ENDOWMENT RETURNS: MPT STILL VALID?

Hey, do you remember a few years ago that there was a “new” asset allocation strategy being used by the big endowments? We are talking about Harvard and the Ivy League schools as well as other big name schools and foundations.

The “old” and outdated strategy was Modern Portfolio Theory (MPT) and up to then had been sort of universally accepted as the way to diversify your portfolio and achieve some semblance of risk moderation.

During the market run up between 2002 and 2007, the endowments thought they could both increase their returns and further moderate their downside exposure. Wow! This sounds like the Holy Grail to me. Increase returns and lower risk? Sign me up!

They thought the way to do this was to increase their investments in “alternative” investments and reduce exposure to traditional stocks and bonds. Things like hedge funds, venture capital funds and absolute return funds. Of course, these investments were doing well in the middle 2000’s like everything else.

So, the strategy was working! But, first of all, who can tell me what a hedge fund is and how it really works? You say, they hedge their bets and make money when the market goes up and when it goes down. Now, what about an “absolute return fund”? Well, it strives to make money all the time, even when the market has negative returns. Don’t we all try to do that?

All of this is not to mention that these products have abnormally high expense ratios. We are talking 2 to 5 % instead of your more normal .5% to 1% that us peons usually pay for our mutual funds. Which, by the way, try to make money all the time as well!

So, what has happened? The endowments are now disappointed with their returns in the last two years. The average endowment lost 19% between June 2008 and June 2009. The endowments such as Harvard, Yale and Princeton have lost around 25% in this period. They are now trying to unwind these "alternative" investments.

Whoa! You mean to tell me that the new strategies didn’t work? True! A simple 60/40 mix of the S&P 500 index and the Barcap Aggregate Bond Index would have “only” lost about 14%.

So, the endowments paid big money for worse than index performance!

All of this goes to show that simple is better; index performance over time is better than managed; the basics of MPT are still valid; and finally, that exotic high priced products only benefit the providers of the products and not the buyer of same!