Investment Moats

The endowment of universities is an area that I took an interest in the past because they have very specific requirements that are similar to what many look for in their wealth. (You can read could we model our retirement spending like endowment funds?)

University endowments sought to address two conflicting goals:

1. Achieve a particular level of income so as to fulfill a certain proportion of a university’s budget. The income requirement cannot be too volatile. If the university do not have this proportion of income, their operations would be affected.
2. Preserve the purchasing power of the endowment. The endowment needs to cater for future budgetary needds. Income requirements will go up over time due to inflation. The endowment would need to grow in value so as to preserve the purchasing power. This means the endowment need to grow at a particular rate of return.

You may realize this is the problems faced by many in financial independence. They need their portfolio to produce income yet at the same time they need to ensure the portfolio have enough to preserve future purchasing power.

What complicates things is that

1. The endowment may not know for a given year, how much in grants and gifts they will receive
2. In particular years, grants from the government might be cut. This puts operational constrains on the university and may mean the endowment may need to take on a higher proportion of the university operational cost. If they are not careful, this might kill the endowment’s future purchasing power.

This is the trade-off between today and tomorrow.

Investing the endowment’s fund to achieve a particular rate of return is very critical. This is the same for your money set aside for financial independence as well.

David Swensen, the famed Yale endowment fund manager who pioneered much of the forward-thinking endowment management ideas wrote the book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.

Near the end of the book, Mr. Swensen shared with us the missteps of the New York University (NYU) endowment in the past. I thought it is too good not to share.

For context, the following were NYU endowment’s trustees:

1. Larry Tisch, chairman of NYU
2. Alan Greenberg, ace trader of Bear Stearns
3. Thomas Labrecque, president of Chase Manhattan
4. Maurice Greenberg, boss of AIG

They had the help of

1. Martin Lipton
2. Larry Silverstein, a Manhattan real-estate mogul
3. Joseph Steinberg, investor at Leucadia National
4. Henry Kaufman, who earned the nickname “Dr Doom”
5. Michael Steinhardt, Steinhardt Partners and recent years WidsomTree Investements

The Story of NYU’s Huge Bond Allocation

In the late 1970s and early 1980s, motivated by concerns regarding the fragility of the university’s finances and the riskiness of the stock market, NYU allocated an average of 66% to bonds, 30% to stocks, and 4% to other assets.

NYU differed materially from her sisters institutions by holding roughly double the average proportion of bonds and roughly half the average proportion of stocks.

Between 1981 and 1982, at the bottom of the equity market, NYU dropped its already low equity allocation from 33% to 7% of the portfolio, increasing the already high bond commitment form 62% to 90% of assets.

Bonds continued to maintain a share in excess of 90% of assets through 1985, according to public reports on asset allocation, while stocks languished at single-digit levels, falling as low as 3% of the endowment.

Even though after 1985 annual reports ceased to provide information on portfolio allocations, it appears that NYU persisted with its unusual portfolio structure throughout the late 1980s and early 1990s.

After a 9-year disclosure hiatus, in 1995 the university reported holding 86% of assets in bonds and 9% of assets in stocks, indicating a continuing commitment to bonds.

Only in 1997 did NYU begin to make a modest move away from fixed income to higher expected return assets.

Unfortunately, the bond-dominated portfolio left NYU on the sidelines during one of the greatest bull markets in history. From 1978 to 1998, stock returns exceeded bond returns in 16 of 20 years, with stocks enjoying a 6% per annum advantage over bonds.

Only in the aftermath of the 1987 crash did the fixed income strategy appear sensible, causing NYU board chairman Larry Tisch to receive a standing ovation at an NYU investment committee meeting.

Market activity supported only a brief huzzah as the S&P 500 ended the 1987 calendar year 5.2% above the level recorded at the beginning of the year.

Even when viewed from the perspective of a time frame as shot as the twelve calendar months that included one of the all-time great stock market debacles, NYU’s strategy failed to make sense.

As the bull market continued apace, Tisxh turned away questions regarding the lack of equity exposure by responding that “the train has left the station.”

Meanwhile, the opportunity costs for the NYU endowment mounted. From 1982 to 1998, an endowment wealth index for colleges and universities increased nearly 8-fold, while NYU’s endowment grew 4.6 times.

Had the institution’s results simply mirrored college and unversity medians, in 1998 NYU’s endowment would have been nearly a billion dollars large than the actual level of $1.3 billion.

Beginning in the late 1990s, NYU began to reduce its overallocation to domestic fixe income, moving assets to domestic and foreign equities and absolute return strategies.

Yet the legacy of the misguided bond bet endures, as NYU’s 2005 portfolio shows scant exposure to the important asset classes of private equity and real assets (Kyith: Swensen really likes these things.)

By failing to understand the relationship between the permanet nature of endowment funds and equity investments, NYU’s endowment sustained long lasting, if not permanent damage.

