By Suzy Kenly Waite
Photographs by Dorothy Hong
Is the endowment model broken? Lyn Hutton, chief investment officer of the Commonfund, doesn’t think so—but she does think institutional investors made some pretty dumb decisions that cost them dearly during the crisis. The endowment model, an investment philosophy for universities that gained steam in the last decade but crashed hard during the recession in 2008 and 2009, stipulated that universities should ramp up their allocations to alternative investments, as endowments have longer time horizons than many investors and alternative investments offered higher potential returns than more traditional assets, according to proponents of the model.
Hutton speaks from experience: She’s had a 32-year career working for endowments, most recently at the Commonfund, a $25 billion money manager that invests on behalf of nonprofit organizations and endowments. She is leaving the Commonfund at the end of November but will continue to serve as a contributor to the Commonfund Institute, a division within the Commonfund focused on educating investors through conferences, seminars, and roundtables.
Few institutional investors have as much experience allocating to hedge funds as the Commonfund, which started investing in hedge funds back in 1982. Since then the hedge fund business has grown from a cottage industry into a $1.2 trillion global juggernaut, but it endured heavy losses and tough criticism after the financial crisis of 2008. After the crash the endowment model came under fire when high-profile acolytes such as Yale University and Harvard University posted double-digit losses (30% for Yale and 27.3% for Harvard) in their endowments in 2009. (The endowments have recovered somewhat this year, with Harvard posting returns of 11% in fiscal 2010 (ending 6/30) and Yale posting returns of 8.9% in the same timeframe.) Critics charged that endowments, particularly those two Ivy League schools, had made too many illiquid investments in hedge funds, private equity and other alternative asset classes and could not quickly exit these investments when the markets crashed.
Hutton has been a strong advocate for hedge funds for years. But the crisis prompted Hutton—along with the Greenwich Roundtable, a nonprofit research and education organization for investors—to study the endowment model in an attempt to figure out what went wrong and how it should evolve.Hutton, who defines the endowment model as having an equity bias, a long-term investment horizon and diversification of assets, does not believe the model is broken nor should it be scrapped altogether, but her research has revealed some flaws in how institutional investors approached hedge funds before the 2008 financial crisis.
For a start, she points to two problems leading into the crisis—investors chasing returns without having the risk tolerance or liquidity for the strategies they were invested in, and the widely held notion that diversification protected investors from all forms of risk.
Hutton adds that financial markets have changed significantly since the Commonfund first started investing in hedge funds, making investing a much more complicated process than it used to be.
“Capital markets are more complex. There are instruments and strategies that did not exist 25 years ago,” she says. “And navigating those if you’re a fiduciary or a trustee requires a really thoughtful approach.”
The Commonfund was founded on a grant from the Ford Foundation to improve the investment management practices and financial resources of educational endowments. The firm first managed money for endowments and later added in all nonprofits, including foundations, public charities and health care organizations.
Today the Commonfund manages money for some 1,500 institutions. It also acts as an outsourced chief investment officer for clients, managing 100% of clients’ assets and handling such diverse tasks as helping with investment and spending policies, offering liquidity and treasury management, and assisting with asset allocation and risk management. “We’ve been doing this for 40 years and were among the first to be an outsourced CIO,” Hutton says.
The Commonfund now manages 30 funds of funds across a variety of strategies, including equity, fixed income, venture capital, private equity, real estate, natural resources, commodities and hedge funds. Three of the funds of funds focus on hedge funds; these funds account for a combined $2.5 billion and invest in a variety of strategies, including long/short, global macro, CTA, market neutral and relative value. (Hutton declined to cite the returns.)
Hutton joined the Commonfund in 2003 and has been responsible for all aspects of its investment strategies, including portfolio management, due diligence and manager selection. She also oversaw the Commonfund Custom Investment Office, its outsourced investment program for large institutions.
Previously, she spent five years as the chief financial officer at the John D. and Catherine T. MacArthur Foundation, overseeing the foundation’s then-$4 billion portfolio, and she also served as the vice president and treasurer at Dartmouth College and senior vice president and treasurer of the University of Southern California.
Staff writer Suzy Kenly Waite spoke with Hutton about how endowments should be allocating their assets now, what constitutes true diversification and how the investment industry has changed since the financial crisis.
AR: Tell us about your research on the endowment model. Is it permanently broken, or does it still have a place as a long-term investment strategy?
