Notes, Views, and the Occasional Provocation July / August 2012 

The long bull market of the 1980's and roaring 1990's created a love affair with stocks that could only end in disappointment, supplied on cue by the dot-com crash in 2000. Ever since, investors have been suspicious of publicly traded securities such as stocks and bonds and been on the prowl for investment substitutes that could give them an edge.

The romance with so-called "alternative" asset classes continues today among the world's most sophisticated investors such as university endowments and public and private pension plans. Alas, recent performance data from public pension plans suggests this romance, too, may end in love unrequited.

Here's to a happy autumnal transition and cooler days ahead to all except those of us enjoying the annual San Francisco "winter."

All the best,

Milo Benningfield

Considering the Alternatives
For some investors, publicly traded stocks and bonds are as boring as chardonnay was to wine connoisseurs a decade ago. But do so-called "alternative" asset classes really offer an investment edge? Not according to recent pension-performance data. more

Considering the Alternatives
As the sun follows the moon, when public equity markets drop, investors look for something other than stocks and bonds to fill their portfolios. Much as the anything-but-chardonnay crowd responded to a wine glut a decade ago, investors typically begin to question how anything as ubiquitous as publicly traded securities can provide them an edge to earn superior returns.

This happened again most recently after the dot-com crash and market slide in 2000. At that time, famed Yale University endowment manager David Swensen published his well-regarded book, "Pioneering Portfolio Management," which attributed much of the endowmentís success – nearly a 30 percent annualized return from 1973 to 1998 – to the use of alternative asset classes such as private equity and venture capital.

Mr. Swensen described the promise of what became known as the "endowment" method of diversifying beyond stocks and bonds:

Alternative asset classes – absolute return, real estate, and private equity – contribute to the portfolio construction process by pushing back the efficient frontier, allowing the creation of portfolios with higher returns for a given level of risk . . . . Investors treating alternative assets as legitimate tools in the portfolio allocation process reduce dependence on traditional marketable securities, facilitating the structuring of truly diversified portfolios.1

During the credit crisis of 2008, institutional investors such as Harvard had some nasty surprises with the illiquidity of alternative investments. Yet today asset classes such as private equity and distressed debt continue to be enormously popular with sophisticated institutions and thus individuals seeking to mimic their performance. As a New Jersey pension spokesperson recently stated, the emphasis on alternative investments "is a continuing response to the problems raised in 2001, when the market collapsed and we lost more than $20 billion in value from our pension fund because we were so strongly invested in stocks and bonds."2

But how much have these alternative investments actually helped these institutions? Pension consultant Cliffwater LLC recently examined state public-pension returns for the ten-year period ending June 30, 2011 and identified the top ten performing pensions:

Rank Plan Sponsor 10-Year Return
1 Missouri State Employees 7.1%
2 South Dakota FRS 7.0%
3 Oklahoma Teachers 6.9%
4 Texas County and District 6.9%
5 Delaware Public Employees 6.7%
6 Louisiana State Employees 6.7%
7 Iowa Fire and Police 6.7%
8 Washington State Inv. Board 6.7%
9 Massachusetts PRIM 6.5%
10 Oregon Public Employees 6.5%
Source: Cliffwater LLC Report.

According to Cliffwater, all the top-ten performers except Oklahoma Teachers achieved these results in part because of their allocations to alternative investments.

So, are these returns good? Well, given that we just passed through the biggest market crash since the Great Depression, earning six-to-seven percent a year for ten years doesnít seem too bad.

However, the public-pension returns lose some of their shine when we compare them to what was possible with publicly traded securities alone. Dimensional Fund Advisors calculates that a fairly straightforward hypothetical portfolio of 60% stocks and 40% bonds, using live mutual fund returns over the same ten-year period, earned 7.3%.3 In other words, individuals could have achieved better results than the top-performing state pension plan using stocks and bonds alone.

Is there a catch? No, except that in order to earn those returns investors had to rebalance their portfolios regularly to maintain the 60% stock, 40% bond allocation. This meant buying stocks when other people were fleeing them in early 2009 and trimming positions a year later when stock prices were climbing – a simple, but emotionally difficult task for most people.

Why didnít sophisticated institutional investors do better with their alternative investments? Part of the problem has been traced to poor market timing. Another problem is the high fees for most alternative investments. Compared to typical costs of about 1% for stock-and-bond portfolios, alternative managers typically charge a management fee of 2% plus 20 percent of the profits on investment returns over 8 percent. Just when the going gets good for investors in alternative asset classes, the managers swoop in to grab a handful of the returns.

More than anything, though, the challenge with alternative investments is that thereís simply not enough manager skill to go around. What passes for skill often turns out to be merely extra investment risk taken to try to beef up returns – risk that can just as easily backfire.

Take Bain Capital, for example, which has received scrutiny during this election year because of Mitt Romneyís direction from 1984 to 1996, when, by some reports, the firm earned a whopping 113% per year.

Wall Street Journal reporter Brett Arends took a close look at these claims and found them to be false, the result of a special method that private equity uses to calculate returns. Bainís actual investment performance from 1984 to 1998 was closer to 30% per year – not bad, until you consider that the U.S. market returned 20% a year during that time. Moreover, Mr. Arends calculated that if an investor had leveraged their stock investments with debt similar to Bainís use of leverage in its private-equity portfolio, they could have ratcheted up their returns to as much as 30 to 35 percent a year.4

In other words, as author and blogger Barry Ritholtz put it, Bain Capital simply

took lots of risk, use[d] immense leverage, and charged enormous fees for performance that was more or less the same as indexing. . . . Bain is worth criticizing not because they are so different, but rather, because they are pretty much just like the rest of Wall Street. And thatís nothing to brag about.5

The old adage that "if it appears to be good to be true, it probably is" applies in spades when talking about alternative investments. With their added risks and costs, they do end up offering an alternative to stocks and bonds . . . but, too often, a very poor one.

Thank you for reading. Please look for our next newsletter in October.

Best regards,

Milo Benningfield

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1 David F. Swensen, Pioneering Portfolio Management (The Free Press 2000), 204.

2 Sam Forgione, "Cash-strapped US Pension Funds Ditch Stocks for Alternatives," Reuters, August 16, 2012.

3 The hypothetical portfolio calculates its 10-year returns ending June 30, 2011 and assumes use of these mutual funds: Dimensional US Large Company Portfolio (12%); Dimensional US Large Cap Value Portfolio (12%); Dimensional US Small Cap Portfolio (6%); Dimensional US Small Cap Value Portfolio (6%); Dimensional Real Estate Securities Portfolio (6%); Dimensional International Value Portfolio (6%); Dimensional International Small Company Portfolio (3%); Dimensional International Small Cap Value Portfolio (3%); Dimensional Emerging Markets Portfolio (1.8%); Dimensional Emerging Markets Value Portfolio (1.8%); Dimensional Emerging Markets Small Cap Portfolio (2.4%); Dimensional One-Year Fixed Income Portfolio (10%); Dimensional Two-Year Global Fixed Income Portfolio (10%); Dimensional Short-Term Government Portfolio (10%); Dimensional Five-Year Global Fixed Income Portfolio (10%).

4 Brett Arends, The Romney Files: From Bain to Boston to the White House Bid (Aug. 5, 2012 Amazon ebook).

5 Barry Rithotz, "No Alpha: Bain Capitalís Investment Results," August 15, 2012, (

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