Stanford, Yale, Harvard, Princeton—we know these institutions as our top providers of secondary education and research in the world. In the investing world, their endowments along with foundations and pension funds like the California Public Employees’ Retirement System (Calpers, the largest public pension fund in the nation) have reached “rock start status.” Trumpeting excessive returns at low risk, they are the envy of institutional investors. Well, at least they were.
Their model for success has been to heavily tilt the investment portfolio toward illiquid assets. However, the market downturn of 2008 and early 2009 has told a different story of risk and return.
Dan Jamieson begins one of his October 11, 2009 Investment News articles with, “Foundations and endowments were the worst performers among tax-exempt institutional funds for the one-year period ended June 30.” (Endowments tend to end the fiscal year in June to coincide with the end of the school year.) For this period, Yale’s endowment was down 24.6%*, Harvard 27.3%*, Princeton 24%*, and Stanford 27%**. These do not compare favorably to the median loss of 19.14% for foundations and endowments as reported by Wilshire Trust Universe.
On July 22, 2009, The Wall Street Journal reported on preliminary losses offered by Calpers and Calstrs (California State Teachers’ Retirement System) of 23.4% and 25%, respectively. And who were the worst performers in their portfolios? Alternative (i.e., illiquid) investments, including real estate (35.8%-Calpers and 43%-Calstrs) and private equity (31.4%-Calpers and 27.6%-Calstrs). (Note: These numbers are for the 12-month period ended in March).
Poor performance in 2008 and early 2009 is not exactly worthy of indictment. Pretty much everyone invested in risky assets saw steep declines in asset values. The real story is the light that has been shown on the value and risk attributed to these illiquid assets. Jamieson reporting on comments by observers states, “…some of the returns posted in recent years may not have given a completely true picture of performance. [T]he funds have taken on more risk than is apparent from their reported results…giving a misleading impression of risk-adjusted return.” The reason for the misleading performance is due to the illiquid assets not being actively traded on a market. The product sponsors (hedge fund managers, private-equity pools and venture capital firms) use valuation alternatives to come up with reasonable estimates. These sponsor-produced estimates cannot exactly be taken to the bank. As Matt Cooper, managing director at Beacon Pointe Advisors, puts it, “until someone makes you an offer [for the illiquid asset], those valuations are never going to be completely accurate.”
In his article, Jamieson also reported on comments made by Professor Christopher Geczy of University of Pennsylvania’s Wharton School of Business, in which he states, “Data show that endowment funds have had problems with pricing real assets and private equity.” Furthermore, according to Geczy, “the estimates of the risk of those [endowment] portfolios [are] too low,” and although “their Sharpe ratios [appear] high and their betas low…that’s not the case at all.” In his research of venture capital funds, Geczy says, “estimated standard deviations in returns can be off by a factor of three.”
This “smoothing of returns” according to Robert Whitelaw, professor of finance at New York University’s Leonard N. Stern School of Business, “also makes it look as if alternative asset classes are less correlated with the stock markets than they really are.” He also says there is “unstated market risk” hidden within illiquid alternative assets.
So, what are these endowments saying in response? Well, their actions are speaking quite loudly. As reported by Andrew Ross Sorkin in the New York Times, “Harvard…looked to sell some assets earlier this year. But…it struggled in a bid to sell about $1 billion of assets before pulling the sale.” Stanford is also selling parts of its stake in private equity firms. As reported by LBO Wire, one executive involved in the auction process called it “the biggest fire sale in private equity, ever.”
*Performance numbers for Yale, Harvard and Princeton quoted from Investment News, “Endowments’ results may be worse than reported,” by Dan Jamieson.
**Stanford performance numbers quoted from The New York Times, “Investment Indigestion at Stanford”, by Andrew Ross Sorkin.