Picking Correct Hard Asset Benchmarks

Hard assets deserve more attention than they get. Commodities, real estate, and perhaps even infrastructure are often lumped together into a very broad asset class. Picking them apart into sensible components requires identifying benchmarks for apples-to-apples comparisons.

Commodities are a very broad subject. Base metals, precious metals, energy sources, foodstuffs, and other materials have radically different uses. The Bloomberg Commodity Index Family is both broad enough and specialized enough to track the sector. The Commodity Research Bureau Indexes represent a less flexible allocation but is nevertheless included in other commercial index products. Picking a broad proxy like the CRB matters for fund managers who run portfolios large enough to include all of the benchmarks components. A fund managing that only hedges with energy futures or metal futures needs more specialized benchmarks tracking just that one thing.

Timberland and farmland are not the same thing in real estate. The end products, final markets, and supply chain inputs (fertilizer, climatology, etc.) are all different. Comparing timber REITs and farmland REITs means using their separate benchmarks. The real estate sector makes it easy. The NCREIF Timberland Index and NCREIF Farmland Index are as different from each other as corn stalks and black walnut trees.

Infrastructure may or may not deserve consideration as a separate asset class. It shares many risk characteristics with equity yet is often funded like a fixed income fund. The problem with benchmarks like the S+P Global Infrastructure Index is their tendency to track actively traded equities that build or maintain infrastructure. It is difficult for infrastructure-related investment products to make pure-play claims if they cannot hold ownership in the infrastructure projects themselves. Muni bond issuance remains the primary funding method for publicly-owned infrastructure. It makes no sense for an investment manager to benchmark a muni bond portfolio against an equity infrastructure index.

Institutional investment managers are often the dumbest people in finance, aside from financial advisers in retail wealth management. They led the charge into alternative assets decades ago with the Swensen Yale model. Some of them probably rode the recent commodities bear market all the way down. Herd mentalities drive smaller endowments and pension funds to mimic the poor portfolio models of the largest universities. Many things can go wrong with an asset allocation leaning heavily on illiquid hard assets. Doing right by any fund's beneficiaries involves picking the correct benchmarks and understanding which hard assets they track.

Thematic Investing Train Leaves The Station

The finance sector is always ready to entertain some new theory.  The latest is thematic investing, which can mean just about anything.  A handful of asset managers and consultancies have think pieces telling institutional clients how to make this work.  Do a Web search to read them yourselves.  I poked around a number of reputable sources tracking thematic investing to see what's missing from the discussion.

Academic validation is the main missing link.  The academic research on focus investing validates a very selective approach to investing in a small portfolio of actively selected stocks, provided those stocks have strong fundamentals and are held for the long term.  Books covering Warren Buffett's methodology support this conclusion but it's worth mentioning that Buffett himself is genetically unique.  No other human investor or human-created selection screen has been able to duplicate his performance.  Ten years is the minimum for a long-term holding but active investors pursuing thematic investing usually don't have that kind of patience.

Whether an average investor can outperform a broad market simply by starting with a pure macro idea is questionable.  Investors awaiting hard evidence need only look at the poor track records of most hedge funds and sector-specific mutual funds to see the problems facing theme investing.  The longer think pieces I've read on thematic investing emphasize wishy-washy concepts like hunches, feelings, and inclinations.  Those are poor reasons to pick stocks.  Thematic investing appeals to some of the lamest institutional investors, specifically sovereign wealth funds and pension plans, who fell for the Swensen-Yale investing model when it was hot.

Plenty of macro ideas are just plain bad.  "Globalization" is a very broad theme implying multinational corporations are best suited to handle it.  The trouble is that multinationals are often tied to the regulatory environment of their home countries.  Here's one I won't try:  the "food-water-energy security nexus."  It matters to geopolitical strategists who try to predict conflict flashpoints.  It matters less to corporations that play it primarily by mitigating its risk.

