The Yale Model for Individual Investors

A new strategy called "endowment in a box" has been attracting individual investors who want a diversified asset allocation that is predominantly in alternative investment.  It is based on the Yale model made famous by David Swensen at Yale and Jack Meyer at Harvard.  The strategy invests in equities and fixed income securities from around the world and has a high allocation to hedge funds, private equity, real estate and commodities.  Some of the more well known managers are HighVista Strategies, Makena Capital Management and Morgan Creek Capital Management.  I was privileged enough to hear Mark Yusko, CEO and Chief Investment Officer of Morgan Creek, speak at the Hedge Fund Roundtable last year.  Their goal is to have high returns with the least risk possible.

The article provided an inside look at HighVista Strategies which is run by Andre Perold, a former professor at Harvard Business School, Brian Chu, Jesse Barnes and Raphael Schorr.  It has $3.6 billion in assets under management.  It has outperformed the Standard & Poor's 500 index by 15.3% for the period between October 2005 to June 2012.  Dr. Perold has two main tenets:  don't lose a lot of money and get the highest returns.  HighVista invests in the top managers and uses index funds to balance their asset allocation.  56% of the portfolio is in hedge funds and private equity.  The remainder is in cash, global stock indices and bonds.  They are invested in 75 fund managers such as Convexity Capital (fixed income hedge fund), Berkshire Partners (private equity fund) and Xander Group (emerging markets hedge fund).  Another alternative holding is catastrophe bonds that pay off when there is a natural disaster such as a hurricane or earthquake.  For the traditional assets, the rule is:  the higher the risk; the higher the cash allocation.  The equities allocation is based on the VIX index which measures the option market's assessment of future volatility in the S&P 500 index.  The higher the VIX; the lower the equities holdings.

The article from Barron's can be accessed here.

Trends in Tail Risk Investing

310 investors were asked their views on tail risk in today's market environment in a survey conducted by the Economist Intelligence Unit on behalf of State Street Global Advisors.  They were located in the US and Western Europe and consisted of institutional investors (asset managers and pension funds), family offices, consultants and private banks.  The definition of tail risk is an investment that moves more then three standard deviations from a normal distribution (think bell curve) of returns.  Since the 2008 credit crisis, these events have seemingly multiplied.  Adding tail risk protection is becoming part of more investors' asset allocation model.

Traditionally, most managers diversified across the standard equity and fixed income classes along geographic, capitalization and security type.  There was a reduction of 5% of investors in using this strategy, led by institutional investors.  Slightly more consultants, family offices and private banks are using diversification even though the credit crisis showed that all asset classes correlate to 1.  The other strategy to fall was fund of hedge funds due to poor returns, high management costs and the loss of confidence with the Madoff affair.

Strategy winners were managed volatility equity strategies, managed futures and alternative investments such as real estate, commodities and infrastructure.  Managed volatility was increased across the board by the investors with the largest increase by private banks.  There was a split decision on managed futures with private banks and consultants allocating more and institutional investors allocating less assets.  Risk budgeting was stable overall with the institutional investors decrease in that strategy offset by the increase by private banks.  Direct hedging was unchanged as institutional investors and private banks doing more and consultants and family offices doing less.  The same split occurred with hedge fund investing.

Seven main factors affected investors' choice of tail risk strategy.  They are, in order of importance, liquidity, regulatory issues, risk aversion, transparency, fees, understanding/persistency of returns and lack of understanding of new asset classes.  According to Bryan Kelly, assistant professor of finance and Neubauer Family Faculty Fellow at the University of Chicago's Booth School of Business, the best hedges are debt derivatives and credit default swaps.  However, they are not liquid as they do not trade over central exchanges.  They are not considered safe investments such as AAA sovereign debt or gold for the risk averse.  The cost and fees associated with tail risk assets is another consideration.  Most investors know that it will lower expected returns and be volatile.  Another issue is the mismatch in time horizons.  Many products are short term and are being bought by long term investors such as pension funds.

