February 2012 Source: Balmain Funds Author: Stephen Tunley - CEO Balmain Funds
Equity market volatility spiked again in 2011, making the ‘investments must be liquid’ orthodoxy even more difficult to sustain.
Readers may recall the Balmain Funds August 2010 Thought Piece ‘Is Volatility the price of liquidity and if so, can you afford it?’1 where we challenged the mantra that a portfolio had to be entirely liquid. This mantra was resulting in investors being directed, by advisors and also through structural decisions by Wrap and Master trust platforms, primarily into listed (‘liquid’) investments.
But in an era of unprecedented volatility and extreme market events, we argued that such a strategy placed investors at risk from reduced diversification and from wildly fluctuating performances.
In this follow-up article, we show what the ‘intelligent money’ is doing when it comes to managing volatility and liquidity. And the simple answer is...more allocations to illiquid and ‘non-traditional’ markets such as real assets and private equity; and less investment in equities.
By intelligent money, we mean the three largest US university endowments (specifically the $19.4 billion Yale, $32 billion Harvard, and $19.5 billion Stanford2 ) that are regarded by some in the investment industry as the leading lights in portfolio management and in particular, the ‘endowment model’ of investing.3
And these three endowment funds have the performance to prove it. In the ten years to June, Yale returned 10.1 percent pa, while Harvard earned 9.4 percent and Stanford 9.3 percent. They beat the often used 60/40 stock/bond portfolio benchmark (used typically by US Pension Funds) which returned just 4.3 percent over the same period. Over twenty years, Yale returned 14.2 percent pa and Harvard 12.9 percent while the 60/40 stock/bond portfolio returned 8.3 percent.
The tables below reveal the asset allocations of these endowments.
Yale Source: The Yale Endowment 28 September 2011
Harvard Source: Harvard Management Company, September 2011
StanfordSource: Stanford Management Company, June 30 2010. *2011 data not publicly available.
Note that Yale has nearly 80 percent of its assets in ‘alternatives’ such as private equity, real assets and absolute return products4, and just under 17 percent in US and global equities.
These allocations are in sharp contrast to Australian investors who, partly as a consequence of the liquidity mantra, have significant equities exposures. For example, SMSFs have on average 44% in shares (directly and via managed equity funds5) while the top 10 not-for-profit super funds have 54% in equities. (See table below)
FIGURE 2: VIX® AND S&P 500 INDEXES Sources: Bloomberg and CBOE
Average allocation of the top 10 not-for-profit Super Funds in Aust Source: Brookvine and Superfund Annual Reports 2010 & 2011
With stock market volatility repeatedly spiking (see chart below), Australian investors are well and truly exposed to the gyrations of equities.
These gyrations are a global phenomenon given;
Another driver of the heavy allocations by Australian retail and SMSF into shares is a function of structural biases within the financial planning industry. These include the leading role that investment platforms play in selecting the product range (biased towards funds and listed markets) compounded by the high penetration of platform usage among financial planners which them means that non-platform products are never considered.
Australia’s largest investor, the $73.1 billion6 Future Fund, has also created a well diversified portfolio...with just 31.6% global and domestic in equities,) which compares quite starkly to the average 54% of the top 10 not-for-profit Super Funds in Australia). The Future Fund is only five years old and being a new player, has been able to deploy leading edge investment strategies (see table below).
Source: Future Fund
What is particularly interesting about the three endowments funds and the Future Fund is the percentage of investments that are typically regarded as ‘illiquid’. More than 57 percent in the case of Yale which is in sharp contrast to the ‘investments must be liquid’ mantra currently espoused by many in the Australian financial advisory and platform industry!
The three endowments also have the majority of their assets in non-traditional assets - 80 percent in the case of Yale.
* If ‘alternative assets’ are regarded as ‘illiquid’, this percentage would rise to 38.5%
Even though endowments such as Yale have far longer time horizons than a typical SMSF (but not that far from superfunds), nevertheless, their asset allocation policy is insightful. Gleaned from their annual reports, they are summarised below;
A recent report by the Australian Prudential Regulation Authority (APRA)8 has also supported our views that the mantra for liquidity has perhaps swung too far.
