Volatility immunization and maintaining portfolio agility matters. The endowment model was better than the long only 60/40 stocks and bond toxic waste that people still get sold. But it had little chance of achieving what universities, foundations, pension plans, sovereign wealth funds and individual investors actually need. Reliable performance with capital preservation at minimum risk and maximum liquidity every year. For that you need to hedge with proper strategy diversification not asset allocation. Assets alone do not have the necessary repertoire of return streams to de-risk a portfolio. You also need access to skill and expertise for tactical trading, short selling and market timing. The ONLY hedge for a long is a short.
Some long term investors didn't realise they still need short term returns and income. Economic fluctuations ought not to have a deleterious effect on capital growth or the asset/liability match. Having so much tied up in illiquid assets makes it difficult to be agile enough to capture changing opportunities or adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Hoping to be paid for holding risk assets is dubious but expecting to also be compensated for illiquidity is dangerous. When liquid securities sneeze, illiquid assets catch pneumonia. Private equity and real estate are highly leveraged and leverage is safer when applied to liquid markets.
I don't believe in static asset allocation and despite reading countless flawed but "seminal" papers have seen little evidence of its utility in achieving RELIABLE long term performance. Why focus so much on beta that fail to work in an alpha world? Such a blunt little tool is ineffective for dealing with the sharp complexities of today's markets. It is an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative investor I favor strategy allocation and diversification. It works if you know what you are doing and conduct proper portfolio construction, tactically adjust and do good manager due diligence.
The endowment model's percentage in marketable alternatives, hedge funds">hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity LBOs, was too high. While asset allocation is about attempting to capture ASSUMED risk premia for a given risk tolerance, the endowment model increased the ASSUMPTION RISK by replacing the liquid with the illiquid. While you can generally hedge liquid securities, not so with illiquid assets. Non-marketable alternatives must still be marked to market. Where was the scenario analysis and stress testing to construct a truly robust portfolio during a recession?
A dynamic investment opportunity set is not optimally captured with occasional rebalances to a policy asset allocation. Overweight alpha, not beta and certainly not illiquid alternative betas. Skill is the driver of outstanding risk-adjusted returns but assets don't have skill. Good fund managers do. The opportunity cost from overallocating to illiquidity was expensive. There is no long term; only a series of short terms which each require competent navigation and risk management. Ride out deep drawdowns? No. Avoid them? Yes.
Long term investors still need short term returns. Long term performance neither requires nor implies a long term holding period. Some of the best track records have been by managers with very short term strategies. Interesting how the same people who said you can't make money day trading now say too much money is being made in high frequency trading! Also the long term investor cannot ignore short term volatility or losses. University endowments survive for centuries but in the short term, professors and other staff have to be paid, spending budgets met and capital projects funded at the same time as alumni contributions reduce due to the economy.
CoRelations are more important than coRRelations. Many illiquid assets like private equity or real estate give the appearance of low volatility because they are valued infrequently. This creates the supposed low correlation to public markets. The disaster that was "Modern" Portfolio Theory favors such assets in a naive mean-variance optimization. But quantitative correlation measures do not give much insight into the coRelationships between risky assets and a risky economy.
While liquid security correlations infamously tend to 1 in down markets, the situation is exacerbated with illiquid assets that cannot be easily sold. Illiquid assets were often able to disguise their high coRelation because of delayed or overoptimistic valuations. However their dependence on a good economy was obvious ahead of time. The notion that liquid markets are efficient but illiquid ones aren't was always ludicrous. Some of the most widely traded and analyzed public securities are the MOST mispriced.
Real estate has been around a lot longer than stocks or bonds. It is not an alternative investment and relies on economic growth and availability of leverage. Real assets? Long only commodities is an even riskier concept than long only equity. Oil and gas partnerships fluctuate with the price of...oil and gas. Long/short commodities trading is safer. Many managed futures CTAs have demonstrated the ability to make money in up AND down markets. Gold and cocoa may be at highs as I write this but they are short term trading vehicles NOT long term investments. Inflation hedging? That's what TIPS and inflation derivatives are for.
Better
"target=_blank>portfolio optimization requires preparing for short term market tornados and long term economic ice ages. The endowment model carried almost no insurance against a bad financial climate. That is why substantial allocations to skill-based strategies that can make money in bad times are essential. Not enough short sales means not enough hedging. Derivatives are not to be avoided; they are MANDATORY for the risk averse. And the endowment model needed more attention to proper risk management, not basic VaR and CVaR stuff since much worse case scenarios than the assumed "worst" case have a habit of actually occurring. Most Monte-Carlo simulations and stochastic asset/liability models output too much optimism. That is not prudent for a fiduciary.
Despite all that alternative beta, there was still a large bet on a good economy of rising equity, easy credit and real estate. Replacing liquid assets with illiquid assets relied on the notion that there is such a thing as a liquidity premium. Many investors, even now, expect to be "paid" for taking higher risk. Despite what the economics journals claim, there is NO link between risk and return. Just because "stocks" are riskier than "bonds" does not guarantee outperformance over ANY time period.
Substituting unleveraged long only public equity with leveraged long only private equity was asking for trouble but was widely popularized by the CIO at the Yale Endowment, David Swensen. Amazing how some people fell into such an obvious trap. Why overcommit to 10 year lockups and ongoing capital calls when there is so much alpha available in the VERY inefficient public markets? Private equity was a misnomer anyway; the correct term was private debt with a sliver of equity.
Construct a portfolio that can adapt to market conditions and achieve a RELIABLE absolute return at the LOWEST necessary risk. Hedge funds are NOT an asset class and do not fit into an asset allocation methodology. The only thing to overweight is SKILL not assumed risk premia. Client wealth can and should be protected and increased regardless of economic volatility. A bear market is no excuse for a fund manager to lose money. Portfolio choice? Simple, choose alpha. Only alpha.
by Veryan Allen. Copyright 
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