What a Difference a Year Makes! Endowment, Buy and Hold, and Tactical Returns

In my last post I examined the performance of the endowments (estimated) versus some publicly traded asset classes, allocations, and tactical models. Below I am going to expand a bit and see exactly what a difference this past year made.

Every reporter has been all over the story including Barron’s , WSJ , Vanity Fair, and Bloomberg – although NONE have mentioned my book. That is a bit frustrating, but to be expected. It is a better story to talk about how much money these endowments have lost rather than review or mention a slightly academic book (with lots of data and tables) that would have shielded investors from the bear markets.

(Note: The endowments have not reported an official number for their 2009 returns, which end June 30th, but estimates center around -25% to -35%. )

Below are some returns from the endowments from 1985-2008, followed by 1985-2009 (and remember these are for fiscal year ending June 30th!!):

(Data sources: Global Financial Data, Harvard and Yale Annual Reports)

US Stocks – S&P 500

Foreign Stocks – MSCI EAFE

Bonds – 10 Year US Govt

Commodities – GSCI

REITs – NAREIT

Buy and Hold is an equally-weighted, monthly rebalanced allocation to the above 5 asset classes

Harvard and Yale are approximate returns for 2009 (probably ranging from -25% to -40%)

60/40 is the old 60% stocks, 40% bonds allocation

Timing model is from my 2007 paper, Rotation is from my 2009 book.

Some observations, 1985-2008:

-Harvard and Yale’s returns are highly correlated at .91, suggesting they follow similar strategies and allocations.

-Harvard and Yale beat any one asset class by roughly 3-5%.

-Harvard and Yale beat most indexed allocation models by 4-5% with similar volatility.

-Harvard and Yale are highly correlated to equity markets, as well as a diversified buy and hold including real assets.

Some observations, 1985-2009:

-Harvard and Yale’s returns are even more highly correlated at .95, suggesting they follow similar strategies and allocations.

-The bear markets of 2008/2009 knocked a full 2% off the compounded returns of the endowments.

-Harvard and Yale still beat any one asset class by roughly 3-5%.

-Harvard and Yale still beat most indexed allocation models by 3-4% with similar volatility.

- The endowments’ Sharpe Ratio took a heavy beating, knocking it down to the .60 range from over 1.0. (A nice rule of thumb is that most asset classes have Sharpe Ratios of around .2, a diversified allocation is around .4, and momentum style models can get you up to .7 and .8.

- The timing model now has a higher Sharpe Ratio than the endowments, largely due to avoiding the bear markets of 2008 and 2009. The leveraged timing model (at 2X at broker call rate) would have outperformed the endowments on an absolute and risk adjusted basis.

-The Buy and Hold allocation now has a whopping .9 correlation to the Harvard and Yale endowments.

Some comments:

What is some of the advice you give individual investors?

1. Diversify across equities, bonds, and real assets. More bonds the less risk you want.

2. Avoid taxes.

3. Avoid fees.

4. Index.

A simple portfolio we advised in the book was:

US Stocks: VTI, SPY

Foreign Stocks: VEU, EFA

Bonds: BND, AGG

Real Estate: VNQ, IYR

Commodities: GSG, DBC, LSC

We further split these allocations into 10 and 20 asset classes in the book. Next,

5. Use risk management (ie the timing model).

6. Seek alpha (via hedge-like mutual funds, AlphaClone, etc.)

Is the endowment model broken?

Just looking at the data, the endowment model has outperformed anything over the time period studied. The biggest criticism for the endowments is that they did not manage their risk, liquidity, and “tail-risk” enough. I think that is a fair criticism. But, in general, diversification works (most of the time).

There is a great paper coming out of a wealth management shop here in LA that deconstructs the Yale returns even further (ie adding value and small cap tilts, a little leverage, etc). They find that most of the outperformance is due to, surprise, the private equity allocation. As we mentioned in the book, is the PE game over now that there is so much competition? TBD.

Is buy and hold dead?

Anyone that makes this statement usually does not have a healthy respect for history if last year changed their opinion of buy and hold. EVERY asset class is great sometimes, and horrendous other times (gold, bonds, S&P 500, foreign currencies, and Argentinean stocks included). Buy and hold has never worked in periods of serious market stress. Just ask those Tulip/South Seas buy and holders.

With a diversified portfolio of world asset classes (or a 60/40 portfolio) I think you need to be able to accept a 50%+ drawdown. With a single asset class or security you need to be able to accept an 80-100% drawdown or total loss of capital. I think using risk management via a trendfollowing method fits me personally.

How is the model allocated now?

You can follow timing updates here.

Comments

[E.D. Hart:]

Mr. Faber,
Great stuff, your posts are one reason I read Seeking Alpha.

