"Kee" Points with Jim Kee, Ph.D.

The short Thanksgiving week ended with pretty strong rebounds in the data on New Home Sales, Durable Goods Orders, Personal Income, and the Michigan Consumer Sentiment survey. Last week’s Kee Points was a little lengthy (sorry about that) so I’ll keep this one short.


The “Endowment Model” of investing: When David Swenson’s Pioneering Portfolio Management was published back in 2000, the author had been managing $6 billion of Yale University’s endowment for 14 years with impressive results. What made Swenson’s approach unique was the huge allocations that he made to so-called alternative investments, particularly private equity but also hedge funds, real estate, natural resources, and emerging markets. Many of these were considered to have low or no correlation with the overall market. A Wall Street firm that I worked for at the time had boxes and boxes of that book for clients.


The endowment model, or “Swenson model” as it came to be known, produced many imitators. Although deemed to be more diversified than conventional portfolios, they lost about as much as global equity markets during the 2008 downturn. In the words of author Ashvin Chhabra, they lost all of their diversification benefits and behaved just like a 100% equity portfolio. Chhabra offers a fairly insightful critique of the endowment model, arguing in effect that all investors need a safety component (i.e. cash, bonds) in addition to a market component (all that other stuff). In a speech I attended in New York, he surmised that Yale’s (and Harvard’s) safety component was their schools’ global draw - they could fill their incoming freshman slots several times over with full tuition paying students even if they had no endowment at all, so the managed endowment contained mostly “market investments” complete with commensurate market risk.


That’s important to know but overlooked for individuals and institutions that don’t have that safer component of their asset allocations covered. I mention this because it highlights the dangers of allocating the safer portion of investment portfolios, namely bonds, to riskier market-type bets. This year has been a good example with the poor performance of hedge funds, master limited partnerships, emerging market equities, and resource or commodity investments (whether commodities are in fact investments is a topic for another Kee Points).


As for private equity, former venture capitalist and hedge fund manager Andy Kessler wrote in the Wall Street Journal last Spring that “the glory days of private equity are over” (the title of his article). I won’t go into all of the reasons Kessler gives here, because it’s really beside the point. The point is that safe investments like high quality bonds are a tried-and-true hedge to riskier stocks, and they belong in most portfolios. Safe bonds are a true diversifier. Allocating the bond portion of a portfolio to risker, market (equity) or alternative investments will certainly lead to disappointment again during the next market downturn.