‘Sophisticated’ money and family offices are moving to less liquid, higher cost asset classes. Am I missing out on something?
The original version of this article first appeared in The Business Times.
From 1985 to 2021, Yale’s endowment achieved an annualised return of 13.7%, growing from USD1 billion to over USD40 billion after making withdrawals for the endowment’s liabilities.
To give you a sense of this 36 year achievement and the power of compounding, a good annualised return of 8% – what global public equities typically return over longer time frames – would have compounded to 16 times your money. Achieving 13.7% as Yale did would have compounded to 100 times your money.
The Yale portfolio was famously deployed not only into broad and professionally managed public equities and fixed income, but also across multiple asset classes, including hedge funds, private credit, private equity, real estate and other alternatives. The main source of incremental returns came from a combination of alpha, manager selection, the illiquidity premium, longer duration assets, and leverage through its investments in various private market funds and hedge funds.
Careful, diversified asset allocation was no doubt key in increasing returns, though often misunderstood is why and how to apply these same principles and diversify well towards one’s own life goals.
We cannot just copy and paste Yale’s asset allocation for ourselves, as an ideal and personalised asset allocation is dependent on the duration, expected return, volatility and liquidity tolerance of your specific and unique wealth goals. This asset allocation should no doubt change as your life circumstances and goals evolve, much like it did for Yale.
More asset classes to help you diversify and seek more sources of returns
Private markets in general give you access to companies that are not available in the public market as they are not listed. Moreover, the information of private companies are not readily available to all investors (unlike public markets) as such the private equity or private credit manager that does its homework and has the relationship with the private company is likely to have a significant information advantage that enables them to generate “alpha”.
Private capital is also likely to demand better terms for funding from the private company given the longer term nature of its capital. This forms the basis of the “illiquidity premium” of higher private market returns versus public market returns.
Hedge funds that normally invest in public market instruments benefit less from the alpha and the illiquidity premium associated with private markets. However, there are certain hedge funds that have developed a systematic edge versus their peers typically through trading and risk management systems and calculated use of leverage to generate alpha within public markets without taking much directional market risk (beta) to generate absolute returns (returns over zero rather than returns relative to a benchmark).
There are many types of hedge funds out there, so it is important to be specific when talking about the infamous category. One strategy that has been successful for many decades comes from a small group of multi-strategy multi-manager hedge funds, which hire talented traders and give them an attractive performance based formula on their compensation but with ruthlessly tight risk limits on both drawdowns as well as the amount of market risk they can take, which if breached can instantly cost them their jobs. This risk management system has enabled these funds to use leverage on the alpha generated by the managers and collectively produce returns comparable to public equities after fees but with significantly lower volatility and correlation to markets.
“Higher returns with lower volatility” – what’s the catch?
The marketing materials of private credit, private equity, and hedge funds is worth being skeptical about. Showing off higher returns and lower volatility must have a catch, and it does – less liquidity with more “gates” and lock ups, higher fees, as well as more complexity and use of leverage that can lead to tail risk.
Beware of high costs and ensure you know why such funds may be pushed to you. Does the bank or platform earn a lot of subscription fees and recurring trailer commissions when they sell you these types of funds? Such incentives may influence their behaviours and decision to sell you certain funds rather than advise if they are best-in-class and suitable for your goals. Fewer high quality funds may also be willing to pay for distribution, causing a negative selection bias.
When assessing whether a fund is good, always consider the manager’s proven implementation, net returns after fees, strategy repeatability, and vintage diversification particularly for private market funds.
Even more importantly, when assessing if a fund might be suitable for your wealth, consider whether your specific investment goals can sustain the liquidity terms as well as less transparent and timely market pricing than that of your public market securities.
Just because endowment and sovereign wealth funds have it in their portfolio, do I need it in my portfolio?
Yale’s endowment understands when in the future they have to renovate buildings, provide scholarships, invest in research programs, and incur other liabilities. Designing your wealth goals towards your life goals is no different as you can know if you are saving for a rainy day, a down payment, children, parents or retirement.
Your allocation to private markets and hedge funds could be a majority of your portfolio, or not have a home in it at all. When deciding how much to allocate to less liquid asset classes, or any asset class for that matter, you must first consider your specific goals that build up to your overall asset allocation – not the other way around.
This is the backbone of personalised, success-oriented, asset allocation of your wealth.
“By relying on the decisions of others to drive portfolio choices, investors fail to take responsibility for the most fundamental fiduciary responsibility—designing a portfolio to meet institution-specific goals.”
- David Swensen, Yale’s chief investment officer from 1985 until his passing in 2021