LH: The thing that we’ve been researching is analyzing the postcrisis world: What are our lessons, and how should we be thinking about asset allocation in the endowment model? What have we learned from the crisis and the turmoil that the markets went through beginning in 2007?
One lesson is that there are a lot of institutions who basically just chased returns. They either did not think about risk, or they thought diversification was the answer to managing risk. They did not think about risk in capital markets and never asked if they were getting compensated for it. What we’ve been doing is asking ourselves, “What did we miss? Was it the endowment model or was it the execution?” The model isn’t broken. It was the execution, figuring out what you own and why you own it. What is the role you expect different strategies and different types of exposures to play in your portfolio?
AR: What other mistakes did they make?
LH: Thinking about executing your portfolio is essential. For institutional investors, ultimately the greatest risk is shortfall risk, i.e., not meeting your objectives or your goals. And a nonprofit that is not able to meet their spending in real terms will not able to support their mission. These assets were given to support the mission of the institution, and that’s how they have to be managed.
Institution X might have the same size portfolio as institution Y but might have totally different risk tolerances, a totally different capital structure and totally different liquidity requirements. For MacArthur, 100% of the grants are supported from the assets. Every grant, every payroll, every capital call, I had to sell something. The portfolio supported 100% of the operating budget. That’s a different risk tolerance than an endowment, which might support only 20% of the operating budget.
Liquidity constraints for different endowments and foundations are going to be different. The focus on shortfall risk is going to be different, and the time horizon is different.
One of the things we’ve learned is that it is so important to focus on the execution of the individual institution. Many followed their peers and said, “I’m going to have the same asset allocation as institution X because their returns are really great,” without thinking about the risk involved.
AR: Was there a lot of copycat investing going into the financial crisis?
LH: There was clearly a tremendous amount of peer pressure. CIOs at a number of institutions were compensated based on their performance. So the better the performance, the better the compensation, which is part of the reason they chased returns. The investment management industry is very competitive, and it is not any less so in the nonprofit world. Investors said, “Well, if I’m going to get those returns like institution X, I’m going to have to have an aggressive asset allocation and an aggressive strategy.” They looked at it without thinking about whether these strategies were appropriate or if they could tolerate the risk. It was a performance derby. I don’t think that’s an unusual consequence of bull markets. I think that long term, people tend to forget about tail risk. And they forget about their own institutional risk.
AR: How has endowment investing changed in recent years, and how did the current model evolve?
LH: In the early ’70s you owned as many equities as you could, and then you used bonds and Treasurys for the deflation hedge. All that trustees remembered was the Depression.
Then we had the period of inflation in the ’70s, and we learned then that for long-term investors, inflation is a terrible thing. It makes it darn near impossible to preserve the purchasing power of the gifts you were given to support the mission of the institution. So you have mission shortfall.
You really need to think in terms of your asset allocation if you have inflation hedges against the long term, especially against unanticipated inflation.
You’ll also need to have some inflation hedges and deflation hedges. You need to diversify. You need strategies that provide absolute returns because they provide tremendous diversification benefits. Institutions need to ask: “Are we really diversified? How are our portfolios structured to meet our investment objections? What do I own in terms of my risk assets?”
AR: How have you applied these lessons to your own portfolios at the Commonfund?
LH: We’re an active manager. So our positioning in our portfolios and the strategies change based on market conditions, our point of view, outlook and where we think the best ways our investors will be compensated for taking risk.
What we’ve articulated to our investors is the importance of structuring the portfolio for the long term, focusing on the bottom up and thinking about how you are positioned, not just filling up each asset class bucket. We seem to have been through a period of what we call the bingo chart of asset allocation, where you say, “If I’ve got small cap equity, large cap equity, small cap emerging markets, large cap developed markets, venture capital, private equity, real estate, global macro, hedge funds and long/short equity, I’m perfectly diversified. If I just identify all the buckets and fill all the buckets, then I will be diversifying away risk and managing my exposure to the capital markets.” That’s simply not true, and it’s one lesson learned.
AR: Do you believe that hedge funds actually add value over the long term?
LH: Yes. I believe there is a good group of hedge fund firms that provide real-risk-adjusted alpha, and they do so over long periods of time with relative consistency.
AR: The Commonfund is invested in about 60 hedge fund managers. How did you do due diligence on them?