Since the credit crisis, investing has been influenced more by macro economic events.  This will continue into the near future as we continue to hear about possible regional and global recessions, the breakup of the Eurozone, the US fiscal cliff and unrest in the Middle East.  Investors are trying to find the best hedges as 80% of them agree that managing tail risk is part of their investment planning.  71% believe that an event is likely to happen within one year and it will be worse than in the past.

The source for this article can be accessed here.

Asset Allocation Trends in Public Pensions

In the October 1, 2012 issue of Pensions & Investments, I noticed an interesting statistic in an article about the funding ratios of public pension plans.  The weighted average asset allocation of the top 100 plans in Pensions & Investments' universe for 2011 is as follows:

• US Equities - 21.6%
• Global Equities - 16.9%
• International Equities - 13.2%
• Fixed Income - 23.9%
• Private Equity - 7.5%
• Real Estate - 6.3%
• Hedge Funds - 2.3%
• Real Return - 1.2%
• Commodities - 0.4%
• Cash/Other - 4.4%

The target allocation for the same year was as follows:

• US Equities - 15.7%
• Global Equities - 23.6%
• International Equities - 9.7%
• Fixed Income - 25.2%
• Private Equity - 7.3%
• Real Estate - 7.6%
• Hedge Funds - 2.8%
• Real Return - 1.6%
• Commodities - 0.6%
• Cash/Other - 2.9%

The weighted average asset allocation 2007 is as follows:

• US Equities - 36.5%
• Global Equities - 6.0%
• International Equities - 17.4%
• Fixed Income - 25.3%
• Private Equity - 5.2%
• Real Estate - 5.7%
• Hedge Funds - 0.9%
• Commodities - 0.2%
• Cash/Other - 2.8%

The biggest losers from 2007 to 2011 were US and International Equities.  Global Equities, Private Equity, Real Estate, Hedge Funds, Real Return and Commodities were net gainers.  Based on the target allocations, we can expect more investment in Global Equities, Real Estate, Hedge Funds, Real Return and Commodities.

The source for this article can be accessed here.

Management Fees and Investor Alignment in Private Equity

In an article in Pensions & Investments, the Blackstone Group announced that it does not count management fees as one of the items that align general partner and investors' (i.e. limited partners) interests.  Instead, the company's investment in its own funds removes that issue - according to Steven Schwarzman, Blackstone founder, chairman and CEO.  During the company's twenty year history, it has invested $6 billion in its funds, alongside their clients.  For example, they committed $826 million in capital for the Blackstone Capital Partners VI LP, a $16 billion fund.

However, Blackstone is one of the few publicly traded private equity firms.  It is in the interest of management, who have large holdings of the stock, to maximize their management fees versus their performance fees.  The reason is that research analysts value these companies based on their management fees and/or assets under management.  Performance fees are too volatile and unpredictable to include in their analysis.  Instead of concentrating on a fund's performance, the company would be gathering assets.  Also, if performance fees are already high, there is less incentive to hit the hurdle.

Charging management fees was originally used to help private equity funds keep the lights on while investing capital.  For larger funds, the fees can be much more than the basic costs.  According to the Institutional Limited Partners Association, management fees should be based on reasonable operating expenses plus reasonable salaries.  In the second quarter of 2012, Blackstone had $373.4 million in fees, $113 million in expenses and $269 million in salaries.  Some institutional investors are pushing back on management fees and receiving fee discounts of 25 basis points if they invest $100 million or more.

The source for this article can be accessed here.

Effects of Pension Risk Transfer on Fund Managers

In the largest pension risk transfer deal of all time, General Motors offloaded $26 billion in pension liabilities to Prudential in exchange for $29 billion in assets.  This plan was executed in two stages.  First, a lump sum settlement was offered to 42,000 retirees which are about 33% of the entire beneficiaries.  For the rest of them, their pensions would be covered by annuities bought from Prudential.  The deal was created with help from Morgan Stanley, State Street and Oliver Wyman.  Other large corporations seeking to follow in General Motors’ footsteps are Alcatel-Lucent, Verizon, Ford and United Technologies.