APRA found that not-for-profit superannuation funds with a higher allocation to illiquid investments, such as directly held property, infrastructure and alternative investments, have higher risk-adjusted returns.
The APRA study was based on 146 super funds with total assets each of at least $200 million between September 2004 and June 2010.
Other key findings include;
When considering higher allocations to illiquid non-traditional investments, there should also be a corresponding awareness of liquidity management....that is, the need for an investor to have adequate cash flow to fund outgoings (or redemptions in the case of a pension fund –see ‘run risks’ in the APRA section above.)
For SMSFs, there is little ‘run’ risk, although SMSFs in the pension phase need careful cash-flow management, with perhaps greater consideration given to reliable yield-driven or dividend-driven non-traditional investments.
This brings us to the topic of accessing non-traditional investment products. Endowments are endowed (pardon the pun) with the resources to access the best alternative investment opportunities. They have analysts scouring for the globe for investments, and a strong alumni that offers contacts, insights and ideas not freely available to most investors (including Australian super funds). And in particular, they are not ‘held captive’ by planners and/or platforms that offer a limited menu of products.
For SMSFs, accessing a truly independent range of alternatives will remain a challenge, particularly as the ‘Big Four’ Australian banks dominate much of the financial planning, platform and product (funds) industry. (see Our article ‘The big banks have large fingers in your financial wallet,’ February 20119.) This ‘quadropoly’ of banks have an economic interest in keeping the independent providers out, and controlling the information flow (via their hefty and powerful PR/lobbying teams) to channel investor interest into their own networks.
The ‘intelligent money’ has significant allocations to illiquid investments and ‘non-traditional’...nearly 60 percent and 80 percent respectively10 in the case of the Yale Endowment. The rationale is to capture an illiquidity return premium and reduce risk by improving diversification within an investment portfolio.
In an era of volatility and increased risk of ‘extreme market events,’ illiquid investments have a role to play to stabilise returns, particularly if an investment portfolio is designed for the long term. Even for investors close to retirement, illiquid assets have a place in a portfolio, particularly if there is a yield, dividend or rent to provide cash flow.
Illiquid investments can become a problem when a forced or urgent sale is required to fund unexpected cash outflows. The global financial crisis of 2008/2009 highlighted this risk but the irony is that many investors were forced to sell illiquid assets when their ‘liquid’ investments also turned out to be illiquid during the extreme market volatility. Damage was added when correlations between many ‘diversified’ liquid investments converged to one, resulting in no real diversification benefits.
By including illiquid investments in a portfolio, the range of assets classes and opportunities are opened. At Balmain, we believe investment ideas are at their most dangerous phase when they become mantras and investment orthodoxy, as it often means the whole world is doing the same thing. We hope this article provides food for thought to challenge the ‘liquidity’ mantra, and for investors to consider new investment options that provide equity-like returns with lower volatility.
(over 70 percent of the investments in private equity, real estate, real assets, and marketable alternatives)
MIT Investment Company Asset Allocations Source:MIT Investment Mgt Company website http://www.mitimco.org/whatwedo/investment_management
*Hedge funds **Timber, commodities, oil & gas
1 Available from http://www.balmain.com.au/Balmain/PublicationsDetail.aspx?Id=3
2 The fourth largest US university endowment is Princeton ($17.1 billion, 9.8% pa return over 10 years. Asset allocation data is not publicly available). MIT is another major endowment –see appendix one for their asset allocation model.
3 See The Endowment Model of Investing: Return, Risk, and Diversification. Wiley Books
4 Private equity –typically includes venture capital and buy-outs, real assets typically includes timberland and direct natural resources investments, absolute return typically includes hedge funds and investment funds that are not swayed by benchmarks.
5 Source Brookvine/Multiport SMSF Investment Patterns Survey Sept 2011
6 31 December 2011
7 Source: Yale Endowment Fund, 30 June 2010
8 APRA Research 7 November 2011
9 Available from here http://www.balmain.com.au/Balmain/PublicationsDetail.aspx?Id=98 APRA Research 7 November 2011
10 Source: Yale Endowment Fund, 30 June 2010
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