Some Personal Reflections

The burden of managing other people’s money

If you mismanage your own wealth, you suffer. If you mismanage your family’s wealth, your family suffers with you.

If you mismanage an endowment, you might destroy the legacy of an entire university. You may have jeopardized the kids’ generation down that could have benefited from the endowment.

Investing money for people you care about comes with a lot of responsibilities.

You may be able to take some concentration, illiquidity, credit, duration risk with your own money, but if you fxxk up, others are still OK.

I dunno about others but when you work in a wealth management firm like Providend, where your inputs may affect the lives of families and generations down, you really feel the weight of responsibility to not fxxk things up.

I start to have immense respect for these people managing money for others (well for those who really cared enough). NYU probably have an investment mandate that guides their allocation.

Many aim to be concentrated in the high return areas but the truth is that forecasting the forward high return areas can be tough

I wonder what led them to this kind of allocation.

1. Was it being too risk-averse after the turbulent 1970s? I don’t think so. If it is, they would have their own better inflation hedges such as equity, commodities, or gold. They moved away from these investment hedges.
2. Were they making a bet on bonds due to the ultra-high interest rates? Could very well be. Bonds have traditionally been a safe haven and have lower volatility compared to many other financial assets. It is a bonus when interest rates have fallen and the value of the bonds NYU held would have gone up a lot. It begs the question: If it ain’t broken, do you fix it?

Further research seem to show that Tisch harbored an irrational and all-weather fear that stocks were “too” expensive. Leonard Stern, a real-estate developer and long time trustee, question the bond policy.

Many investors try to suss out how to avoid certain areas of risks and uncertainties and get into areas where the returns are the highest.

In their brain, they would like to find the holy grail of investing in the sector, country or the stocks with relatively high returns yet avoid the world’s problems.

When they find that, they will dump their money in.

NYU probably found that holy grail in bonds due to the almost 20 years fall in interest rates (from 1980s to end 1990s).

But in a way they incur a huge opportunity cost because the 1980 to end 1990 was an even more massive secular bull market for stocks.

This is synomyous with perhaps our concentration on REITs, in Singapore or in the NASDAQ.

Diversification does two jobs:

1. It reduces the risk of concentrated blow-ups
2. It allows you to capture the market returns (read this)

NYU suffered from #2 in that they earn a good return but they missed out capturing an even better returns.

Many have question why not just invest in the S&P 500 and the answer is, are you OK with a decade of 0-2% a year returns for 10 years? Because that was the level of returns when everyone was rating the United States as an underperform (2000 to 2010).

The chart above shows a monthly chart of the iShares MSCI Emerging Markets ETF divide by the SPDR S&P 500 ETF Trust.

It shows the relative performance of the emerging markets versus the United States. We can see a tale of emerging market outperformance and then underperformance.

Is this a turning point for emerging markets or would it continue lower? In the small box, we see that even the frontier markets are showing strength.

What could cause a turn? I have no idea. This might not be a turn at all.

The question is… if you are concentrated in S&P 500, would this be your NYU bond moment?

What is the right way to make investment decisions as a group?

Lastly, what gets me curious was the decision making at NYU and what lessons we can carry with us in investment management.

I realize that:

1. You need to have an investment philosophy that you stick to, that you can clearly communicate. If you do not have something like that, you will be easily mistaken as market-timers or that people will be very confused by your investment decisions.
2. Yet financial paradigms may sometimes shift with is very difficult to detect when you live through it. Most things stay the same and do not change but paradigms do shift. How do you evaluate when things shift and when you should take action?

The need to be coherent yet be able to change when we need to is another tradeoff that is challenging to navigate.

I am not sure what were the conversations in NYU, but I think that it is the kind of conversations that may plague many of us. If we were in their position, we may change our allocation so often that it is as detrimental to our portfolio.

I think the right setup is a good decision making process that is independent of the investments we make.

It should be like a computer or checklist style that brings us through areas where we need to look more into, and when the evidence is strong enough, we look at the spectrum of risks, figure out whether we can live with the risks, make the decision, and pivot accordingly.

Everyone should come to the table and be radical truthseekers, no political correctness. The objective is to ensure we make the investment decisions with the greatest clarity we can.

If we fxxk it up after that then there is really nothing much we could do better. We figure out the next best decision with the new information that comes to light.

Experiences can Haunt You

Some people say that having experience in the markets can be invaluable. But it could haunt you as well.

Tisch and perhaps some of the managers and trustees were probably trained that valuation comes into play in finance. That is my training as well.

There is a price to pay for something and you should not overpay.

That vigilance not to overpay ultimately costed them.

If you are someone fresh in the markets, such as the investors today, you would have less reservations about potential dangers if you don’t know what is the danger you are suppose to guard against.

You may be able to benefit from that.

But at certain point, that lack of respect to value will come back and bite you.

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