It seems that we have experienced a tectonic shift--earthquakes happen not often--but when the do, they are the result of many years of seismic forces building up in the tectonic plate. In a matter of minutes the landscape is changed, something I believe happened in fall 2008.

I was a financial earthquake and the landscape is completely different. People are asking, when will things return to normal? It depends on what you mean by normal. We have seen the results of the seismic shift, but the shift itself is invisible, unlike an earthquake. (My answer is that they will never return to normal--the financial landscape is permanently altered.)

Going forward I expect, significantly lower equity returns, significantly higher inflation, and the gradual erosion of the US Dollar hegemony resulting in re-rating of US Government debt, and much higher interest rates. The economic locus of power will shift to Asia, etc, etc. Nothing that about 10,000 other people haven't already predicted before me.

This begs the question, which asset class can be expected to perform best in such an environment?

One answer I suggest is gold. From a low of $252 on July 20, 1999, to a price of $950, on July, 20 2009--this is a greater than 14% CAGR.


I have pilfered, plagiarized and otherwise stole the following from a Lee Rogers editorial to make my point below:

Lee Rogers
From 1982 to 2000, the Dow Jones Industrial Average went from a bottom of 776.92 to a peak of 11722.98. This represents an annual compound return of 16.8% over the course of 17 years and 5 months. Ironically this rate of return is almost identical to the annual rate of return gold is delivering in its current bull market run. If we say for argument sake that the gold bull market lasts the same amount of time as the previous run in the DJIA from 1982 to 2000, we can project a gold price of $3,736.13 per ounce of gold by 2016.

Gold bottomed at $252.80 on July 20, 1999. 6.81 years later on May 12, 2006 gold peaked at $725 per ounce. This represents an annual rate of return of 16.7% which is only .1% off from what we determined the DJIA’s annual rate of return during its bull run from 1982 to 2000. Based upon the 16.7% annual rate of return this is how we came up with the $3,736.13 per ounce figure by 2016.

Please consider running your numbers with gold broken out as a separate asset class, if nothing else, for curiosity sake. What would a 20% allocation to gold do to a portfolio returns/volatility/Sharpe ratio in sample periods you've already considered?

Thanks for all of your work.

Jul 23 12:25 PM

[dsrtwriter:]

very good point. I would also like to see that gold analysis.It might provide some helpful clarity as to how to position gold in a market which is currently in recession but has the possibility of trending into inflation, just when everyone has ruled it out.

Jul 23 02:27 PM

[WorldBeta:]

Both a strategic (buy and hold) and tactical (using the timing model) allocation justifies up to a 20% allocation to gold.

Thanks for the read! And PS, SA only pulls some of my posts, you can find them all on my blog World Beta.

Jul 23 02:27 PM

[E.D. Hart:]

Mr. Faber
I will check WorldBeta, thanks of the quick reply.
looking for those elusive numbers....


On Jul 23 02:27 PM WorldBeta wrote:

> Both a strategic (buy and hold) and tactical (using the timing model)
> allocation justifies up to a 20% allocation to gold.
>
> Thanks for the read! And PS, SA only pulls some of my posts, you
> can find them all on my blog World Beta.

Jul 23 03:46 PM

[LKofEnglish:]

20% in gold? whats next? a claim that it will be the democratic party that reinstitutes the gold standard? you people are wacko. you missed the equity boat last fall and you're missing it again now. sometimes (and it is very rare) the bull gets the bull fighter. this is today's "black swan." sure the bull gets killed no matter what--but the bullfighter dies first this time. wisconsin energy still a strong buy and getting stronger.

Jul 26 02:24 AM

[southgent1951:]

I started to invest in 1968 when I was a teenager. Just in my lifetime, I have experienced two prolonged periods where stocks failed as an asset class. The first period started in the 1960s and ended in August 1982. The second period started in 2000 and continues to today. During those periods, individuals facing significant situational risks will find holding stocks for the "long term" painful. I use a dynamic asset allocation approach that takes into account what is happening in the market to fine tune my asset allocations. Recognizing that there may be prolonged periods where bonds and stocks will fail as asset classes, I am constantly developing tools to help me shift some assets between major and minor asset classes. One such tool that I used in 2007 is what I call the VIX Asset Allocation Model that gave a bearish signal in August 2007.

If you are interested in this approach, I have linked a few of my posts discussing how this model would have signaled a reduction in stock exposure in 2007:

tennesseeindependent.b...

tennesseeindependent.b...

tennesseeindependent.b...

tennesseeindependent.b...

This is a link to my Gateway Post containing links to all of my discussions on this model. tennesseeindependent.b...

I would not be one who follows fixed asset allocations, changing them just based on factors unique to me.
tennesseeindependent.b...

Jul 27 09:35 AM