[MUSIC] We now discuss asset allocation for institutions. [MUSIC] Earlier we discussed asset allocation for retail. And we have suggested that indexing is a strong, powerful idea. And the put in power of the average result is that you will be the top of investors, if you passively index. So how could you possibly do better, and who would want to do better? So let's just get into asset allocation itself and why have we spent so much time thinking about the practice of asset allocation. Should we study something else? And the reason is that if you look at this graph, asset allocation determines somewhere between 80 to 110% of all returns. And everything else contributes 127% of returns. The strategic asset allocation determines most of your outcome and that's really why we've been spending a lot of time thinking about asset classes, asset allocation. I'm trying to think about how to put together a good portfolio. So today we're going to think about and study to a limited extent what endowments do. Long horizon investors, they take advantage of the predictability of long horizon in returns. They try and access more complex betas through multiple asset classes. And they use their ability to tolerate volatility to invest in some exotic investments. What is the opportunity set for a typical endowment? And here's a possible answer. And this particular chart has expected risk on the x axis and expected return on they y axis. And what you can see is that the highest return investments are in this exotic realm, private equity and venture capital. And since everybody is in the business of trying to get higher returns, people are naturally tempted by this area. And this also has high expected risk and so the average retail investor cannot invest in this. But institutional investors can. But lets first study some of the data before getting into this wide question of why do endowments and other institution investors engage in some of these strategies. And the first is, this is a graph that shows you that there are some predictability for very long horizon returns. And on the x axis here, we have a P/E ratio and the y axis we have a subsequent 20 year annualized returns. So these are very long horizon statistics. And you can see there's sort of a negative correlation. It shows us that high P/E ratio tends to suggest low future returns and similarly, a low P/E ratio seems to suggest high future returns. So that sort of suggests that there's some predictability in long horizon equity returns. The next graph I want to show you has, again it's just data, and what it does is take annualized returns And increases the time horizon. In this case, this is UK data. And it says what happens if you borrow and hold equities for 10 years, this is where the meter starts. 20 years, 30 years, 40 years, 50 years to so forth and what you can see is the dispersion of real returns, as the holding period increases, goes down. And the academics have a lot of debate about this but most practitioners certainly believe that as a time horizon goes up, the risk from holding equities goes down. And this chart seems to suggest that's correct if you just look at dispersion I want to show you another chart, and here, this is the This is across multiple asset classes, it's US Stocks, it's Bonds and Bills. So equities, fixed income and then short term cash like instruments. And here, again, you see as the years of holding increase the volatility of equities comes down quite dramatically. And if you look at the long term 30 year return, you will see that equities is the only asset class which positive returns over these 30-year horizons that Professor Siegel studied. So that suggests that long run perceptions of risk are different from short run perceptions of risk. In the long run, money market securities may in fact be the riskiest asset class. So with that as background, let's go back to these long horizon investors, these endowments. Because they know they're in the business for a long time and so their measures of risk are very long-term focused. And they may in fact have a remarkably different view of risk than the average investor. Who are these long term investors? Typically they are endowments, government pension plans, sovereign wealth funds. Sovereign wealth funds in particular are endowments too, they are virtually perpetual investors for very, very long term horizons. We're going to look at the Harvard endowment, probably the largest university endowment and a very successful practitioner, along with Yale, called the so-called endowment model. And prior to the 1990s, as we're going to see, it was mainly domestic stocks and bonds. Then Jack Meyer came in and he changed the portfolio somewhat. And what he aimed to do is, he aimed to get a long term asset allocation which had a beta portfolio, it was just index returns and tried to come up with an optimal asset allocation based on long term risk and return force. Here is what the Harvard asset allocation has looked like over time. And you can start in 1992 which is when Jack Meyer took over. 40% of the portfolio was in domestic US equities. 70% was in equities. Go forward in time to 2010 and you can see that the US portfolio is down to 11%. What is most interesting really is that the allocation to alternative assets has gone up very dramatically. So absolute return which would probably be hedge funds, commodities These have gotten large increases. And by the same token bonds have gone down quite dramatically in their asset allocation. So there's a strategic shift from our traditional asset allocation that we would still recommend for most retail investors into a more complex asset allocation. Are there nay benefits from changing the mix? Periodically the answer is yes, diversification. By diversifying into more uncorrelated assets, you're able to get more return for the same risk or the same return for lower risk. What then is this endowment model? And the idea really is that the endowment model is an investment approach that exploits among other sources the illiquidity premium across different public and private markets in an attempt to generate higher returns. The question you need to be asking is, what is the edge? What is the advantage that these endowments have? The first and most important is Time Horizon. And Time Horizon is longer than most individuals. The next is they're trying to get indexing returns through betas. Through multiple and more complex asset clauses. The third is the ability to tolerate volatility. And the fourth is that there's sum predictability in long horizon returns. Now, one big draw back to the endowment model is illiquidity. And here is how David Swensen, the pioneer of illiquid investment, particularly at Yale, pioneered the endowment model. He sort of suggests that illiquidity is not as much a risk as you may think. And he says it also gives a lot of advantages. The advantages typically less liquid securities are not well covered by the investment community. So there are often a lot of opportunities. And he'd like to benefit from these opportunities. He liquidated trying to ride higher returns. And then, he also says, you can never be sure what liquidity, and he gives the example of a dot-com company, Etoys, which in 2 years went from a billion dollars of traded value to $100,000 of traded value a day. That's just to show that companies which fail, liquidity tends to dry up in any case. And then, we'll have a few quotes from Keynes, Who suggests that, there's no such thing as liquidity in investment for the community as a whole, and this is really what happened in the crisis of 2008. Everybody wanted liquidity. And there are no plans for providers of liquidity, and so market prices went down and down. So these are some of the examples that Swensen says liquidity or lack thereof is not as important as a lot of people think and that's why he thinks the endowment model has a lasting advantage. To summarize, what does a typical endowment do? And in this graph you can see a typical endowment can go much further out and that it can and does go much further out the risks. Co. And thereby picks up excess return. We'll go back to this idea that asset allocation is an extremely important idea. Most investors, many of the early endowments, [INAUDIBLE] investors, spend a lot of time on manager selection. And, the reality is that manager selection can be important, but asset allocation is far more important. Asset allocation gets you to a good place. This chart basically tells you what the endowment model recipe is, most important thing is strategic asset allocation You needed to tell me your time horizon. You need to think about risk and you need to think about returns. Then, you need to hire managers. You can either hire a passive manager or an active manager. And lastly, you have the choice of doing some amount of asset class timing. When there is some predictability returns you can actually engage in some amount of asset class timing. So you see how endowments put together these multiple approaches into powerful portfolios. In doing so, they are taking risks. Return is always tradeoff against risk. And the nuances that they take to get their risk, to get the higher return is they want to debate between passive and active, between beta and alpha, uncorrelated strategies. Diversification was a concentration. Liquidity was leverage and then importantly when these are more complex portfolios they need to be thinking about risk exposure that is not easily observed. With that, you've now got a good introduction to the endowment model that has allowed many endowments to realize very attractive rates of return. [MUSIC]
