In 2009, the Harvard and Yale endowments were praised for beating the market with their broad diversification strategies. One year later, each of the endowments posted double-digit losses -- forcing Yale to borrow money to cover the shortfall. Here's what went wrong.
“In today's volatile market, investors are looking for new ways to lower their risk profile.… The best means of achieving this goal is to look towards large university endowments, which attempt to capture consistent returns while maintaining a low level of risk.”
This anonymous praise was for author Matthew Tuttle who wrote, “How Harvard and Yale Beat the Market: What Individual Investors Can Learn from University Endowments to Help Them Prosper in an Uncertain Market.” It was published in 2009. Now, a year later, things have changed. The writer might wish to alter his statements, especially about risk.
This is because the Yale and Harvard endowments are no longer on top of the world. Instead, they are picking up the pieces. In fiscal year 2009, when the book was published, Yale’s endowment lost 27.3% and Harvard’s endowment dropped 30%, according to a report in the New York Times. Yale had to borrow money at high interest rates just to meet the school’s needs.
This means that the broad diversification that Tuttle espoused in his book didn’t hold up in crises. Investing in real estate, commodities and hedge funds, in addition to traditional stocks and bonds, in an attempt to stretch lack of correlation to its maximum didn’t make much of a difference. Instead all of these asset classes that ideally don’t correlate started moving in line with each other.
The evitable result was that all slumped together. Since Yale was fully invested, it was left with no spare cash for operating funds unless assets were sold at significantly reduced prices. The school chose borrowing money instead.
We can all learn from the Ivy League miscalculation. Investing is not only about constructing a portfolio to achieve the best return, it is also about living with the consequences of the choices. Not having money when needed, as was Yale’s predicament, was the unfortunate outcome of an overly extended portfolio.
Sebastian Page and Mark A. Taborsky from PIMCO addressed this issue in their recent commentary on the importance of tackling risk, as well as diversification, in a portfolio. In their article, “The Myth of Diversification: Risk Factors vs. Asset Classes,” they calculate correlation among asset classes -- U.S. equities, large-cap and small-cap; global equities; emerging markets; bonds, real estate and commodities -- during “quiet” and “tumultuous” times.
The analysts found that asset classes correlated (or moved in the same direction) during relatively calm times only 30% of the time, but in turbulent periods the correlation jumped to 51%.
They apply their findings to individual investors as well as institutions. In the words of the authors: “When they seek to diversify their portfolios, a majority of investors don’t think twice before they average their risk exposures across quiet and turbulent regimes. Consequently, much of the time, investors’ portfolios are suboptimal. For example, during the recent financial crisis, correlations and volatilities across asset classes changed drastically and seemingly diversified portfolios performed poorly.”
Page and Taborsky use this information to suggest an approach that takes into account risk factors during turbulent times. This is especially important for the retiree or near-retiree. Their analysis confirms and supports what Peter Bernstein said years ago: “Consequences are more important than probabilities.”
The practical advice here to the average investor is that not only is asset allocation important in a portfolio, but the level of risk within the asset allocation during unstable as well as uneventful periods must be considered, not just the average of the two.