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Alternative Investments: Part 1

David Swensen, manager of the Yale endowment, has been lauded for his innovative approach to portfolio management. Under his guidance, the Yale endowment grew from $1 billion in 1985 to $22.5 billion in 2007. Although the endowment has subsequently plunged almost 30%, Swensen's track record relative to his peers is still very good. Based on his long-term success, it is reasonable to ask if some of his ideas can add value for individual investors.

When Swensen started at Yale, the standard asset allocation model for institutional portfolios was 60% U.S. stocks and 40% U.S. government bonds. Swensen bucked conventional wisdom by adding international stocks and bonds to the Yale portfolio along with a substantial allotment of alternative assets. He also increased the percentage of equities or equity-like assets and decreased the percentage of fixed income investments. The rationale for these moves was that broader diversification lowers portfolio volatility (or risk) without sacrificing expected returns and the endowment's long time horizon justified an aggressive equity-heavy allocation. Based on Swensen's success, the Yale model has been widely emulated at other U.S. universities.

Our current approach to portfolio management has some similarities to the Yale model and some differences. Like Swensen, we invest in developed and emerging international markets. We also favor equity-dominated portfolios for clients with an appetite for risk and a long time horizon. But what about alternative investments? The term "alternative" encompasses any asset class outside the traditional stock and bond markets. The alternative assets in the Yale portfolio are divided into three categories:

  1. Absolute return vehicles: hedge funds with returns that are uncorrelated with traditional marketable securities

  2. Real assets: real estate, timber, oil and gas

  3. Private equity: venture capital, leveraged buyouts

Most of these assets are not readily available to individual investors, but there are some exceptions. Individuals can invest in domestic and international real estate through real estate investment trusts (REITs). In addition, several funds have recently been launched that offer exposure to a variety of other alternative assets. The case for including these assets in individuals' portfolios is mixed, however. Alternative asset managers are often reluctant to divulge their investment methodology resulting in a lack of transparency. Many alternative assets have a prohibitively high price of entry for individual investors and exorbitant investment management fees. Individuals are less likely to qualify for discounted fees than large institutional investors. Some alternative assets are illiquid and some require periodic capital calls requiring additional deposits. Finally, the Yale model itself has come under fire for steep losses and illiquidity problems since 2007.

My view is that we cannot ignore the potential diversification benefits of alternative assets, but should proceed with caution. A rigorous analysis of the available investment options is required to assure that we only use securities that are reasonably priced, guided by sound investment processes, and sponsored by reputable firms. Part 2 of this topic in a future newsletter will review some of the alternative asset funds suitable for individuals. In the mean time, please feel free to contact me if you are interested in learning more about alternative assets.

Jeffrey J. Brown, MD CFA Principal, Shearwater Capital

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