Smart Money Takes a Dive on Alternative Assets |
Date: Monday, January 19, 2009
Author: Jason Zweig, WSJ.com
The ideal investment portfolio is solid and liquid at the same time. Perhaps because this principle defies the common sense of physics, even some of the world's biggest investors have overlooked it.
Now, with billions of dollars trapped in illiquid investments, many colleges and charities are cutting budgets at the worst imaginable time.
How did the "smart money" get into this fix? As bond yields shrank in the 1990s and stocks shriveled soon after, institutional investors began looking for assets that would generate solid returns no matter what.
The solution was "alternative investments" -- hedge funds, real estate, venture capital, private-equity funds and natural resources. Between 2000 and 2002, as stocks collapsed, endowments led by Yale University beat the Standard & Poor's 500-stock index by huge margins thanks to their stake in alternatives.
Word got around. In 1995, according to Managing Director Celia Dallas of the consulting firm Cambridge Associates, endowments had less than 10% of assets in alternatives; by 2008, that average had climbed to more than 30%.Some went much further. As of last June, 41% of Columbia University's $7 billion endowment was in hedge funds and 40% in private equity, with only 4% in U.S. stocks, 4% in cash and a piddly 1% in bonds. That is light-years away from the old-time institutional rule of 60% stocks, 40% bonds.
So what? Many hedge funds lock up investors' money for as long as three years. The typical private-equity fund makes "capital calls," requiring investors to pony up another 50 cents to 75 cents for every dollar they already have committed. Columbia is on the hook for another $1.6 billion in capital calls through 2012. When all goes well, as it had for years, endowments pay for capital calls with gains elsewhere in their portfolios.
Now, however, all isn't well. With no gains to be found, many institutions are short on liquidity just when they need it most. A recent survey of college and university presidents found that 50% have, or will soon, put in a hiring freeze. Nearly 7% admitted selling assets into a bear market; another 9% have been forced to borrow money at punitive rates.
Sadly, they didn't have to plunge into a pool that is run dry.
In 2007, Laurence B. Siegel, research director for the $10.9 billion endowment of the Ford Foundation, wrote a paper warning that alternatives could suck the liquidity out of institutional portfolios.
His argument boiled down to this. Institutions used to rely upon bonds to generate income. But if you sell your bonds to make room in the portfolio for alternative assets, what is left to sell when you need to raise cash for capital calls and to fund your operating budget? The answer is stocks. And in a bear market for stocks, warned Mr. Siegel, an endowment with 50% in alternatives could run out of cash in as little as two years. (The Ford Foundation has 23% in alternatives.)
Mr. Siegel sent the paper to two or three dozen people in the investing community. (Disclosure: I was one.) He asked all his readers to poke holes in his argument. None could.
Even after his article was published in last fall's Journal of Portfolio Management, said Mr. Siegel, the general reaction was: "Don't tell me not to sit on a hot stove. I know not to sit on a hot stove."
Why, then, is the air suddenly filled with the smell of burning wool and cotton?
Even institutional investors move in herds, and it is always hard to think amid the sound of hoofbeats. Your peers, feeling the need to rationalize their own commitment, will try to drag you into the pack. If you take too long to commit, all the best opportunities may disappear.
Institutions, said Mr. Siegel, "just didn't think about liquidity as a variable, and to the extent they did, they were too optimistic in their projections." He adds: "When you've never had a problem before, the worst-case scenario is not the first thing that pops into your head."
So, no matter how big or small an investor you are, take a couple of hours to take an inventory of all your assets: stocks, bonds, your home, your business and anything else you own. Size up what it would cost, and how long it would take, to turn each of them into cash. If one part of your portfolio takes a dive, you want to make sure you don't crash-land on dry concrete.
- Email: intelligentinvestor@wsj.com
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