Asset allocation? Wait for the “long haul”? Short term volatility can’t be ignored regardless of time horizon. It can be avoided with prudent strategy and manager selection. The endowment model was once seen as the “solution” to investing for the long term but it was deeply flawed and overexposed to recession. It was too long biased, illiquid, unhedged and high risk.

Though asset diversified it was not properly strategy diversified. The “alternative” assets failed to offer alternative returns. The RETURN ON RISK of David Swensen’s folly, even in the good times, was poor. Many didn’t see the obvious errors, particularly the weak diversification and mistaking of leveraged beta for alpha. Incredibly because he is not smart enough to “understand” quant funds he avoids them, further damaging Yale’s endowment.

Long term investors still need short term returns and income. Economic fluctuations ought not to have a deleterious effect on capital growth or spending policy. Having too much tied up in illiquid assets makes it difficult to be nimble enough to capture changing opportunities or adapt to market conditions. Flexibility, adaptability and liquidity are prerequisites for consistent performance. Expecting to be paid for holding risk assets is dubious but hoping to also be compensated for illiquidity is dangerous. When liquid securities sneeze, illiquid assets catch pneumonia. Private equity and real estate are often highly leveraged. More than most hedge funds.

Volatility immunization and portfolio agility matter. The endowment model had little chance of achieving what universities, foundations, pensions, sovereign wealth funds actually need. Reliable absolute returns with capital preservation at minimum risk and maximum liquidity EVERY year. For that you need to hedge with proper strategy diversification. Assets alone do not have the necessary repertoire of return streams to de-risk a portfolio. You also need access to the expertise required for tactical trading, short selling and market timing. The best way to diversify a long is with a short.

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 fails to work in an alpha world? Such a blunt tool is ineffective for dealing with the sharp complexities of today’s markets. It’s an anachronism and fails to emphasize RISK. The world has moved on in financial engineering and portfolio innovation. As a conservative investor I favor skill diversification. It works if you know what you are doing and conduct proper portfolio construction and manager due diligence.

The endowment model’s percentage in marketable alternatives, hedge funds, was too low while the allocation to long only non-marketable alternatives, mostly private equity and real estate, 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 liquid with illiquid. While you can generally hedge liquid securities, difficult with illiquid assets. Non-marketable alternatives must still be marked to market. Even if there isn’t a 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 asset classes 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 require competent navigation and risk management. Ride out deep drawdowns? No. Diversify to 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 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 fall due to the economy. Hedge for bad times!

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 and coDependencies 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 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 diversified portfolio to lose money. Portfolio choice? Simple, choose alpha. Alternative alpha.

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