[MUSIC] Learning outcomes. After finishing this video, you will be able to understand how an institutional investor thinks about strategic asset allocation. Understand the asset allocation strategies followed by endowment funds. So far we've looked into investment philosophies that represented two extremes, passive, index investing, and active hedge funds and alternative assets. We have seen that for an investor who has no information edge, index investing gives market returns. And in the long-run, those alone are very attractive. We see that index funds consistently beat actively managed mutual funds in the long run. For hedge funds that are professionally managed, they aim to generate alpha by employing highly complexed strategies. Sometimes in very niche markets. Does it make sense to combine these investment styles? Who would do it? And why? Institutions with long time horizons and large portfolios often engage in both of these strategies. Institutions could include university endowments, insurance companies, pension funds, and sovereign wealth funds. The asset allocation decision of large institutions like these, are influenced by factors and thought processes which are different from that of the individual investor. The individual investor ought to rely on beta. But hedge funds who aim to generate alpha. May be useful to institutional investors. Large institutional investors often have very long time horizons. They have a massive, often have massive amounts of capital to invest. And they employ sophisticated professionals who have the resources and the networks to source the best fund managers. Institutional investors can also put together complex betas, non-traditional betas by investing in multiple asset classes, and they may have the unique ability to withstand short term volatility. We will touch upon each of these aspects in the next few minutes. And we'll also discuss some of the risks associated with adopting some of these mindsets. So first, long term horizons and the predictability of long horizon returns. Institutional portfolios like those of a university endowment, or solving one fund are much more long-lived than retail portfolios. Retail portfolios have, at most, one lifetime to consider. The reason it's important is that long horizon returns are often a lot more predictable than short horizon returns. If you take rolling long term periods, the volatility of some asset classes, particularly equity appears to decrease. And returns become much more aligned with long-term intrinsic value creation. Take a look at this particular graph, which plots P/E ratios on the x axis and subsequent long-term returns on the y axis. There's a mark negative slope to this. What this means is that low PEs tend to produce low returns and high PEs tend to produce future short term returns. What this suggests is that there is some predictability to returns as a function of the valuation of market. So let's look how an institutional investor would think about strategic asset allocation. The first and most important thing is that their asset class choice is large. They look for very many different asset classes, which a retail investor might not. So the first thing they do is identify the broad asset classes. Of course, they're ideally looking to see for things that are uncorrelated because they want to harvest the fruits of diversification. The next they want to look at is look at the risk return profiles of each asset class. And then of course, they've got to figure out how much weight to allocate to each asset class. These types of institutional investors often have very long time horizons, and so their view of risk may be somewhat different from those of the short term investors. Let's go a little bit deeper into the asset classes in which the institutional investors invest. Apart from the usual stocks, bonds and cash, institutional portfolios include a big chunk of non traditional asset trusts. These include commodities, precious metals, real estate, hedge funds, and private equity like we have discussed before. These asset classes are often less collated than stocks and bonds. Some of these asset classes are liquid. And as such provide an illiquidity premium to long horizon investors. Hedge funds themselves offer a magical alpha. And like institutional capital, because of the type of capital, it's patient long term and all fund managers love patient, long term capital. Lets look at the canonical example, the Yale Endowment. They shifted towards hedge funds and alternative assets from traditional stocks and bonds. This shift was pioneered by David Swensen who was considered the father of the endowment model of investing. His approach is now followed by many endowments. The key idea and the key differentiator is the move toward illiquid assets. In a similar but slight different fashion, the Harvard endowment, which now has about 37 million in assets managed by the Howard Management Company, also has substantial allocations toward alternative asset classes. Both these institutions have had long track records of extreme success. And so now large public pension plans and many other institutional investors are following in their footsteps and increasing their asset allocation to alternative assets. Owing in large part to higher returns, lower perceived authority, and lower correlation to traditional assets. The most important point that needs to be understood is that large institutional portfolios with long time horizons,have a higher ability to tolerate short term volatility and retail portfolios. It does not mean that they are immune to volatility as we will see in a minute. What the advantage of these types of endowments, is that they know that their operating expenses are pretty predictable and that the capital is not required to be distributed. And most of the capital can be untouched for long periods of time. So these kinds of portfolios can tolerate short term royalty much better. They use it to their advantage. In portfolio generally have substance ill allocations to alternative assets as you can see from the graph below. From the... With the increasing accessibility and comfort of alternate asset classes, endowments have shifted more and more towards. You can see in this particular graph, from 15% in 1992, Has grown to more than 40% in 2010. And there's been a corresponding reduction in the access allocation to traditional equities and fixed income. Allocations of this type are not risk-free. And in fact they capture some risks that are unique to the alternative asset process. The first and foremost risk is that to generate higher returns, large investments are made in liquid assets with long locking periods, capital calls, and the inability to exit early. In times of extreme stress, these can effect even long rising investors during the 2,000 raid credit crisis. 44% of Harvard's endowment was locked up in assets that would require more than five years to liquidate. So you can say these are very liquid portfolios with a lot of liquidity risk. Critics of the model followed by the Harvard endowment and other similar endowments have cited these endowments for under allocation to liquid investments as a fundamental flaw. After all, unforeseen liquidity issues from crises or from capital calls particularly from private equity instruments. For a private equity investor, market crashes actually create opportunities. And so they have committed capital. Time for capital is precisely when the market is the weakest. In particular they had a large allegation They had further capital calls and that couple were the usual payouts to run their underline businesses, and some of these people even had leverage. There was a lot of portfolio. So the existence of alternative assets within portfolios leads to a higher likelihood of increasing liquidity prices. And leverage tends to magnify this risk. Additionally, as we've suggested before, many alternative assets do not have an easy public market exit. They often have no prices. And therefore the true price of an asset is a big question mark. Additionally many of these private equity investments have underlined cash flows that are uncertain. [INAUDIBLE] and there is tremendous information [INAUDIBLE] so conventional evaluation is often difficult for some of us. And finally at least from an academic perspective. Because of a lack of information and transparency it is very hard to distinguish alpha from beta in alternative investments. Also, high returns don't mean anything if they are taken with a lot of leverage. So trying to distinguish things like leverage from actual skill in either security selection or an operational execution takes a lot of deep understanding, which is only available for institutional investors. If your time horizon is long, your view of risk may be different from short horizon investors, and as a consequence, your portfolio allocation, and your investment strategies, may also differ from short horizon investors. Over the long run equity returns in particular tend to be more predictable, and institutions with long investment horizons are better positioned to weather short-term noise. Alternative assets institutional portfolios also entail a lot of liquidity risk, and some of the characteristics of the acid itself remain opaque. How our every investor is in an perpetual quest for high returns. An altering of assets have provided high returns in the past. Sophisticated investors want these returns even though there's a lot of complex risk. [MUSIC]
