Over the past decade, the “endowment model” of investing has become very popular. The model was developed through the pioneering work of the Yale University Endowment under the leadership of its chief investment officer, David Swensen. In earlier times, endowments invested primarily in cash-generating fixed income securities (bonds). Later, they added publicly traded, generally large capitalization domestic stocks to the mix.
Swensen and his team de-emphasized stocks and bonds in the Yale portfolio and loaded up on “alternative investments.” In addition to foreign and emerging market stocks, these included hedge funds, real estate, commodities and something called “private equity.” The most recent Yale Endowment annual report states that U.S. stocks and bonds constituted only 15 percent of its portfolio and foreign and emerging market stocks only another 14 percent. More than two thirds of Yale Endowment’s assets were held in illiquid alternatives in categories such as “absolute return” (23 percent), “private equity” (19 percent) and “real assets” (27 percent).
For many years, Yale’s strategy provided stellar returns, averaging something like 15 percent a year, on average, for the two decades leading up to 2008. Swensen has written best-selling books and now has an almost cult following among investment advisers. Many endowments, foundations and large pension funds (like California’s CALPERS) have sought to emulate the Yale model and have committed vast sums to alternative investments.
But something happened this past year in New Haven, Cambridge and Sacramento. All those fashionable alternatives seemed to have come unraveled at the same time. Yale, the lodestar, has suffered losses that, according to its President Richard Levin, will result in university-wide budget cuts and deferral of capital projects.
Since most of the losses to the Yale Endowment have occurred since the start of its current fiscal year on July 1, we won’t have a full sense of the damage until their annual report comes out this fall. What we do know so far is that the Yale Daily News reported that the Endowment lost about 25 percent in the four months from June 30 to October 31, 2008. That’s a decline of almost $6 billion, real money in anybody’s world (other than the government’s).
But this story has only partly been told. First, equity markets have continued to suffer significant losses since October 31, and the same likely goes for the Yale Endowment. As I write this, the overall U.S. equity markets are down 35 percent since June 30, 2008. Since the Yale loss through October 31 was roughly equal to the decline in U.S. stocks for the same four-month period, it’s safe to assume the Yale endowment has lost another $2.5 billion during the past three months.
Second, and perhaps more important, we must remember the most common feature of “alternative investments” is that they’re illiquid, meaning they can’t readily be converted to cash. And that means there’s usually no market value to plug into one’s appraisal of value. So the 25 percent reported decline in the Yale Endowment could well be considerably worse if an appreciable portion of the alternative assets are being carried on the books at values based on their cost rather than the current market.
And now the coup de grace: The one-fifth of Yale assets described as “private equity” not only lacks a readily discernable market value, but typically come with a nasty feature known as a “capital call.” The private-equity investor must periodically come up with another $0.50 or $0.75 for every $1 they’ve invested. We don’t know Yale’s liability for capital calls, but the Wall Street Journal recently reported that Columbia University’s endowment, with 40 percent in private equity, is obligated to meet $1.6 billion in capital calls between now and 2012. Where will that cash come from? Either Columbia must divert cash from its endowment that would otherwise go to fund operations, it must sell its liquid investments like stocks in a very depressed market, or it must dispose of its illiquid private equity holdings at fire sale prices (assuming a buyer can be found).
Other alternatives are wreaking similar havoc on investors following the endowment model. Consider commodities, whose prices escalated rapidly in recent years, until July 2008, then fell far more rapidly than they rose. Oil, by far the largest commodity traded by dollar volume, has plunged from $147 a barrel to below $40 in just six months, a decline of 75 percent. Even at a gaudy annual rate of return of 15 percent, it would take a full decade just to get back to even.
In a recent presentation before the Marin County Estate Planning Council, highly regarded investment adviser Tim Kochis of San Francisco advised attendees that one should have at least $5 million of investable assets before venturing into “alternatives.” That’s certainly good advice. I’d add that one should also fully understand the stress that illiquidity will place on one’s investments during difficult market periods. “Alternative investments” have more doubtful expected returns and considerably higher risks than investors have generally counted on.
