Sunday, October 7, 2012

Some Endowments are about to Follow the Strategies of the Pentagon and the Old UK War Office to their Detriment

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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