YWR: The Great Front-Run
Disclosure: Personal views only. Not investment Recommendations
It started with the Stanford Endowment. I was curious how the smartest people in the room (and I’m not using air quotes) invest their money for the long term. Their returns and investments have been legendary (11% annualised for 30 years). How do they do it? I was positively surprised to find Stanford issues an annual report on their endowment including information on the asset allocation and performance of the different asset classes.
Being the financial enthusiast (nerd) that I am I found this insight into endowment asset allocation fascinating and wondered if all the universities published these reports. So I started looking into Yale and Harvard. Next, I wondered about the big pension funds I used to cover like ERS and TRS in Texas? So, I checked out their annual reports too. Then what about the oil funds like Alaska Permanent and Alberta Heritage? So I started looking at their reports. And since we are looking at oil funds I wonder if there is information on the asset allocation of the Middle East sovereign wealth funds. A double latte and a few hours later I had clipped 85 slides of charts and text from 22 different institutions representing $6.5 trillion in AUM.
So what can we learn from these hours spent clicking through fund positioning reports? What are the trends?
One trend is that for public equities these big funds are mostly managing the money in house and able to run public equity portfolios for 5 bps. Another trend is that with public equities and also for fixed income the money is mostly indexed. This is why they are able to get the costs down to 5 bps.
But these are not the big trend. This is not the thing that sticks out page after page as you look at the different funds. No. The big, obvious, impossible to miss trend is the large and growing allocation to private equity and venture capital.
The Swensen Approach
David Swensen is the famous CIO who ran the Yale endowment from 1985 until his death in 2021. His big innovation was that long term funds, like college endowments, should stay away from low return asset classes like fixed income and commodities and allocate heavily to equity related asset classes, especially private equity. Over time equities should outperform bonds and are better at providing protection against inflation.
Swensen had studied under James Tobin while writing his Phd at Yale and as a result was a big fan of Modern Portfolio Theory. One of the ideas in Modern Portfolio Theory is that investors will earn extra return, ‘the illiquidity premium’ for investing in private equity and venture. Later in 1990 when Swensen was CIO he shifted the Yale portfolio from a traditional allocation of 65% domestic stocks and bonds to just 10% with the rest in PE, VC, natural resources and international equities. The defining move though was the outsized allocation to private equity and venture capital. That is the allocation which made Swensen famous and why most colleges all follow his approach.
The problem with the Swensen approach is that what was edgy and innovative 30 years ago has become crowded and consensus. Everyone is copying the private equity and VC overweight, which has created record inflows into the private equity asset class. Yes, it probably still works over the very long-term, but I think we’ve hit a multi-year air pocket.
If you are invested in PE the two charts below from the Bain 2022 review are depressing. Record new flows into the asset class in 2021 and record dry powder. It’s everybody trying to be David Swensen. It tells you future returns will be awful.
Is Norges the new Swensen?
This is where you say…. “Interesting Erik, but when do you get to the part where you say how to make money?”
OK. Here it is.
Hartnett has this view the inflation paradigm has changed from deflation to inflation and potentially everyone is invested in the wrong assets. To perform in the next ten years you need to sell what worked (Tech, PE, VC, Growth) and buy what didn’t (International, EM, Commodities, Gold, Value). It makes for a catchy research report, but do you really move a multi-billion portfolio around on a call like this? Do you move away from a strategy that has worked so well for so long? Ooof. That’s tough.
When I look at the Bain charts and the 22 mega fund positioning and see ADIA saying their private equity teams struggle to find deals because there is so much money in the space; I think you have to take a reality check and consider whether it’s time to go the other way. Maybe public equities, especially EM and International are the new Private Equity.
Maybe you reduce all the asset classes that everyone has overweighted and you reinvest where they aint. Add to EM public equities, add to Natural Resources, add to Europe, add to Africa, create a bucket for precious metals and add to that too. And you know what else? You will save a lot on fees paid to Blackstone and KKR. Oh. One other thing. Three years from now, in 2026, set yourself a reminder to create a special fund to buy distressed secondary private equity positions from funds trying to exit.
Meanwhile do you know what world leading mega fund resisted the move into private equity? Norges. The conservative Norwegians with their $1.4 trillion just stuck to public equity, and managed it all in house at 5 bps. Maybe in the years ahead being like Norges is the cool new trend.
The multi-year front run
The good thing is if this switch to international and EM public equities is correct the trade will work for years. It will take the mega funds over allocated to private equity years to get out of their positions and years for the board of directors to think about changing the allocation targets. So after 5 years of EM and International outperforming there will still be another 5 years of outperformance still to go as Yale and Stanford have finally disposed of their money losing fintechs and are ready to buy European banks at 10x earnings (up from 6x today). Effectively, you can front run the endowments for years.
I posted the YWR Mega Fund Positioning Review in the subscriber section if you want to flick through all the slides. If you are running a multi-asset portfolio it’s good to know what the leaders are doing.
Trying to be fun
My wife and I have a new couple we are trying to be friends with. The husband is really into football/soccer and has invited us to attend a match this weekend. It starts late though (around 7pm), so we probably won’t get home until 11pm. I’m not a big soccer fan and I love going to bed early, but I’m going to try really hard to be fun.
Have a good weekend!
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100% agree. Great piece of research Erik. This is going to be a super painful transition fanned by public outcry when the fantasy private marks are exposed.
Africa is a failed state and Brazil is about to become one.