Core & Satellite

 

Investment Philosophy - The Endowment Core & Satellite Approach

 

Paul R. Krause - Chief Investment Officer, Krause Investment Advisory Group

 

I believe it is impossible to accurately predict the future.  For evidence, just look at the track records of so-called "expert" forecasters whether it's in the areas of the economy, investing, technology, international affairs, politics, sports or whatever.  Like a stopped clock that is right twice a day, they occasionally get it right, but they also get it wrong.

As of today, the stock market has gone up eight straight years.  Eight years ago, who predicted that?  I don't know of anyone. I certainly didn't.

In early 2009, I believed we were in the midst of a secular bear market that began in 2000.  Secular, i.e., long-term markets typically last from 12 to 18 years.  We could call from 2000 to 2013, a 13-year secular bear market, because during that time, the market suffered through two severe bear markets of 2000-2002 and 2007-2009, and at the end of those 13 years, the market finally reached the previous highs it attained originally back in 2000 and matched in 2007.

Granted, it took five years from early 2009 to 2013 to get back to its previous high of March 2000.

Which brings up a point regarding secular bull and bear markets that I hadn't considered in early 2009, and that is, defining secular bull and bear markets is a useless endeavor.  They do not matter.  Within each, there are periods of strong markets going in the opposite direction. 

As I said at the beginning of this paper, we have been in an eight-year bull market that virtually no one predicted.  And as to where we go from here, no one knows.  And by the way, this 8-year bull market has taken place while the economy's growth has been tepid at best, well under the historical average GDP annual growth rate of 3%. 

A wild card the past eight years has been the Federal Reserve's unparalleled quantitative easing (QE), which has injected never-before-liquidity into the system and fueled the stock market's rise.  The fact that interest rates have been abnormally low as a result of QE has also been a contributor to the market's rise.  Who predicted eight years of QE?

What Lies Ahead?

Here's the short answer: Nobody knows.

So What Can We Do?

We can invest in market index funds.  That way, we won't beat the market, but we'll come very close to tracking it.  Of course, the market tends to go through severe corrections every so often, like 40%, 50%, 60% 70%, etc.  It does come back, but it sometimes takes many years.  Do we have the patience and intestinal fortitude to ride that roller coaster down and stay on it all the way to the bottom and back?  

We can diversify by some simple standard, such as 60% bonds - 40% stocks, and maybe throw in some real estate, and hold these positions for the long-term. 

But building a portfolio of stocks, bonds, and possibly real estate, and buying and holding, is not only risky, but in fact is the equivalent of gambling - no different than betting on California Chrome in the feature at Churchill Downs.  Why?  The performance of a portfolio structured that way can be too dependent on a single set of "baseline conditions" and thus, too closely correlated to be considered "safe."

We can take a more sophisticated approach based on the precepts of Modern Portfolio Theory developed by Harry Markowitz in the 1960s, and followed by most financial advisors today, call it the traditional asset allocation approach.  Here is that approach:

The Traditional Asset Allocation Approach

  1. Gather the asset classes you will use.  Use large-cap growth, large-cap value, mid-cap growth, mid-cap value, small-cap growth, small-cap value, international, and fixed income.
  2. Forecast returns for each of those asset classes.  
  3. Forecast how correlated they will be to each other
  4. Forecast how volatile they will be.  
  5. Create a portfolio based on all your forecasts that will provide the best risk-adjusted return.  We would use software called an optimizer to figure this out.
  6. Hire money managers.  They should be style pure (stick to their style like large-cap value or small-cap growth, and never deviate).
  7. Monitor your managers.  Make sure they don't deviate from their style.

But this approach has a number of concerns:

  1. The asset classes can be too narrow, and highly correlated, giving you very little diversification benefit.
  2. You cannot forecast returns, correlations, and volatility with any real accuracy.  If you could, you could make a killing. 
  3. If you can't accurately forecast, then your results are suspect.
  4. The money managers have to stick to their style religiously.  If they don't, they are guilty of style drift, and even if they do well, can get fired.
  5. You might find a money manager who has generated great returns over the years, but doesn't fit neatly in a style box.  Using the traditional approach, you could not use this manager.

My Recommendation for True Diversification - The Endowment Model

Large endowments build diversified portfolios.  They will normally have a number of different money managers, sometimes 100 or more, with a number of different investment styles.  

Endowments recognize that adding assets with two characteristics can enhances portfolio performance:

  • Positive returns.
  • Low to negative correlation with other assets in the portfolio.

I recognize that individual investors cannot exactly mimic what the large endowments are doing, for a number of reasons:

  1. There are asset classes that endowments use that individuals cannot.  For example, some endowments buy actual forests with timber.  Most individuals don't have the money or access to invest in timberland.
  2. Endowments do not pay taxes, individuals do.
  3. Endowments have an unlimited lifetime, individuals do not.
  4. Endowments can access money managers that individuals cannot.  There is a large difference between going to a money manager with $1 billion to invest and going to a money manager with $50,000 to invest.
  5. Endowments can access some private equity deals that you cannot.
  6. Endowments have entire teams of people managing their funds.

But given these limitations, we can mimic endowment portfolios enough to benefit.

The processes that endowments follow and that we can mimic:

They focus on asset allocation.  The asset classes the endowments use are:

            Absolute Return.  These are money managers who seek some return regardless of what the market is doing.  Endowments use these types of investments as a bond substitute.

            Stocks.  Domestic and international.

            Bonds.

            Real assets.  This encompasses commodities and real estate.

            Private equity.  These are non-public equity investments.

They focus on manager selection and portfolio construction and look for the best talent available.  They look for managers who are not well correlated to each other.

They do not focus on security selection.  They hire the money managers and leave it up to them.

They focus on avoiding large losses.  Endowments realize that avoiding large losses is much more important than trying to generate large gains.

Investment Policy Statement (IPS)

Endowments have an IPS that puts their strategy in writing.  A well-thought-out IPS will set out the following:

  1. What goals you have for your money.
  2. What types of investments you will consider.
  3. Your performance expectations.
  4. What you will benchmark your investments against: S&P 500, Hedge Fund research Index, Lehman Aggregate Bond Index, etc.
  5. How you will choose money managers and investment strategies.
  6. What has to happen for you to decide to fire a money manager.

Conclusion

The twin objectives of an endowment-like portfolio are 1) generate satisfactory returns, and 2) avoid large losses.  Endowments attempt to accomplish this by investing in a more varied mix of asset classes with low or even negative correlations, and with a varied mix of investment strategies.

The objective of the endowment-like portfolio is not to give the individual market-beating returns, but to provide returns that help meet their needs.

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