It's Warren Buffett vs. Yale on Alternative Investments

Yale University has a long track record of allocating its endowment capital to alternative asset managers. This strategy has delivered, according to the university’s reports, impressive risk-adjusted returns. However, the headline returns may not be all they seem. As we have discussed in previous articles, benchmarking returns to private equity and other alternative investments is far more difficult than it may appear. Indeed, these sorts of asset managers frequently conceal fees and often lack a robust system for measuring true risk-adjusted returns.

Warren Buffett (Trades, Portfolio), the "Oracle of Omaha" and doyen of value investing, has lambasted alternative asset managers for years, especially on the subject of fees. And his criticisms have clearly ruffled feathers at Yale. The latest annual report of the Yale Endowment Fund, released this week, makes the case that Buffett and his fellow critics have it all wrong and that their decision to go big on alternatives has been a saving grace.

Who is right? Today, we will attempt to offer an answer to that question.

Buffett on the offensive

In his 2016 letter to Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) shareholders, Buffett made clear his antipathy toward alternative investment managers and the high fees they command:

“In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial 'elites' – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars. This reluctance of the rich normally prevails even though the product at issue is – on an expectancy basis – clearly the best choice. My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds 10 years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.”

Pension funds in particular have earned Buffett’s ire, as he sees them as operating under a range of perverse incentives that cause them to make suboptimal allocations. We have covered that subject as well, discussing in detail the perverse incentives damaging the outlook for pension funds in the United States.

But Yale is not free from Buffett’s negative view, and the university is well aware of that fact. Indeed, Yale’s reactions to Buffett’s comments in his 2016 and 2017 shareholder letters suggest the endowment’s managers feel the criticisms are pointed squarely at them.

Yale counterattacks

In its own 2016 report, Yale took aim at Buffett and other critics of its alternative investments strategy:

“A couple of years ago, when a New York Times op-ed piece compared the estimated fees earned by Yale’s private equity managers to financial aid distributions from the Endowment, Malcolm Gladwell infamously tweeted, ‘I was going to donate money to Yale. But maybe it makes more sense to mail a check directly to the hedge fund of my choice.’ More recently, Warren Buffett joined the chorus, suggesting that endowments (among others) suffered from behavioral biases that preclude them from ‘meekly’ investing in index funds and that cause them to believe ‘they deserve something ‘extra’ in investment advice.

What Buffett, Gladwell, and other fee bashers miss is that the important metric is net returns, not gross fees. At its core, Yale’s investment strategy emphasizes long-term active management of equity-oriented, often illiquid assets.”

Yale’s argument is sound insofar as it makes sense to look at the net-of-fees returns rather than being fixated on the fees themselves. It is a bit of a myopic view, however, to simply treat those fees as a cost of doing business, even when they are absurdly high and end up taking a very substantial piece of the returns on investment. The defensiveness might have been understandable last year, since the Yale Endowment posted a relatively meager return of 3% for the year

The endowment’s investments did better last year, as reported in its latest update, released this week, but it has not removed the perceived need to defend the strategy. The endowment’s managers once again defended the high-fee allocations, claiming the allocations helped to build better risk-adjusted, long-term returns. With a reported return of 11%, some commentators have called 2017 a "rebuttal" to Buffett’s criticisms. However, that is not a particularly accurate conclusion.

Who’s right?

Ultimately, the evidence clearly stands in favor of Buffett and his fellow critics. While Yale is right to point out that improved net-of-fees returns are what matter (if an asset manager can deliver market-beating risk-adjusted net-of-fees returns, then it might make sense), in practice that is not what allocators to alternative asset managers have been getting.

In the case of the Yale Endowment, the past two years of performance do not stack up terribly well against broader market indexes. The S&P 500, for example, saw annual returns of 11.96% and 21.83% in 2016 and 2017 respectively. Yale’s reported 3% and 11% for each of those years is not terribly impressive. Likewise, the Yale Endowment’s 20-year average annual return of about 12% is not much better than the long-term average return of the S&P 500 index.

Clearly, Yale’s performance in 2017 was far from a "rebuttal" of Buffett’s criticisms. While there are clearly advantages to diversification, and there can be real value in allocating to some alternatives, the notion these allocations are making a world-shattering difference to the financial performance of the Yale Endowment or other big allocators is not borne out by the evidence.

We have to side with Buffett on this one.

Disclosure: I own no stocks discussed in this article.