The highly coveted Nobel Prize has been awarded as the pinnacle of academic achievement for advances in science, literature, medicine and peace for over 100 years. Unfortunately, the Nobel Foundation doesn’t apply the same standards to the investment strategy for their own endowment.
In a recent interview with Bloomberg, Nobel Foundation Executive Director, Lars Heikensten, stated that the foundation would be looking to increase its assets in hedge funds and private equity in order to make up for the recent lack of performance. The performance has been so bad that the foundation had to cut its prize amount by 20% in 2012 to safeguard the longevity of their capital. In his own words, Director Heikensten claims that, “when we look at the analysis, we see that we can get more return with less risks by doing that.”
Obviously Mr. Heikensten would be better served if he were to review the Nobel prizes awarded for financial economics. A mere two decades ago, the Nobel Prize Committee awarded 3 economists for their contributions to what has been coined “modern portfolio theory,” which provided a substantial amount of evidence that risk and return go hand-in-hand. In other words, what Mr. Heikensten is seeking – more expected return with less risk from hedge funds and private equity - is not supported in the academic literature or in the results of large institutions. (see pension-gate.com)
It is important to note that earlier explanations of risk and return have been refined. The Capital Asset Pricing Model (CAPM), which was developed by Nobel Laureate William Sharpe, has since been expanded to include other “risk factors” that go beyond Beta (market risk). But the idea that you can get more return without more risk is limited to the addition of low correlating assets and diversification.
Further, the Nobel Foundation is looking in the wrong direction to steer their foundation into the future. The hedge fund industry, in general, has not been providing any sort of long-term benefit to investors. In a recent book titled, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, longtime industry professional Simon Lack exposes how poorly served investors have been, mainly due to excessive risk taking and high fees. In fact, hedge fund managers have kept 84% of the total profits generated since 1998, assuming the standard “2 and 20” fee structure. And those returns have not been outstanding compared to a standard blend of 60% stocks and 40% bonds, usually in the realm of 3% to 7% lower. Even worse, investors of hedge funds would have done better by investing in T-Bills, widely considered the risk-free standard among the investment industry. In terms of academic achievement, there has not been a single research study that exhaustively concludes that hedge funds provide any long-term benefit to clients, but there have been many that conclude the exact opposite.
The performance of the Nobel Prize Foundation is likely due to the large allocation to alternative investments (33%). According to Mr. Heikensten, the fund has returned 1.5 – 2.0% on average over the past 10 years. Adjusting for currency, this would be equivalent to earning 5.84% - 6.28% in U.S. dollars. Assuming that the Foundation has maintained its roughly 20% allocation to fixed income with the remainder allocated to equities and alternative investments, it would have (roughly) the same risk structure as IFA Index Portfolio 70, which happened to return 7.29% net advisor fees. Figure 1 below compares the annualized risk and return results for 7 IFA Index Portfolios and the Nobel Foundation from January 2002 – December 2011.
At the end of 2011, The Nobel Foundation had 2.97 billion kronor ($448 million) in investments. Using the 6.28% annualized return it has experienced over the past decade, the approximate value of the foundation’s investments 10 years ago, assuming no cash flows, was 1.62 billion kronor in nominal terms. If instead the Nobel Foundation invested in a globally diversified buy-and-hold strategy with a similar allocation to fixed income, they would have ended up with almost 300 million kronor ($44 million) more, assuming current exchange rates. That is the equivalent of 30 more Nobel Prize Awards!
Underperforming a simple buy-and-hold strategy is nothing to brag about, especially when you have awarded economists in the past who recommend such a strategy. Should the Nobel Foundation expect underperformance in the future? Maybe the foundation should start listening carefully to one of its own award recipients.
1 Professors Harry Markowitz, William Sharpe, and Merton Miller
2 Lack, Simon. The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True.” John Wiley & Sons, Inc.: Hoboken, New Jersey, 2012.
3 Dichev, Ilia & Gwen Yu. “Higher risk, lower returns: What hedge fund investors really earn.” Journal of Financial Economics, 100, 248-263, 2011.
4 The Nobel Foundation, Annual Report 2011