast new world of riches to money managers.
Not surprisingly, money managers are marketing the wonders of alternative investments: better returns, less risk and greater consistency. Who wouldn’t want to sign up for that bundle of characteristics? What began as a model designed for university endowments and a small group of high net worth individuals began to proliferate about 15 years ago. Eventually even the big public pension plans jumped into alternative investments. As more and more plans, including the North Carolina Retirement System, joined the fray, alternative investments became less and less effective. Today the pension plans are no better off, and Wall Street has minted a cadre of hedge fund and private equity billionaires on the backs of rank-and-file public employees and retirees.
Having conquered public pensions, alternative managers are now targeting you. The retail market, especially the mutual fund, is the last great frontier for private equity and hedge fund managers. From the canyons of Wall Street to the blue skies of North Carolina, money managers are launching products aimed at bringing the endowment model to the average investor. The marketing blitz will be compelling but ought to be resisted.
Beware of exit barriers
Most of these products will be laden with multiple layers of fees, some of which will be well hidden. They will promise investors daily liquidity just like stock and bond funds. However, many of the assets will be illiquid and hard to value, and thus the price, or net asset value, will be an educated guess. And when we hit one of those periodic financial crises, these kinds of products will be prone to throw up exit barriers, known as gates, and limit their investors’ access to their capital.
Here’s the fundamental problem with the widespread application of the endowment model. It tends to work reasonably well in normal markets, although long-term investors would still be better off in a mix of stocks of bonds, net of fees. However, it’s during the financial crisis that the alternative strategies tend to break down. That’s not to say that stocks don’t dive during a financial crisis. However, the benefits of owning a diverse set of strategies in an endowment-style portfolio tend to disappear when the markets seize up.
It isn’t easy investing in a conventional investment portfolio today. There’s little income in bonds and periodic volatility in stocks. The endowment model is a useful way to swap these apparent risks for a series of risks that are hidden. I suppose there is one benefit to the alternative solutions. Individual investors can sound more sophisticated at cocktail parties if they can talk about their hedge fund and private equity managers.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002 to 2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/