Critics question whether endowment model should be used by individual investors

Observers question using the approach for individual investors

May 10, 2009 @ 12:01 am

By Dan Jamieson

Some industry observers are questioning whether an endowment model of investing — as popularized by the Yale University endowment fund — should be used for individual investors. The endowment model adds diversification to traditional stock and bond portfolios by including large doses of alternatives and real assets. In recent years, the approach has produced some eye-popping returns. “There's been a noticeable move to include non-traditional assets in portfolios” of high-net-worth investors, said Scott Welch, a senior managing director of Fortigent LLC in Rockville, Md., a platform provider for advisers. At the same time, mutual funds, exchange traded funds and hedge fund replication products have lowered the “access point” to alternatives, he said. “Three years ago, you probably needed $10 million” to gain access to a broad portfolio of alternatives, Mr. Welch said. “Today, you could probably build something close with $2 million” or less, he said.

<b>Scott Welch:</b>
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Scott Welch: "What blew up were the private-equity holdings."

But the democratization of the endowment model may be arriving just as the investment approach is blowing up.

Yale's endowment reportedly is looking at a 25% loss for its fiscal yearend in June. Meanwhile, Harvard University's endowment might be down about 30%.

Many college endowments are being forced to unload their private-equity and hedge fund stakes at discounts.

“What blew up were the private-equity holdings,” Mr. Welch said.

As of June, Yale's endowment had 20% in private equity, with another 55% in absolute-return strategies and real assets. It had just 10.1% in domestic equity.

Harvard had 13% in private equity, another 36% in timber, agricultural land and real estate, and only 11% in domestic equity.

“Everybody copied Yale,” said Andre Perold, a professor at Harvard Business School and founder of HighVista Strategies LLC, a Boston firm with $1.7 billion under management for endowments and high-net-worth individuals.

“Somehow, people thought being illiquid was no problem,” he said during a presentation last week at a meeting of the Denver-based Investment Management Consultants Association.

The crisis that endowment funds face was a major point of discussion among advisers at that meeting.

Mr. Perold poked fun at his own school. He showed an artist's rendering of a proposed new Harvard medical-research facility that has since been put on hold, leaving a hole in the ground from the groundbreaking.

Some observers are even questioning the huge returns posted by endowment funds prior to the meltdown.

Yale in New Haven, Conn., boast-ed an annualized 10-year return of 16.3% as of June 30, and Harvard in Cambridge, Mass., had a return of 13.8%. The Standard & Poor's 500 stock index, meanwhile, returned 2.9% on an annualized basis, according to Morningstar Inc. of Chicago.

Some endowments might have assets priced at book value rather than market value, said Ron Surz, president of PPCA Inc., a San Clemente, Calif.-based consulting firm.

Furthermore, “some kind of stale pricing is smoothing [hedge fund] returns,” said Adam Patti, chief executive of IndexIQ of Rye Brook, N.Y., which offers hedge fund replication products.

“Sometimes [hedge funds are] overestimating returns and underestimating volatility,” he said, citing his firm's research into the correlation of monthly hedge fund results.

Valuation is a challenge for private-equity holdings, Mr. Welch said, “but I tend to believe the performance numbers” of the endowments because “they truly were invested with the top [private-equity] firms.”

But most individual investors don't get access to top private-equity firms and hedge funds.

That is why individuals shouldn't use alternatives, Mr. Perold said in an interview.

“The reason is, it's costly, and they have no advantage in figuring out who's good and who's not,” he said. “All they're doing is incurring costs and lockups.”

Instead, Mr. Perold recommends that investors buy a world equity index and reduce risk with inflation-protected bonds, using only low-cost, liquid products.

Mr. Welch disagrees.

“If you included long-short [strategies] and [commodity-trading advisers] in your portfolio, then that helped you last year,” he said.

Most investors don't want alternative investments that aren't transparent and aren't liquid, Mr. Patti said. His firm's products use a transparent model and ETFs to mimic hedge fund performance.


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“The days of the hedge fund with the secret sauce [that] can't tell you what [it does] are gone,” Mr. Welch said. “That's not an acceptable response.”

Matthew Armistead, president of Camelback Wealth Management LLC in Phoenix, pointed to the Hussman Strategic Growth Fund, which uses a hedging strategy, as an example of a registered product that advisers can use to replicate alternatives for smaller investors. Hussman Econometrics Advisors Inc. of Ellicott City, Md., manages the fund.

“I think advisers in general got complacent [about risk] over the last few years,” said Mr. Armistead, whose two-year-old firm has about $9 million under management.

After last year, though, advisers are clearly in the mood for alternatives.

At one point during the IMCA conference, advisers were lined up several deep at the IndexIQ booth.

E-mail Dan Jamieson at


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