he disappointing losses suffered by investors during the 2008 credit crisis and its aftermath have raised questions about the validity of the investment approach that has become known as the endowment model.
What is the endowment model? In essence, it can be summarized as follows:
c assemble a broadly diversified portfolio using the full range of investments, including both traditional and alternative investments (hedge funds and private illiquid funds);
c focus on opportunities with good prospective returns that have low cross-correlations of returns; and
c form a portfolio within an acceptable level of overall risk.
This approach remains as valid as ever, but not the way it's been implemented. The approach is called the endowment model because endowments were among the first to increase their allocations to alternative investments to gain the risk/return characteristics and diversification benefits that those investments are intended to deliver. The losses in 2008 by investors who included alternative assets in their portfolios were typically somewhat lower than losses by traditional portfolios. But alternative investments generally failed to provide the protection expected of them, and they caused some investors serious liquidity problems that are not over yet. Why?
Implementation suffered two key shortcomings:
c the way investors judged the volatility of their alternative investments, and how they estimated the correlations of those investments with the stock market, the credit market, and one another; and
c the way investors estimated the liquidity of their hedge funds and the cash flows from their illiquid investments and the liquidity of their overall portfolios especially in the event of a market crisis.
Modern portfolio theory has traditionally assumed, among other things, frictionless trading of liquid securities. With less liquid or illiquid investments, calculating volatility and correlations among investments is more difficult, and possibly meaningless. Volatilities and correlations of alternative investments can at times be far higher than measures based on historical changes in reported net asset values.
Because underlying assets in a portfolio of alternative investments are harder to analyze, many investors had more overlapping risks than they recognized and less liquidity. In many cases, hedge funds offered their investors far more liquidity than the liquidity of those funds' underlying portfolios. As in any market crisis, prices of diverse securities plummeted together as investors rushed for the door en masse. To meet investor redemptions, hedge funds often had to sell the most liquid portions of their portfolios at distressed prices, injuring all of their investors. Many funds suspended or restricted investor redemptions by imposing gates and other measures.
At the same time, a number of private equity funds drew down committed capital to finance the funds' investments. This phenomenon added further pressure on valuations and the liquidity of institutional portfolios.
What are the remedies? Investors must do a more thorough job of due diligence before they select their investments and as they make continuing decisions to retain their existing investments. Investors must also work to improve the way they:
c estimate the actual and expected worst-case volatility and correlations of each of their portfolio investments, especially their alternative investments, using qualitative judgments as well as historic quantitative methods;
c determine whether there are potential market scenarios in which their overall portfolio would deliver greater losses than their constituents could live with;
c estimate the liquidity of their hedge fund investments, especially in the event of a market crisis, and limit their investments only to those funds whose liquidity to investors is consistent with the liquidity of their portfolios;
c evaluate the appropriateness of the amount and duration of the leverage used by the managers of their alternative investments; and
c plan reliable sources of cash to meet payout requirements, including investors' capital commitments to fund private illiquid investments.
Sponsors of alternative investments also need to make changes, especially in two areas.
c The prices of all underlying positions should be supported by independent market-based quotes. Fund managers should place any positions they cannot sell in a timely manner at a reasonable price into a segregated account, or side pocket, and actively manage that account for all investors until they can sell those positions at a reasonable price.
c All funds should maintain multiple counterparty relationships for trading and custody. Funds that in 2008 concentrated their brokerage with Lehman Brothers are still trying to determine what portion of their assets they can recover.
We have witnessed some growing pains in the implementation of the endowment model, but with steps such as those above, the combination of traditional and alternative investments can continue to be an effective portfolio management approach. n
Ray Gustin is a partner of Drake Capital Advisors LLC, Greenwich, Conn., and Russell L. Rusty Olson, who operates his own Rochester, N.Y.-based business consulting on institutional investing, retired in 2000 as director of pension investments, worldwide, for Eastman Kodak Co.