A fund-of-funds structure is also commonly used to grant access at lower minimums and increase diversification.  However, it can also be quite costly.  Let’s use hedge funds as our example in Exhibit 10.  The typical fund-of-funds structure consists of an annual management fee with some degree of carry (or performance) fee.  In our example, we will assume a 1.25% management fee and a 5% carry.  If we also assume that the 13.1% return Yale reports as their Absolute Return performance is net of underlying manager fees, we can then calculate both the gross underlying hedge fund manager’s performance and the net return an investor would receive if they accessed the same manager through a fund-of-funds vehicle.

EXHIBIT 10

With the assumptions stated in Exhibit 10, the typical high net worth investor who accessed the same manager through a fund-of-funds would have experienced a meaningfully lower return after-tax (7.2% versus 12.9%).

While access to alternative investment strategies such as private equity and hedge funds presents a challenge to individual investors, the individual investor also does not have the scale to benefit from fee breakpoints in traditional strategies such as equities and fixed income.  Let’s use a sample equity manager from Exhibit 7 as an example.  In this instance, we allocate $2.5 million to a long-only equity manager, Manager A, which consists of 4.2% of the portfolio.  Yale would have to allocate $750 million to Manager A based on the same allocation.  It is realistic to assume that Yale would receive a breakpoint from Manager A of at least 50% less than the individual investor.

Time Horizon

An investor’s time horizon is a basic factor used by advisors to assess the suitability of an investment for a client.  As you would expect, the more risky an asset class (i.e. wider range of potential outcomes) the longer an investor’s time horizon must be for the opportunity to be appropriate.  The investing time horizon varies by investor based not only on age, but also factors such as continued entrepreneurial aspiration, estate planning goals, spending rates, and charitable intentions.  An individual might be investing based on their life expectancy, their children/grandchildren’s life expectancy, or even with a view towards perpetuity in the case of some charitable goals.  The classic example is the difference between stocks and bonds.  It may seem intuitive why an equity investor must have a long time horizon, but the logic behind it is supported by the numbers (See Exhibit 11). 

EXHIBIT 11

While there are many people who prognosticate on what the equity markets will do 6 or 12 months out, you will notice in Exhibit 11 that the range of experience over any given 12 month period can be quite divergent.  However, a long-term investor can become more comfortable with the range of expected returns the longer he or she holds the investment.  Increased certainty means decreased risk.

“Hot” new asset classes are often discussed in the business news media with reference made to a well-respected, “smart money” investor and their past involvement in the space.  It is not uncommon that many investors then attempt to imitate these opinion leaders using access vehicles available to them.  Often, little thought is given to whether the time horizon of the asset class is appropriate for the situation.  A prime example is timber.  Timber is often hailed as a truly “uncorrelated” asset class because the primary driver of value over the long term is a tree’s biological growth.  A bigger, older tree is generally more valuable than a younger, smaller tree.  For a tree to reach its “prime”, it may take over twenty years from planting.  In timber investing, it is prudent to diversify not only by region and tree species, but also by planting year.  However, a twenty year planting cycle implies that an investor must have a very long time horizon in order to have exposure to more than one investment cycle.  While this may be appropriate for some private individuals whose intent, and thus investment horizon, meaningfully exceeds their own natural life, it does not appear to be a “standard” asset class to be included for our investors.

Putting the Pieces Together

We have separately reviewed the impact of taxes, access, and time horizon on the attractiveness of replicating Yale’s portfolio for the typical high net worth investor.  However, most investors face these factors together.  As seen in Exhibit 12, we estimate that taxable investors with less than $60 million in liquid assets would have earned a net 13.8% annualized return from 1996 – 2006 compared to Yale’s 17.2% return taking into consideration the factors in combination.  Using Yale’s active benchmark returns, the net return after taxes and access fees are even more profound.  The net return is 8.7% compared to a 13.0% gross return, which equates to 44% of the gross return eaten up by taxes and access fees.
  

EXHIBIT 12

Finally, we must consider the potential annual costs for Yale’s illustrious investment office.  Yale’s infrastructure is also not easy to replicate because we estimate that it has roughly $5 million in annual fixed costs as seen in Exhibit 13.  The infrastructure costs alone would be a 1.00% drag for a family with $500 million in assets.  For Yale, however, we estimate the infrastructure fee is just 0.03% thanks to its scale with over $18 billion in assets under management.

EXHIBIT 13

Conclusion

The investment successes of David Swensen at the Yale Endowment are remarkable.  The approach employs evolving investment opportunities offered in the alternatives space within the framework of traditional modern portfolio theory by distilling down asset classes to their true sources of risk and return (and not be blinded by legal structure).  Many lessons can be learned and applied to private investors, but we must be mindful that differences in circumstance discourage outright duplication.  The three primary differences between an $18 billion, tax-exempt endowment and an individual investor are taxes, access (and the resulting added cost), and investment time horizon.  Each of these three factors alone are enough to warrant concern of true replication; in concert we believe they make a solid case why it should not be considered a “turn key” solution to investment management for private individuals and families.    

Henry Jones
Partner, Edge Capital Partners, LLC

Will Skeean, CFA
Partner, Edge Capital Partners, LLC

Sources

Disclosure and Risk Summary
This report is intended to provide interested persons with an insight on endowment investing.  The opinions expressed herein are those of Edge Capital Partners, LLC and the report is not meant as legal, tax or financial advice.  You should consult your own professional advisors as to the legal, tax, financial or other matters relevant to the suitability of endowment investing.  The external data presented in this report have been obtained from independent sources (as noted) and are believed to be accurate, but no independent verification has been made and accuracy is not guaranteed.  The information contained in this report is not intended to address the needs of any particular investor.

This presentation is solely for the recipient.  By accepting this report, the recipient acknowledges that distribution to any other person is unauthorized, and any reproduction of this report, in hole or in part, without the prior consent of Edge Capital Partners, LLC is strictly prohibited.

This communication is not to be construed as an offer to sell or the solicitation of an offer to buy any security.  All figures are estimated and unaudited.  Past performance is not necessarily indicative of future results.

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