With the rise of defined contribution plans like 401K’s, corporations have reduced or terminated their defined benefits plans.  Since 1975, the number had dropped from 250,000 to less than 30,000 – and 33% were frozen.  At the same time, pension funds have been reducing their risk profile by reducing their asset allocation to equities, doing buy-in deals (buying annuities to hold on their balance sheet) or buy-outs (doing a General Motors type of deal).  The giant deal is a harbinger of things to come.  In a survey of 500 global companies, Aon Hewitt discovered the following pension planning:

• 35% will offer lump sums to beneficiaries
• 6% will buy annuities to cover their payouts
• 6% will transfer their plan
• 4% will terminate their pension plan

Of the insurance companies involved in pension risk transfer, only Prudential and MetLife are able to take on General Motors-like transactions.  There is capacity to handle approximately $100 billion in pensions and General Motors has taken $26 billion of it.  Besides the big two, other firms that are participating in the business include MassMutual, Principal, American General and Mutual of Omaha.  Non-insurance companies such as JC Flowers and private equity firms are also targeting US companies.

These transactions may change the game in the financial services sector.  Asset managers of pension funds will lose assets to the insurers.  Managers specializing in long duration bond, liability driven investing, ETFs and alternative managers will gain.  So will consultants in risk transfer:  Aon Hewitt, Mercer and Towers Watson.  Corporate pensions currently hold twenty percent of US stocks.  As these assets are sold in exchange for bonds, there will be secular weakness in the stock market.  From a government point of view, the Pension Benefit Guaranty Corporation (PBGC) will be under pressure as only healthy pensions can transfer their risk, leaving underfunded pensions to be insured.

The source for this posting is the September 2012 article of ai-CIO.com.

Multi-strategy Funds Are Disappearing

Multi-strategy hedge funds have had a tough time lately due to poor performance and high redemptions since the credit crisis of 2008.  Several large funds have closed - Arrowhawk Capital Partners ($575 million in AUM), Drake Capital Management ($6 billion in AUM), Deephaven Capital Management ($4.5 billion in AUM) and Stark Investments ($7.2 billion in AUM).  The last and latest, Stark, is still running $1 billion in single investment strategies such as Stark Mortgage Opportunities and Stark ABS Opportunities fund.  Other funds have converted to single strategies successfully.  They include some of the more famous names:  SAC Capital Advisors, Highbridge Capital Management and Maverick Capital Management as well as Black River Asset Management, Halcyon Asset Management, Polygon Global Partners, HBK Capital Management and York Capital Management.  The challenges in the current environment for multi-strategy funds are:

• Difficult to generate excess returns (alpha) in all strategies at the same time
• High employee turnover
• Work culture is not collaborative across strategies.  Multi-strategy funds start in convertible arbitrage or event driven strategies and then add equity long/short and other strategies.  The mindsets needed to be successful in each strategy are different and not conducive to working together.

The source for this article can be accessed here.

Fund of Hedge Funds Continue Losing Market Share

Fund of hedge funds (FOHF) are under pressure due to poor performance in 2011 and their failures of 2008 - ability to give their investors liquidity and superior due diligence.  Many funds' liquidity was negatively affected by their hedge funds' imposition of gates and side pockets for poorly performing assets.  Confidence in FoHF's due diligence capabilities were lost in the Madoff ponzi scheme.

In 2007, 43% of hedge fund assets were invested through FoHFs.  In 2010, it was down to 34% (Statistics are from Hedge Fund Research.) as more investors started making direct investments into funds.  In absolute numbers, assets under management for FoHFs are down from 2010 to 2011 - $646 billion to $620 billion - despite the uptick in hedge fund assets.

Since 2008, private banking clients have divested themselves from hedge funds.  Insurance companies and endowments are investing directly into funds and family offices are using managed accounts and pension consultants instead of FoHF.

According to Peter Laurelli, vice president, research, eVestment Alliance in the article at finalternatives.com, “To an evolving landscape of hedge fund investors, it is increasingly difficult to showcase a clear, superior value provided by funds of funds, specifically using performance comparisons over every possible sub-classification, to other methods of accessing the industry.“Fund of funds’ core strength of single investment diversification to the hedge fund industry is moving towards a niche role as larger allocators to the industry become more comfortable investing directly, or working with consultants who may already be employed for traditional portfolios.”

The source for this article can be accessed here.