HOFFMAN,
WHITE & KAELBER FINANCIAL SERVICES, LLC
Investment
managers & WEALTH Advisors
This is the January 2007 monthly Wealth Management
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Large University Endowments
In 2006, speculators
were rewarded by the market while risk-averse investors weren’t. How did you do? Now let’s look back to 2005. Then, the markets were not as generous to these
risk takers or their counterparts. How
did you do then?
Year in,
year out, those who rely on one style of investing or another can experience
wide differences in results from one year to the next. Professional investors understand this fact
all too well. Yet, a great lesson can be
learned from how large university endowments create reliable returns, year
after year. In fact, the institutions
they represent require it.
When we
invest, we are placing a wager on the future.
So, reason should guide you to acknowledge that predicting the future is
an uncertain task. Or, that past
performance may not always be indicative of future results. What would you think if I told you that
2005’s “Dogs of the Dow” were last year’s winners? Or, that this year’s top fund managers could
have been found in the middle or bottom of the pack at some point also? Chasing today’s “hot picks” often causes
investors to buy when the price is already too high. And, how many times have you exited a poorly
performing strategy only to see it do well afterwards? What’s an investor to do? Try doing your own research? Muddle through the conflicting babble of
“experts” only to wind up scratching your head in confusion? By the time a magazine tip hits the newsstand
it is often old news. And, with the
instant impact of global events, the markets invariably will bounce around in
unexpected ways over the course of time.
Yet, there
are workable strategies. One investment
At Hoffman,
White, & Kaelber Financial Services, LLC, we are deeply committed to
providing our investors and our readers with every advantage when trying to
preserve and grow their wealth. We seek
to empower you with the results of careful, deliberate and rigorous thinking.
In this
newsletter we explore some insight into the observable traits driving the
success of top performing endowment funds and give you some guidelines that you
can use to increase your financial wealth.
If you are looking for information and ideas to help you achieve better
long-term results with your investments, we think you’ll get a great deal from
this newsletter. Then, be sure to look
over our market comment and performance data at the end.
Endowments and Their Performance
According
to the National Association of College and University Business Officers
(NACUBO), the “one-year average annual rate of return of 10.7 percent for the
fiscal year [ended June 30] 2006 marks the third consecutive year that
endowment investment income is enough to both support annual educational
spending as well as reinvest a portion of earnings to protect against
inflation, and pay management fees…Over the long run, a nine percent annual
return rate allows higher education institutions to maximize both the
endowments’ current and future support for priority activities.” These figures represent average performance for
seven hundred and sixty-five (765) endowment funds reporting to NACUBO. Funds at the top performing schools did much
better.
Thinking
like an endowment can create advantages for many investors
Yet, the
situation of a large university endowment fund is somewhat unique. While the better performers operate much like
a hedge fund, there are observable differences in perspectives and execution
when compared to the typical hedge fund.
According
to NACUBO, “In keeping with recent years, preliminary data indicates that
overall endowment investments continue to increase in the non-traditional asset
classes while investments in the traditional equities and fixed income classes
decrease.” This is a reflection of the
growing breadth of investment strategies available and the desire for more.
The primary
purpose of endowments at large universities is to ensure the school’s financial
independence while it pursues academic excellence. While every investment manager wants to
maximize returns, they do so within the context of their strategies and the
goals of their clients. For a
university, this means seeking returns in a way that ensures operational
budgets are met and that the returns are also large enough to grow the
endowment fund beyond the rate of inflation.
These requirements usually set the target benchmark for returns at roughly
eight percent. More is always welcomed.
The primary
responsibility of the endowment fund manager is to preserve capital and the
purchasing power of the institution.
This translates into the priorities of meting subsidies, keeping pace
with inflationary pressures and then growing the capital, in that order. Risk management is therefore of primary
interest to the fiduciaries and their strategies are built from this
foundation. While bonds and other fixed
income instruments form a small portion of their portfolios, by themselves they
are not sufficient to meet the universities’ requirements. So, the fund managers use the principles of
Modern Portfolio Theory (MPT), the uncorrelated diversification of assets, a
disciplined approach to portfolio construction and continuous rebalancing to
manage risk while reaching for higher returns.
While many
hedge funds make similar claims about using MPT, one difference lies in the
extent, breadth and depth of the strategies employed. For a large endowment, illiquidity is not
much of a concern. So, as discussed
earlier, they can take an extremely long view in their strategic approach and consider
investments, like timber, which could take twenty years or longer to
monetize. However, only larger endowment
funds would probably consider investing in something as specialized as
timber. In contrast, many hedge fund
strategies are so narrowly focused that they can rapidly reach a point of
diminishing returns as assets grow faster than available opportunities and the impact
becomes dilutive. By comparison, the
diversity of investment strategies employed and expertise developed within an
endowment fund can offer distinct advantages over the typical hedge fund.
