by Prateek Mehrotra, MBA, CFA, CAIA
The portfolio managers atop the country’s most respected university endowments failed to make the honor roll during the current bull market despite their top salaries and genius IQs. Harvard University’s $32.7 billion endowment returned an average of 10.5% annually over the past three years through June 2013 versus 18.45% for the S&P 500, including dividends, over that same period, the Wall Street Journal reported. Yale University’s $21 billion juggernaut gained 12.8% annually over the same period.
Underperformance this market cycle is hardly a reason for endowment managers to be ashamed. All investment strategies experience bouts of underperformance. Looking back 10 and 20 years, endowments outperformed the stock market with a lot less volatility. Endowments failed to live up to expectations this bull market cycle because they’re thin on equities and heavy on alternative assets, which lagged the stock market the past five years. For example, the Yale Endowment has only 11% of assets invested in foreign markets and 6% in domestic stocks. About half of Yale’s portfolio is invested in alternative or illiquid assets such as hedge funds, private equity, venture capital, real estate, timber, oil and gas.
“Less liquid markets exhibit more inefficiencies than their liquid counterparts, illiquid markets create opportunities for astute investors to identify mispricings and generate outsized returns,” the Yale Endowment 2013 report stated. “Intelligent pursuit of illiquidity is well suited to endowments, which operate with extremely long time horizons.”
Here are five reasons I’m confident the endowment investing method will prevail again soon.
1. The law of mean reversion will eventually turn against U.S. equities in favor of alternative assets, which offer more opportunities to find dollars selling for pennies.
With the stock market trading at sky-high valuations and investor sentiment at a 17-year high, stocks are long overdue for a correction. A selloff appears to be already under way. The S&P 500 currently trades at a Cyclically Adjusted Price to Earnings, or CAPE, ratio of 26 versus its long-term average of nearly 17. The more commonly cited price-to-earnings ratio of 17.4, according to Morningstar, is expensive relative to emerging and foreign developed markets. Secular bull markets cannot occur unless P/E ratios are in the single digits in an environment with higher interest rates and inflation than we see today.
Although companies are showing decent sales and earnings growth this year, the numbers have to be taken with skepticism because of financial engineering via share buybacks. Share repurchases shot up 50% year over year in the first quarter to $154.5 billion, according to FactSet. The research firm notes that’s the biggest amount in nearly a decade. The Investor’s Intelligence Bulls/ Bulls+Bears indicator shows investors are the most optimistic they’ve been since the summer before the epic crash of 1987.
2. Alternative assets offer risk-to-reward opportunities that are uncorrelated with the stock market, the potential for higher returns and portfolio diversification.
Hedge funds can absorb shock or protect against losses in case of a stock market selloff as they have short positions that go up when the market goes down.
3. Private equity and venture capital move to the beat of their own drum, independent of the stock market.
CEOs of private firms can take more entrepreneurial risks to grow their business and take a longer-term view. They are not beholden to a quarterly earnings report and beating analysts' estimates by the proverbial penny. Investors in private firms can have greater influence over the management and get more detailed “inside” information to better assess a company compared to investors in publicly traded companies. Private equity lagged the stock market slightly over the past five years ending December 31, 2013, rising 16% vs. 18% for the S&P 500, according to Cambridge & Associates. But the asset class surpassed the stock market by a wide swath over the past 10, 20 and 25 years. Venture capital also lagged the stock market the past five years but outperformed over 10, 20 and 25 years.
4. With interest rates slowly rising from their lowest levels since at least 1954, bonds are going to be about as popular as cops at a frat party.
The Federal Reserve is hellbent on lifting the inflation rate to 2%, and I’m confident it will do whatever it takes to hit that target. As the economy expands further and unemployment continues falling, workers will command higher salaries, thereby fanning inflation. New U.S. jobless claims have dropped to their lowest level since 2006. The unemployment rate has reached a seven-year low of 6.1%. The country has added more than 200,000 jobs a month since February.
5. Once inflation returns, hard assets – real estate, timber, gold, oil and gas – will come back into favor.
They not only hedge investors against inflation but also geopolitical and economic crises, which seem as abundant as commodities these days. Argentina has defaulted on its loans for the second time in 13 years. Israel, Iran, Iraq, Russia, Syria and too many African countries to list are all at war, threatening oil production and metals mining.
As this table below shows, the Endowment Index – a benchmark for endowment-style investing – outperformed 60/40 stock and bond strategies, commodities and the S&P 500 by 1 to 4 percentage points annually on average between July 2000 to June 2014, according to calculations by NASDAQ OMX.
Prateek Mehrotra, MBA, CFA®, CAIA, has more than 20 years of experience with alternative investment strategies for institutional and individual investors. He serves as the chief investment officer of Endowment Wealth Management and ETF Model Solutions in Appleton, Wisc., with $60 million in assets under management.