Thematic investing is not for everyone.  Investors are welcome to pick their favorite sectors provided they know a sector inside and out.  Sector market leaders have pricing power and the sectors themselves have barriers to entry (like switching costs) that deter competitors.  Those are components of a Buffet-style durable competitive advantage.  The dearth of competent investment managers means the mediocre majority will fall back on weak top-down selection strategies.  Thematic investing is gaining speed with people who don't know where they're going.

The Haiku of Finance for 02/12/14

Risky endowment
Overweight stupid sectors
Insult to donors

Get Rid Of The Yale Endowment Model

Investment managers become enamored with faddish theories from time to time.  Theories that promise to outperform the stock market's broad benchmarks always work until they don't work anymore.  It's time to retire one theoretical model that doesn't work anymore - the Yale endowment model from David Swensen.

I can boil this model's argument down to one pithy sentence:  Put one third of a portfolio into the most illiquid, highly leveraged products imaginable, provided those products are based on mathematical formulas that have no relationship to reality.  That worked in the era up until the last housing crisis, when every marginal dollar of debt added to the economy added more than one dollar of additional GDP.  The US economy passed that tipping point and every dollar of additional debt is a burden upon corporate earnings.

The Yale model cannot account for the underperformance of the hedge fund sector over the past decade yet advocates hedge fund investment simply because it is not correlated to equities or bonds.  It also endorses private equity allocations at a time when VC funds are in a long-term trend of underperformance.  Leveraged buyouts are based on the premise that debt-driven restructuring can unlock buried value.  That was fine when average corporate earnings were under their historical norm of 6% of GDP.  Earnings are now almost twice that figure.  They will revert to their mean at some point and companies undergoing a leveraged restructuring will turn in disappointing results to their private equity owners.

The model's logic doesn't even pass a test of internal consistency.  Mr. Swensen's books on portfolio theory argue that more intermediaries between a client and their money provide incrementally less value.  The Yale model implies that hiring more sub-managers for private equity and hedge fund investments adds value, which contradicts any inclination to minimize intermediaries.  Mr. Spock from Star Trek would say that's illogical.  Fictional aliens don't manage money, but if they did I think they'd put a Vulcan nerve pinch on anyone who insisted that ten levels of sub-managers deliver ten times the value of one.

My final beef with the Yale model is its inability to detect fraud.  Remember Bernie Madoff?  He made off with a bunch of cash for his Ponzi scheme because institutions trusted their funds-of-funds managers to perform due diligence on sub-managers like him.  They did no such thing.  Trusting additional layers of money managers increases the possibility that one will be a phony.

The Yale model ignores the effectiveness of the shareholder activist model that used to work well enough for institutional investors.  Maybe CalPERS and other institutions got lazy after the 1990s and decided to contract out their original thinking to sub-managers who did little thinking.  The Yale model gave them all convenient philosophical cover to take their eyes off the ball.  Today's economic climate demands attentive money managers.  They cannot afford to hang onto the Yale model.  

The Haiku of Finance for 07/24/09

CalPERS rolls the dice
Bets big on Swensen model
And insolvency

Calpers Board Votes to Assure Its Self-Destruction

CalPERS has lost money. Haven't we all lately? Well, apparently they want to lose the rest of what they have left. They've gone and selected a new leader, Joseph A. Dear, who will probably assure that result:

Mr. Dear wants to embrace some potentially high-risk investments in hopes of higher returns. He aims to pour billions more into beaten-down private equity and hedge funds. Junk bonds and California real estate also ride high on his list. And then there are timber, commodities and infrastructure.

This guy and his ideas are the epitome of everything that's wrong with modern pension fund management. First of all, by his own admission, he's not an investment expert. His formative experiences were all in political appointments. He even thinks "the fun part is the investment part," in his own words, as if it should be secondary to things like organizational design and political relations. Secondly, his big bet on bold ideas is nothing more than a rehash of the Swensen Yale model. Remember that one? The one that delivered outsized returns during David Swensen's tenure at the Yale endowment until it blew up spectacularly last year? Yeah, that one. This dude didn't get the memo that the Age of Leverage is over, so all of those years that private equity delivered alpha of 3% are long gone. He also thinks that political tricks like asking investment firms to sequester the state's money in separate accounts will help manage risk. News flash: Sequestering money is of zero benefit if the manager's investment philosophy fails, because you'll have a heck of a time getting it out if other claimants to that failed fund litigate the manager.