A second
advantage, albeit related to the first, relates to the intellectual diversity
focused on and developed within the typical large university endowment. Many hedge funds are started by managers with
deep expertise in a market niche – expertise that is often “an inch wide and a
mile deep”. As such, great familiarity
with various other markets and investment strategies beyond their area of
expertise is often lacking. Whereas, the
typical large endowment fund manager would be actively engaged in the rigorous
auditioning of fund managers representing a broad spectrum of opportunities and
develop experience with many different styles and strategies. In order to manage risk, you have to understand
it and this global perspective provides the background and context with which
to compare, blend and create funds of funds that manage risk and augment the
core strategy of the endowment pool.
While endowment managers are focused on the big picture, they are seldom
involved in picking stocks and are less likely to seek opportunities through
timing the markets directly.
Lessons That Can Be Learned
There are a
number of factors that come together to support the success of the best
endowment funds.
Managing risk: An endowment’s portfolio is designed
to provide the university with a reliably stable source of funds. This isn’t going to happen through concentrated
investing in highly volatile investments.
Chasing big returns requires taking big risks, and big risks lead to potential
high volatility which is anathema to a stable, reliable source of funds sought
by these non-profit institutions. Risks
are managed through methodical portfolio allocation and diversification
techniques that are applied to combine uncorrelated investments to achieve
stability. Finally, risk is managed
through a continuous monitoring of performance and periodic rebalancing of the investment
weightings so that allocations stay true to the expected outcomes of their
strategy. While returns may not compare
well to riskier strategies in the short run, over time it is “slow and steady
that wins the race.”
Alternative investments/alternative
managers:
Endowments have
been early adaptors in the alternative investment markets. As mentioned in the NUCABO reference above,
the portion of stocks and bonds in the portfolio has diminished over time in
relation to the portion of funds at work in alternatives. Endowments also spend a great deal of effort
identifying alternative fund managers whose reputation, history of returns, and
fund strategies fit and augment the endowment’s strategy. On-going monitoring is as essential a part of
the process as the initial identification.
Long horizons: While endowments may look to
capitalize on market inefficiencies, they are not looking for quick hits. They put more trust in the construction of
their portfolios and their allocation formulas than they do in the ability of
the portfolio team to guess correctly about short-term trends in the marketplace. The view of the endowment manager is a long
one. They have the time to let their
strategies mature and garner benefits.
Not having to placate “hot money” or compete on a monthly or a quarterly
basis provides an environment that allows the blend of seasoned qualitative
judgment with sophisticated quantitative analysis to build powerful results in
real time. It is well known that few active
managers outperform their passive benchmarks over the long-term, regardless of the
strategy employed.
Global reach: Finally, endowments have broadened
their thinking beyond the traditional thoughts of investing all of their eggs
in simple baskets of domestic stocks and bonds.
They seek superior returns while artfully controlling risk through
understanding the advantages of investing in global financial markets and
non-traditional opportunities. This
understanding affords them the ability to construct portfolios of made up of
high risk and reward opportunities while maintaining overall stability in their
portfolios. The focus on managing risk
rather than avoiding it offers more choice and flexibility when seeking out
opportunities. To do less is much like
playing tennis with one hand tied behind your back. There is no need to play that way if the
rules of the game do not require it.
What should this mean to you as an investor?
There are
ways to operate in the financial market place that can provide you with
superior returns over time while controlling your exposure to unwanted
risks. Look for an investment advisor
with a strategy for the long-term.
Short-term windfalls are associated with long-term mediocrity. If you know a little about baseball, then you
know that the overall batting averages of home run hitters usually trail those
of their more consistent teammates. It
takes a wide variety of athletes to make a winning team, and in managing wealth,
success comes from steady performance over time as well. Next, returns must always be considered in
relation to the amount of risk tolerated by the investment manager (and by
extrapolation, the risk appetites of his or her investors). Thoroughly explore that risk tolerance of
those managing your investments. Terms
like high risk or moderate risk are insufficient for you to understand the
implications of the manager’s strategies and the choices he or she will make
when seeking returns for your money.
Finally, a deep knowledge of and experience with alternative investments
creates a vital advantage in someone you entrust to preserve and grow your
wealth. Solid research on your part on
where you are entrusting your funds can go a long to enabling good returns.
How do we
know so much about endowments? When you
have investment professionals who have worked at the venerable
Hoffman, White & Kaelber Financial Services Investment
Performance Update
According to The Wall Street Journal’s 2006 year end review,
“Many investment pros, most notably at the bigger hedge funds, became overly
skeptical during the summer and fall and refused to believe that the markets
would resume rising.” We were in that
over-conservative camp and prices did resume rising. It wasn’t until mid-fall that we moved back
into the markets with greater confidence.
Thankfully, we were able to out-perform in the last quarter of the year
and regain some lost ground.
For the month ended December 31, 2006, our
one-month performance is up 3.41%, our one-year return is up 8.30%, our
three-year return is up 5.97% and our average annualized return since inception
is up 9.42%. Purposefully, our since
inception risk measures edged upwards slightly, but remain very conservative at
+/- 6.01% (+/- 7.03% and +/- 6.21% for one-year and three-year
measures, respectively) and our since inception Sharpe Ratio (reward for risk
taken) remains very respectable at 1.12.
For more
performance information, please see our web site for details.
Is a comfortable retirement or preservation of wealth important to
you?
Want better long-term results from your investments?
Choose Us As Your Investment Manager!
Research us on the web at www.hwkfs.com