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How Can You Invest Like a Well-Run Endowment?
05/22/2017 2:50 am EST
How can individuals invest like a well-run endowment fund? Last week, we featured Axel Merk’s overview of constructing a portfolio in an era of increasingly-correlated assets prices. Here, the money manager and of editor of Merk Investments’ newsletter, Insights, continues to share his insights on long-term asset allocation. (Read Part 1 of this report here.)
In this market where nearly every pessimist is fully invested, is there a better way to build your portfolio?
The other day, we met with an investor who has 40% of his portfolio in cash. He doesn’t like market valuations and has decided he’ll put money to work if the market declines by 10%; then more money to work if it declines another 10%. We think this investment philosophy beats that of many. At least, he has taken chips off the table during the good times and has money to deploy.
Before readers cry out: “There’s so much cash on the sidelines, this market must go up!”, I would like to caution that this investor is a rare exception of many investors I talk to. And I talk to retail investors, advisors, family offices, to name a few. The same person, by the way, told me he is at a loss on what to advise his friends, as he doesn’t want to encourage them to get into the markets given current valuations.
Indeed, this appears to be a market where just about every pessimist is fully invested. Because folks have been wrong so many times calling the market top, we believe many market bears are fully invested.
I think there’s a better way. The better way of investing is to take the long view. Sure, it’s great to have one’s stock portfolio surge, but investing, in the opinion of yours truly, isn’t about gambling, but about asset allocation with humility.
Passive investing is all right for certain things, but should not replace common sense. When the likely successor to Janet Yellen (we put our chips on Kevin Warsh) has complained that asset holders have disproportionally benefited from monetary policy, and that the focus has to shift, I think it’s but one indication to do a reality check on one’s portfolio, as headwinds to asset prices may well increase.
The short answer is that investors may well look at their portfolios more like pension funds or college endowments do. Except, well, many pension funds and college endowments have fallen into the same traps individual investors and advisors have.
Let me rephrase: investors might want to invest according to a philosophy a well-run endowment might have. Let me just mention a few principles here. Here’s the investment allocation of an endowment of a private college. I’m not suggesting this specific allocation is the right one for any specific person or institution, but want to provide it as food for thought:
- 31% hedged strategies
- 27% equities
- 21% private equity
- 8% real assets
- 6% cash
- 5% fixed income
- 2% equity-like credit.
Note that the equity holdings are less than 30%, not the 60% often touted in a “60/40” portfolio (with 40% referring to bonds). The number can be larger or smaller for any one investor, but I believe we should get away from the notion that one needs to have a large portion invested in equities.
Endowments are long-term investors, yet they don’t go to 100% equities; so why should a young investor be all in equities? By allocating a far smaller portion, you don’t need to lose sleep over asset bubbles. Instead, you can indeed rebalance or make gradual shifts.
Note the biggest bucket is “hedged strategies.” We have long advocated that investors need to look for uncorrelated returns. A long/short equity strategy or long/short currency strategy might generate such returns. Importantly, this bucket of alternatives is far higher than what many advisors choose. In an era of very expensive assets, we think this may be rather prudent.
This doesn’t solve the issue of how to find the right hedged strategy. Remember that those strategies will have under-performed the overall market. Important here is the investment process of the underlying ETF, mutual fund or whatever product one might want to consider.
Private equity is obviously not accessible to many investors. Relevant though is that there’s a big bucket allocated to investments where one expects a long-term return without seeing the daily price moves. Sometimes it’s good not to have tick-by-tick data. An individual investor might be able to replicate this by opening another account, selecting a few long-term ideas, then throwing away the key to the account for a few years. Well, one should still review the investments periodically, but the point being: it is okay to invest different portions of a portfolio according to different philosophies. Say, be a day trader for a small portion, but do hold strategic positions. Some of this can be achieved by intentionally mixing up the styles of different investment products. If not all of them perform well at the same time, that’s a good thing!
This particular portfolio has a small allocation to “equity-like credit.” We are not making a judgment whether this is too high or too low; the point again is that there’s a very broad allocation to different asset classes. Note, by the way, that equity-like credit is likely to perform, well, like equities. Even with those assets added, the equity portion is still modest.
Not mentioned in this portfolio, as least not in the headline numbers, is an allocation to precious metals or commodities. Those who have followed us for some time know that we encourage investors to consider gold as a diversifier. We have often referred to gold as the “easiest” diversifier because it’s easier to understand than some exotic long/short strategy. In our analysis, the price of gold has had a near zero correlation to the S&P 500 since 1970; however, over shorter periods, correlations can be elevated. In our analysis, gold has done well in every bear market since 1971, with the notable exception of the bear market in the early 1980s when then Fed Chair Paul Volcker raised interest rates rather substantially.
The point of all of this is not to suggest that investors need to add equity-linked credit or private equity to their portfolio. No, the point is that there’s more to investing than chasing high flying companies that promise to make Mars habitable.
You might have also noticed that I squeezed in the word “humility” in asset allocation above.
Have some respect that things that go up can also go down. Having respect means that one doesn’t adjust one’s lifestyle (expenditures) as a reaction to rising asset prices. Investors can control expenses more so than income. So maybe we should be spending far more time talking about how we spend our money rather than how we invest it. But I digress.
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