Applying institutional tactics for your clients

Big institutional investors are making headlines again.
A wide range of articles continue to praise the efforts of managers such as Yale University’s David Swenson not just for the performance of the endowment fund among its peer groups (the market value of the New Haven, Conn., university’s endowment fund grew from about $10.5 billion in 2002 to about $19 billion last year) but also for forward-thinking investment methodologies.
So what do these large funds teach us about investment strategy, and what are its lessons for investment advisers? Perhaps the best way to begin thinking about how to apply best practices of large institutional investors is to challenge some of the accepted realities of investment strategy among smaller investors.
Volatility: The volatility of an investment is often given as the standard deviation of the return rate. This measure is useful in assigning a probability to the expected performance of a stock against its previous prices but shouldn’t be used by investors as a sole determinant of risk and return. Unfortunately, many investors are under the false impression that high volatility is a necessary evil in pursuit of returns in excess of 10%.
Large institutional investors recognize that if two investments have the same average return, but one has higher volatility, the investment with lower volatility will actually end up with more money, even with the same average return. In addition, volatility can cause a lot of pain for individual investors, depending on market conditions. Ask a retiree who has tried to withdraw funds from a mutual fund during a bear market.
For many investors, even those with a long-term investment time horizon, capital preservation is a primary objective. To help minimize decreases in their clients’ net worth, advisers should look for investment opportunities that hedge against market fluctuations, while generating relatively steady long-term returns. The performance of the Yale endowment fund and other large institutional investors validates the use of “alternative” investment strategies, including long/short hedge funds, managed futures and debt arbitrage funds.
Market timing: Market timing, or “tactical allocation,” has traditionally been viewed as a good strategy for taking advantage of shifts in the market. The reality, however, is that this reactive strategy often results in capital movement at the wrong times, since capital is chasing returns. A recent study of mutual fund returns illustrates the cost of market timing. From 1980-2000, the average equity mutual fund was up 9.3%, but the average investor was up only 2.7%. The reason is that capital tends to flow to the wrong asset class at the wrong time.
Beyond stocks and bonds: Conventional investment advice suggests that the universe of attractive investments is U.S. stocks and bonds. The reality, however, is that there are plenty of investment opportunities that can generate favorable returns while diversifying risk. The Yale endowment provides a great example of this trend. Over the past several years, the fund has steadily decreased its position in U.S. long-only equity in favor of increased alternative investments.
Although this type of strategy appears to be effective for large endowment funds such as Yale’s, it may be more difficult for smaller investors to duplicate the success of large endowments, due to a variety of limitations. Depending on the size and accreditation of your investor, consider using either the 3(c)1 or 3(c)7 portions of the Investment Company Act of 1940 to achieve some of the investment advantages typically reserved only for large hedge funds and university endowments.
Diversification strategy: Several years ago, investments in international stocks and real estate investment trusts represented a viable diversification strategy, because they were still new to many investors. The reality, however, is that each provides only a small amount of diversification, due to their increasing correlation to the U.S. equity markets. This is true particularly among international stocks — Norwalk, Conn.-based financial research firm FactSet Research Systems Inc. reported a positive correlation between the Standard & Poor’s 500 stock index and the Morgan Stanley Capital International Europe, Australasia and Far East Index by a coefficient of 0.91.
REITs are also becoming a less viable diversification strategy, due to an increasing correlation to small-cap-value stocks. Recent studies comparing the performance of the Nareit Equity Index with that of the Russell 2000 Value Index show a positive-correlation coefficient of 0.77.
New asset classes: A traditional view of investing is that there are not many safe ways to diversify. But further analysis of the Yale endowment and other large institutional funds suggests that there are a variety of new alternative asset classes that can lead to lower volatility. One example is long/short hedge funds. Hedge funds can be used as an alternative-investment vehicle, because the average volatility of the aggregated hedge funds is less than the volatility of the S&P 500. The Yale endowment fund currently allocates about 25% of its assets to hedge funds.
Another proven method for reducing volatility is investments in managed futures, which have become increasingly popular among institutional investors in recent years, due to their lack of correlation to the equity markets. Like other strategies designed to maximize absolute returns regardless of the direction of the market, they don’t depend on the long-term return in an underlying traditional stock, bond or currency market.
Large institutional investors can be a valuable source of information for investment advisers who seek consistently high returns. Among the lessons learned are that use of long/short hedge funds, managed futures and debt arbitrage funds can serve as a viable alternative-investment strategy for generating high returns while minimizing volatility.
Additionally, we can see that market timing techniques are often misguided and that advisers should consider a universe of investment opportunities beyond stocks and bonds in seeking diversification.
As a final thought, it is important to examine continuously investments that have traditionally been viewed as alternative (such as international stocks and REITs) to make sure they are, in fact, a true source of diversification.
As we can observe from large institutional investors, a wide variety of new asset classes make up an important ingredient in maximizing returns while minimizing volatility.
Neal Simon is founder and president of Highline Wealth Management, a registered investment adviser in Bethesda, Md., with more than $400 million under management.

Related Topics: Investment Strategies