Endowment management - Market power, private information and liquidity as drivers of asset allocation

What are causes for portfolio differences between large and small endowments? All portfolio allocation information is readily available from a number of sources. Endowments know the allocation and performance of their peers. There have been books written on the so-called "endowment model", so there is no secrecy with what Yale or other Ivy League schools do, yet there are significant differences in allocations based on endowment size. 

It cannot be said that small endowments are driven by ignorance of their peers. It does not seem likely that there will be significant differences between the risk preferences of endowments based on size. There have to be other reasons for allocation differences.

Differences in portfolio management are likely to be driven by market structure and not financial knowledge. I suggest that asset allocation differences based on size across endowments are driven by three factors:

• Market power and costs 
• Private information 
• Liquidity 

Market power - Small endowments do not get access to the best private equity, venture cap, and real estate deals. They also do not have the size and staff to dictate terms in a deal. Big and more successful managers want to deal with big and successful endowments. Size receives attention and commands attention. Size has benefits that allow these endowments to increase allocations to less liquid and less well-known investments. 

Private information - Large endowments that receive more attention also receive more information about new opportunities. Large endowment also have the staff to create private information through their due diligence analysis. There are able to find hidden value in less public deals.

Liquidity - Large endowments may have less of an immediate need for cash and also have more budget flexibility. These endowments can invest in more long-term illiquid projects. Hence, this lower need for liquidity will be seen in their allocations.

The activities of large endowments cannot be replicated by small endowment. This difference impacts allocation decisions and create a barrier to entry to replicate the Yale endowment. Market structure and organization matters. 

There is no control on quality as a factor - Be careful when you buy a factor

There is growing interest in factor and alternative risk premia investing, but investors need to understand that there is not complete agreement on definitions of terms. An investor may want to hold a specific factor yet it may be offered in different forms with different returns streams because different providers have different definitions for the factor. Academic definitions may not be the same as index provider definitions. The definitions used for a swap index from one bank will not be the same as another bank. 

The quality factor as measured by Fama and French as operating profits has been described as a core factor independent of value and size. However, this is not the only way to measure firm quality. Some researchers have measured quality as return on invested capital, earnings stability and some leverage metrics. 

Five different index providers define quality five different ways. Now just because it was tested one way in an academic journal articles does not mean this definition should be written in stone. There are many considerations for developing a usable product for investors, yet each choice will lead to a slightly different return pattern.  Is one return pattern the true essence of equity quality? There is no agreement among practitioners or researchers. Quality may have more than one attribute and those attributes may be weighed or ranked to form a better quality measure. The above table is from https://www.financial-planning.com/news/factors-are-remaking-asset-allocation. There is commonality with return on equity and return on assets; however, there are also other criteria that can further differentiate firms for ranking.

What this means is that a buyer should careful of his product choice. An investor can buy a quality factor portfolio and find he is under-performing against a few quality benchmarks. Just like there are degrees of "organic" food for consumers, there are various measures for factors. 

Markets seem mixed to the "mid-cycle adjustment in policy"

We heard about the Fed cuts incessantly during July but the returns for the month end with a whimper. At the Fed press conference, Chairman Powell told investors that the cut was not a change to an easing cycle but a “mid-cycle adjustment in policy”. Words have meaning, yet it hard to understand the meaning in those cryptic words. Who would say that we are in the middle of the economic cycle? What is a mid-cycle adjustment? While Chairman Powell made the case that the Fed was able to talk down rates since December, how is this just a mid-cycle adjustment? It also is not clear how a monetary policy shift to a 25 bps cut will help consumer or businesses. Nor is it clear why the balance sheet reduction program had to be cut a month early. Investors are left with more questions than answer and that creates uncertainty and risk avoidance.

What is clear as we complete over half the year is that returns do not reflect either perception or reality in the real economy. If there are economic fears, we are not seeing them in asset prices. US large cap returns are now over 20% for the year. Small cap value and growth all have double digits returns. The global economy weakness has only impaired returns in global and EM equities. Fixed income returns are all positive based on fear flows and liquidity. Basic asset allocations like a classic 60/40 stock/bond blend have produced double-digit returns. There may be investor fears, but they are not showing in financial asset returns. 

With central banks around the globe focused on providing more liquidity, albeit in varying degrees, there is little on the horizon to suggest a return reversal based on policy mistakes. With summer heat and humidity comes a work slowdown, people in New York and London move slower and we expect the same for markets. There have been exceptions to this rule like August 2007, but there is little to suggest that markets are preparing for a fall. Can there be a decline in August? A correction after the strong showing for the last seven months is natural, but that should not change asset allocations. 

What are multi-alternative funds? You cannot tell much from their names

Multi-alternative hedge funds are growing in popularity even though there is an issue of defining exactly what they are and how they should behave. Obviously, if there is more diversification or alternative sources of return within a fund, the return pattern will be different than traditional assets, but it is not clear what will be the beta or correlation with traditional assets. Two funds with similar names could have very different correlations with equities.

The naming convention across the multi-alternative fund choice set is quite wide. Key words within the names include:

• Multi-strategy, 
• Alternative strategy, alternative beta, fundamental alternative
• Global Macro, Macro Opportunity
• Systematic 
• Tactical
• Opportunities 
• Diversified
• Multi-style 
• Alpha, Dynamic alpha 
• Global Absolute
• Absolute return 

If a fund can be called the Diversified, Multi-strategy, Multi-style, Alternative, Systematic, Dynamic, Global Macro, Tactical, Alpha, Absolute Return Opportunities Fund, it will have covered all of the key word descriptors. Yet, we would have no idea what it does. 

The difference in returns within the multi-alternative category from Morningstar is significant. The year to date returns have a spread of 27 percent between the highest and lowest returning fund and the one year return spread is 24 percent over more than 350 firms.

The name will tell investors nothing about what the fund will do or how it will produce returns. The only easy way to determine what these funds are or can be is through some form of beta decomposition with different indices. Is it fixed income focused or equity focused? What are the conditional correlations or beta? How stable are these relationship? Can these strategies be grouped into style buckets? Of course, this analysis will be subject to the problem of a backward-looking analysis but there is no real alternative beyond using the description of the fund. 

"What’s in a name? That which we call a multi-alternative fund, by any other name could return something different".
In the case of multi-alternatives, a name does not provide much information.