What You and I Can Learn from the Endowment Blowups

Barron's was a keeper this weekend. Of most interest was an article about the latest trials and tribulations of the university endowments and an interview with the guy running CALPERS these days.

First up is the CALPERS interview. There was a money quote and the fund's allocation:

Global Equities 49%
Fixed Income 20%
Private Equity 14%
Real Estate 10%
Inflation Linked Including Commodities 5%
Cash 2%

CALPERS had to increase the target for private equity because the value of everything else fell so much, it raised the weighting to private equity. This is the same concept I talk about with using SDS. If the market falls a lot, SDS will grow to a larger weight in the portfolio, thus hedging more. As I understand the article, had they not done this CALPERS would have been forced to sell some of their PE exposure.

The fund is trying to make its "assumed rate of return of 7.75%." This brings up an important point. Many people think in terms of the stock market averaging a certain percent every year. Maybe the number is 10% or 8% or something else - but something. Unfortunately, reality is much lumpier than 9% per year. Whatever the real number is, it includes all the 1997s, 2008s and everything in between.

Pensions and endowments cannot be very flexible with what they pay out for their obligations, but you can be -- maybe. Obviously, living below your means helps here. When the market has the occasional really bad year (not talking a 10% decline) you have a better chance of cutting back on certain expenditures than a pension fund does.

The money quote:

To try to capture more growth, we have to look at expanding our allocations in emerging markets. In emerging markets over the past year, we've greatly increased international exposures.

So they need to increase their foreign exposure to get the growth they need. That should sound familiar to long time readers. This has been an ongoing theme and I am convinced it will continue to become ever more important. I would note this does not have to mean 30% in emerging.

This table is from Barron's and shows the allocations of several college endowments. It seems that things were great for a long time and then the market declined, which coincided with liquidity problems, and now the entire endowment theory is being called into question. Well, Byron Wien questions it anyway.

The article is a good read. I certainly am interested in what happened and what changes there may be as a result of 2008, but I am more interested in what you and I can learn from all of this - benefiting from their mistakes if there were any mistakes.

One of the ideas that emerged from the article was that returns in the future will be less than they were in the past. Perhaps that is correct, but I had one encouraging thought for the endowments to the extent they continue to invest with hedge funds. If US interest rates go up as much as some people think, there will be some hedge funds that go up several hundred percent shorting the bond market and perhaps the endowments will own such a fund.

In looking at the table, you can see how heavy they are in alternative assets (also illiquid) and how they did. A big focus over the years in my thinking and writing has been the concept of all things in moderation and I don't think the above weightings in the alternative stuff is moderate - far from it. Anyone, anywhere caught up in some sort of illiquid asset implosion had no control over what happened and probably could not have anticipated the totality of what happened, but they did have control of how much they allocated to these things.

A little can go a long way. People have a tough time with that one, but all I can say is it is true and simple.

Comments

[RiskAverseA...:]

"Changes there may be as a result of 2008" might better account for the elevated possibility that 2008 could be like a walk in the park on a sunny, summer day.

Per PE, there are just two words to summarize possibilities: Peloton Partners.

Jun 29 07:50 AM

[bob will:]

Not only university endowments, but most pension funds will be destroyed in the coming crash. Most of the people I know have received official notices from their fund administrators, that their pension funds are technically bankrupt--and that the funds may have to be turned over to the federal government pension fund--which is also bankrupt--unless the stock market skyrockets back up to a new nominal high of DJIA 15,000--which is about 98% UN-likely. Hello, Mexican style poverty for Baby Boomers--because Social Security, Medicare and Medicaid are also bankrupt. (But,of course, politicians have a separate retirement plan--so, they will retire in luxury.)

Jun 29 11:48 AM

[David Van K...:]

Is it just me, or do the people running these funds begin to look a little stupid? Maybe that's too harsh...let's say asleep. The bear market began in October 2007 and was clearly obvious by early 2008. Yet these funds kept these sorts of allocations throughout 2008 and into 2009? Nobody "went to cash"? Nobody increased their allocations to bonds? Is this the sort of investment practice being taught in the schools themslves?

The author has it right about moderation. These allocations seem designed for perpetual explosive growth--the same mistake made by millions of homeowners, mortgage lenders, and purchasers of MBS...who bet that the only direction in housing prices was up.

Jun 29 12:02 PM

[Mat-Tye 22:]

Hedge Funds, on average, performed much better that the overall markets in 2008. It's not fair to lump the entire category into one and assume it is a "risky" asset class. Alternatives can play a very important role in portfolios, they have in the past and will continue to do so in the future. I think last year, however, has shown that when things are bad all correlations move towards 1.

Jun 29 12:26 PM

[Old Trader:]

When I first read about the problems that various widely touted endowments had over the last year, or so, and the effects on various scholastic spending.budget plans, my first thought went to the weight of illiquid assets being carried in their portfolios.

I'd think that at some point, there'd be a discussion about budgeted outflows/spending vs. expected returns from the endowment. I'm not certain who's more at fault, the board of regents (or whoever decides how much gets spent) or the fund management for not positioning the fund properly. As in most things, I suspect blame can be placed on both sides.

Jun 29 06:30 PM

[DWStein:]

What kills me is the logic used in 'the golden quote'. to get more return, we're going to buy riskier assets. After all that's happened, they still don't get it. All you get when you buy a riskier asset is more risk.

The very fact that endowments are demanding a minimum return should be a red flag. They should be managing toward the lowest possible volatility and/or best inflation hedge.

Jun 29 08:26 PM

[Alfredo Mar...:]

The reason these endowments and pension funds are moving into riskier assets is they feel they have nothing to lose. They will of course be bailed out by this current administration if they lose their bet.

Do you really think college endowments and public pensions funds are going to be left out in the cold because of their stupid investing decisions?

Definition of Moral Hazard- the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk

Jun 30 12:56 AM

[mkreisel:]

Chasing returns via more risks: you go up the elevator and later jump out of the window.

Jun 30 03:44 AM

[Nom De Plum:]

Risk premiums were overpriced in 2007 (too low) and underpriced in 2009 (too high). These funds should ABSOLUTELY increase risk exposure. The investment committees should look at 10-yr track records of delivering alpha and allocate more capital to those managers that should be able to identify undervalued securities (those with risk premiums that are too high).

Jul 01 10:23 AM