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December 1, 2014 - Kim Moore [see other posts]


Investment Worries...for Foundations, Pensioners, Small Investors

We have been living in an investment climate since 2008 which is either a near-term new normal or an aberration of sorts. At least, it seems that way to me. At three investment committees that I participate in, the word has been virtually consistent since the 2008 debacle -- "expect returns below the historical norm for the next 5-10 years." While advisors have been providing this sobering line -- even to the extent of questioning the ability of foundations to meet their five percent payouts from available returns, the US stock market has been soaring. Meanwhile, the fixed income market has been dealing with interest rates at historic lows, creating concern that increased rates will "sometime soon" hit fixed income with significant principal losses. [I personally felt this had to happen at least four years ago and have missed out on lots of good fixed income returns as rates ratcheted down toward zero.]

At an investment conference last week, five of my directors and I heard over and over again that the "endowment model" is being questioned, although the speakers uniformly supported its continuance -- it is their livelihood, after all. What is the "endowment model"? As a lawyer, I thought it was simply the accumulation of a corpus from which only income was distributed, subject to recently-enacted state laws recognizing the total return concept of investing and permitting invasions under reasoned approaches. Apparently, to the investment community, the "endowment model" is a diversified portfolio of investments from different asset classes which tamps down volatility -- movement in returns and values -- because the various asset classes do not move in tandem under the vast majority of market conditions.

Okay, that was a mouthful about the "endowment model" (which was never stated at the conference but assumed by all). More concretely, if an investment fund has US stocks and bonds, emerging markets stocks and bonds, developed foreign stocks and bonds, fixed income, hedge funds, private equity, real assets (timber, gold, etc.), infrastructure (a new asset class to me), distressed debt and others covering many investment vehicle sizes (small, mid and large), those assets should not all tank at the same time and they will certainly not all soar at the same time. The range of returns should moderate on a long-term basis at a good level -- say 7-8 percent -- and you will not face the prospect of selling under duress. You will give up upside and presumably be protected somewhat on the downside. We all know that recovering from 10 percent down requires 11 percent up.

There are several apparent problems with the "endowment model."

First, we learned in 2008 that correlation -- how asset classes related to one another under a given set of market conditions -- can be similar or identical; virtually all investment assets went down together in 2008. In spite of all of the exotic asset classes, you may still have "all your eggs in the proverbial basket." Experts say 2008 was a liquidity crisis, the global liquidity threat affected all assets and that type of economic issue is rare (a "black swan" event). There is also the awareness that we have a global economy so regional variations, currency hiccups and country-specific distress spread everywhere to some degree. There seem to be drivers toward correlation which have to be monitored.

Second, by intent, the basket of assets will not keep up with the stock market when it is soaring -- as it has been for several years. The complaints about the endowment model occur now due to five years of serious underperformance of highly diversified, complicated endowments compared to 60/40% or 70/30% stock/bond passive portfolios. The apparently unsophisticated may be true sophistication!

Third, the endowment model is expensive. Although in this model, some asset classes may be passively invested to mirror the market, the need for asset classes not correlated to the general market will invariably lead to expensive managers and consultants, and some asset classes for small endowments can only be accessed through funds of funds, which create double tiers of fees. Fees matter a lot in any size of investment portfolio. Evidence concerning benefits of active investing (selecting a few from the universe of available stocks, bonds, etc.) versus passive investing (buying a representative slice of the market) is debated in investment committees, coffee shops and academic circles. Active investment has certainly not been a winner in recent years.

So, what's a person to do? Hang on or abandon the endowment model? If you have paid for the downside protection (and assume it might be there when the correction happens), is now a good time to change? Sorry, there are no good general answers to this my way of thinking.