I have no philosophical objection to investment vehicles like real estate partnerships and private equity funds. When used judiciously, in severely limited amounts that are restricted to areas within a manager's natural sphere of competence, they can diversify a very large portfolio. The problem comes when illiquid structures become a huge allocation within an investment philosophy that must be liability-driven (i.e., significantly liquid!). Year after year into perpetuity, a pension fund must cough up enough cash to pay its retirees according to tables designed by actuaries. If any one of those sequestered, illiquid investments blows up, CalPERS will risk defaulting on its legal obligations to pay pensioners and the state of California will be forced into a legal crisis. Taxpayers will of course have to fill that hole.

The funny thing is that I was just about to turn cautiously optimistic on California muni bonds now that the state's elected leaders have reached a budget compromise. CalPERS' stupidity is going to blow that right out the window within two years. The risk of a muni bond default is increased dramatically if state taxpayers have to make up shortfalls in CalPERS' payments to its retirees. Maybe a sovereign bankruptcy will ultimately be necessary to sort out whether muni bondholders or state retirees have a senior claim on California's tax revenues.

The NYT article ends on a telling note. This dude plans to spend a third of his precious time on "outside issues," as if the job of running the nation's biggest state pension plan isn't important enough to warrant all of his time. Note to Joseph A. Dear: Quit thinking of this job as some kind of extracurricular activity with a fun investment part. There is nothing more important to you right now than the security of retirees' money.

Nota bene: Anthony J. Alfidi does not receive a pension from CalPERS or hold California muni bonds. He is in fact a taxpayer to the state of California and is very interested in that state's financial solvency.

Swensen Model Jumps On Inflation Bandwagon

Some of the smartest money managers in the business haven't looked so smart since last September. Maybe now they're getting smart again:

David Swensen, the top-ranked college endowment manager in the past decade, said individual investors should own inflation-protected Treasuries because U.S. economic recovery efforts may lead to an increase in consumer prices.

Mr. Swensen is an original thinker, which is rare among portfolio managers. His Yale portfolio has performed badly since 2008, so perhaps recognizing the inevitability of inflation will help restore his model's reputation. The only disadvantage of using TIPS instead of gold as an inflation hedge is that TIPS are subject to default risk. This is low now, but then again no one thought the U.K. would be in danger of losing its AAA rating for gilts.

I don't own TIPS. I do own IAU and GLD (with covered short puts).

Comment on Preppie School Endowments

Yesterday I posted one of my typically insightful (and snarky) comments to this post at Clusterstock:

Big universities having very little in bonds? It's not that hard to match expected income (bond interest) to projected liabilities (tuition and operating expenses) one or two semesters out. Thanks a lot, Dave Swensen. The Yale model was innovative, but outsourcing much of your strategy to multiple managers invites trouble. Funds-of-funds that charge fees-of-fees are neat conversation pieces at cocktail parties but not good for much else. There's only so much investment talent to go around, you know.

No wonder Sequoia Capital told its portfolio companies not to count on cash infusions from here on out. They probably had advance warning from endowments that the check would be a few quarters late, if it arrived at all.

I guess someone will have to break the bad news to the preppies at these schools that there will be less foie gras and more grilled cheese sandwiches in the dining halls. Boo hoo.

I still like Dave Swensen's overall concept, but its execution by endowment managers has been flawed. Endowment CIOs simply have too much faith in multilayered teams of investment managers. Mr. Swensen has also argued that the more intermediaries you place between a client and his money, the less value you add as a portfolio manager. Warren Buffett is able to make a multi-strat approach work because he looks at his portfolio selections as capital infusions into real businesses and not slices of statistically non-correlated asset classes.

There's a lesson here for aspiring portfolio managers. Think like a corporate treasurer or operations manager when you make investment decisions.