Last summer in Cambridge, Massachusetts, the Trustee Leadership Forum for Retirement Security held its annual meeting at Harvard's Kennedy School of Government. Trustees and representatives of various state pension funds listened to explanations about the challenges facing endowments and pension funds.
The conference is an attempt to explain why so many state pensions are underfunded and underperforming. The event was run by Jay Youngdahl, a senior fellow at the Hauser Center for Nonprofit Organizations at Harvard University. Youngdahl is the author of “Investment Consultants and Institutional Corruption,” and as you might imagine, there was very little in the way of minced words at this event. I was invited to give a presentation to this group on how cognitive bias and performance-chasing leads to investing failures (you can see “The High Cost of Neuro-Financial Errors” here).
A large part of the impetus for this sort of conference is the solidifying consensus that what has become known as the Yale model -- outsized investments in hedge funds, venture capital and private equity -- no longer works. Indeed, the performance numbers for the past 10 years make it clear that this model has failed to live up to its promise for a while, perhaps because there just aren't enough good alternative investments to go around. Note that none of this is cutting-edge theory or newly discovered knowledge. Rather, it is a result of institutional inertia, where even a failing approach to investing holds on to its adherents long past its sell-by date.
I was reminded of this today by an article by Gregory Zuckerman in the Wall Street Journal titled “Big Investors Missed Stock Rally.” “Corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances,” according to the article.
The article went on to say:
The average college endowment had 16% of its investment portfolio in U.S. stocks as of the end of June 2013, the most recent academic year, according to a poll of 835 schools conducted by Commonfund, an organization that helps invest money for colleges. That is down from 23% in 2008 and 32% a decade ago.
The endowments at Harvard, Yale and Stanford -- $32.7 billion, $20.8 billion, and $21.9 billion respectively -- all significantly underperformed the benchmark Standard & Poor's 500 Index during the past three years. The results have led to much hand-wringing, but not a lot of soul searching. The complaints come in many forms and include Nobel Laureates debunking inflated claims of the merits of alternative diversification to financial analysts who criticize investment fund fee structures.
When it comes to endowments, the real surprise was how enormous the exposure to alternatives has become. In the poll by Commonfund mentioned above, the $450 billion in endowments had 53 percent of their assets in alternative strategies as of this time last year, up from 33 percent in 2003.
That goes a long way toward explaining the woeful underperformance.
Similar trends were evidenced in public pension funds -- alternative investments are now as much as 25 percent of portfolios, up 150 percent from just a decade ago. Corporate pension funds have almost doubled their alternative holdings, which now make up 21 percent of their funds.
There are many reasons for this, but I suspect the biggest explanation is the concept of “expected returns.” For reasons unfathomable to me, the expected returns for alternatives are always far above those of bonds and equities. Somehow, the consultants who help place funds at endowments and the accountants who enable them have managed to create false return expectations, which seem to have been accepted as gospel at these endowments
But the real trouble comes at public pension funds. The higher expected returns --based as they are on wishes and gossamer dreams -- allow states to contribute that much less to their public employees pensions and retirement accounts. Taxes, in turn, are lower than they need to be to meet the promises made by politicians to public employees.
The big scam isn’t the high fees or underperformance. It is the knowing, systematic and willful shortfall in contributions by the states. Alternative investments are merely the vehicle by which they accomplish this.
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