In a recent poll conducted
by SEI (NASDAQ:SEIC) of US non-profits and endowments, 46% of responses indicated
that volatility has had a high or extremely high impact on their investment
strategies. The solution chosen by about half of these groups was to increase
their illiquid holdings. Typically these choices were private equities and commodities.
Three concerns
I have at
least three concerns with the currently preferred solutions for those institutions
that are chartered for long-term or eternal uses. The first is that I believe
almost all of life is cyclical. Almost every culture recognizes the regular
changes of seasons and that good and bad times are occasionally bunched.
Considering we have had a twelve year period of flat equity markets combined
with perhaps a thirty year period of rising bond values, I believe we are due
for a significant change in direction; with the values of stocks rising and
those of high quality bonds declining. Because I serve on the boards of several
non-profits as well as managing money for a few, I am conscious of the pressure
from those board members who are focused on operations and grant-making rather
than meeting the long-term needs of the institution. Further along in this post I
will offer a strategic answer to these concerns.
My second
concern is the current growth in the appeal of private equity investing.
Generally this means subscribing to various private equity funds, usually with
lengthy periods of lock-ups (no redemptions), and often with the requirement to
make additional cash contributions. Historically some of these funds have done
brilliantly. They have done so well that not only have they raised new money,
but their success has caused others within the winning groups to start new
funds and new fund organizations. We are even seeing new funds managed by some
of the younger partners from the premier groups. Thus we have a situation today
with a number of funds having more cash than they have immediate opportunities.
Often this has led to higher entry prices and/or rushed decision-making. These
are largely tactical considerations. A more basic strategic hurdle is at
variance from the somewhat bearish views of those trustees questioning a
long-term rising stock market. Keep in mind that the brilliant record from the
past is based on exits from these portfolios, largely through the IPO (Initial
Public Offer). What really appeals to certain investment committees of non-profits
is the tradition of marking these holdings at their purchase price unless there
is a transaction that takes place that causes the manager of the fund to write-off
some of the value. This artificial expression of value does not represent the
reality that every company gets better or worse on almost a daily basis.
However the auditors will not allow the reporting of these changes unless
there is a transaction. While this restriction is understandable, it does not
truly recognize what is actually happening. For smaller and less experienced
institutions, I would not be an advocate of starting into private equity today.
My third
concern is with commodities. Often an investment is approached not on the basis
of short-term scarcity, but as way to protect the value of the institution’s
capital from expected significant inflation. Most responsible investors are
concerned that the manipulations of various central banks will kick off several
rounds of inflation way beyond what the learned doctors at the central banks
can effectively control. The favored commodities are timber, energy-related
resources and gold. While each of these have some investment value, most of the
time they will not rise in price when stocks go down in value; thus they are
not effective as a direct hedge. Somewhat contrary to these cautions, I am
trying to find some good managers who know what they are doing in finding
partial solutions to what I perceive as very long-term problems: the twin and
related shortages of food and water.
The three-part buffer strategy
I believe
very few can regularly predict the market. If you can, concentrate on your
own account and prevent others from ruining your
timing opportunities by not publishing your holdings. As mere mortals, we don’t know the future for our
responsibilities. For long-term/eternal money, we need a strategy that
can weather most storms. What I recommend is a three unequal-part strategy.
The first is
for an institution, or even a family, to have up to two years of expected
spending invested in the highest quality short-term paper. (Strange to say,
considering my aversion to what governments are doing, I prefer US Treasuries
with scattered maturities up to two years.)
The second
layer would be a funding vehicle to rebuild the short-term layer as the money
is expended. Typically one can start the refunding mechanism at the beginning
of the second year. The portfolio for the second level would be publically
traded securities of high quality depending on where one is in the investment
cycle (inverse to the current enthusiasm). This balanced portfolio might be
75-80% in equities recognizing that the refunding need is paramount and could
lead to selling some positions at a loss.
The third layer, the long-term portfolio does not have to have substantial
liquidity. Nevertheless, the long-term portfolio has to be carefully invested
to derive the optimum, not maximum result.
This
three-part strategy is not a ‘Maginot Line’ type of approach. The strategy is designed to buy time in
order to prudently invest the corpus of the institutions.
In the past I
have written about the folly of trying to learn from previous wars in preparation of
fighting future wars. Investing is no different.
The US
Pentagon and the old UK War Office used to regularly study past wars in
preparation for the next series of wars. In contrast, I know that the US
Marine Corps regularly plans for future wars that are much different than those
it has recently won. Perhaps endowments should not follow the patterns of the Pentagon
or the old War Office.
In prior
posts I have observed that the way the brain is wired is to compare each new
decision point to its collected experience. Thus, all of us can understand that we have a tendency to fight the last war brilliantly as we deal with today’s
threats.
How do you
structure for the future?
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