LH: I could go on for two hours on this. We have a rigorous 12-step process. Our investment teams research the managers, and separately our operations team has its own due diligence review, as does our risk management team, our legal team and our compliance division. When we pull it all together, it’s quite robust.
There are about 200 hedge fund firms that we actively follow or monitor at some point in time, but right now in the portfolios we’re working with, it’s about 60. There are a lot of wonderful managers, but they might not fit into the portfolio at a particular point in time. There are roughly 15 to 17 hedge funds in each of our funds of funds, and we’ll increase the weight or decrease the weight. We also have four separate accounts for other clients.
AR: For the Commonfund to invest in a hedge fund, what are the necessary boxes you have to tick? What would make you not invest?
LH: We do a lot of quantitative analysis on the funds’ specific positions. We will ask for position-level detail at various points in time, and we try to establish the managers’ footprint so that we understand where they would add value and how they execute. We will also do an awful lot of qualitative analysis. Our concern is about having the appropriate amount of diversification for our funds and what is the role that this manager will bring to the total portfolio.
If a manager self-custodies the assets, or we don’t recognize an account administrator, auditor or prime broker, that’s one red flag. Another is a lack of transparency. Clearly, some credit managers have self-custody for bank loans, and that by itself is not a red flag, but in combination with a lack of transparency without other independent verification, it’s a red flag. The first step is filling out our basic information sheet. You see certain answers that mean you don’t go to step two.
There are some managers who won’t fill out the questionnaire, which to us means a lack of transparency. If you won’t fill out the questionnaire, we’re not going to step two. It’s just the way we do things.
AR: One point from your research with Greenwich that you highlight is the need to reshuffle portfolios as the market cycles change. How is the Commonfund invested now?
LH: We have three different funds-of-funds portfolios. One is purely directional, which has a combination of long/short equity, global macro and CTA strategies. Then we have a global absolute alpha fund, which is a nondirectional portfolio made up of predominately event, equity-market-neutral and relative value strategies. Then we have our best ideas fund, which has directional strategies, hedged equity, relative value, some event-driven and some global macro.
None of the three funds are designed to be a full portfolio that has deflation hedges, inflation hedges and growth diversifiers. Our clients use one of these portfolios in their total asset allocation in combination with other programs. If they want to increase their inflation hedges, they might go into our natural resources fund or our commodities fund, for example.
A lot of our investors are still worried near term about deflation and might have more deflation hedges, but longer term there is the fear of an inflationary environment. They’re also thinking about the diversifiers. There has definitely been a lot more attention paid to inflation, deflation and diversifiers.
AR: What hedge fund strategies do you expect to do well for the remainder of 2010 and into 2011? Which should be avoided?
LH: I think event-driven and credit strategies have some opportunities. We’re still not through all of the possibilities on the distressed side. You are seeing some merger arbitrage strategies coming back; we expect those to do well. There are some good risk-return payoffs and some excellent managers. Some of the long/short equity funds with strong stock-picking skills are doing well also.
We’re not so much steering clear of certain strategies as much as we are underweighting these strategies. For example, we made a lot of money in high yield last year. So we’re taking those gains and investing them in things that are cheaper.
AR: How do you feel about the new hedge fund regulations?
LH: I can’t weigh into taxing of GPs. What Washington does on tax policy is what will happen. I think having managers register is not a bad thing. Long-only managers are registered, so why wouldn’t hedge funds?
AR: In your experience, have managers improved in terms of providing transparency and liquidity to investors?
LH: Yes. They are now demonstrating their willingness to be better partners. For example, if a strategy calls for longer lockups or less liquidity, they now make a powerful case to us and discuss why they have the terms that they do. Before, they would say, “Take it or leave it.” There is an investor friendliness and a willingness to be transparent now.
AR: Were hedge funds always secretive?
LH: In the early days they weren’t. They were pretty investor friendly and open about what they owned and why they owned it. But then in the early 2000s, we went through a period where there were high degrees of secrecy. I call it the “I’d tell you, but then I’d have to kill you” attitude. That was pretty hard to deal with. Then they realized that if they want investors to stick with them, investors need to know what’s happening.
AR: In your research, you said there can be no returns without risk. Does this mean that you recommended that investors take more risk in their portfolios?
LH: That’s just to remind people that there is no free lunch. Just because you take risk doesn’t guarantee a return. This notion that there are only returns is silly. We had forgotten about risk in the role of risk management, how much risk institutions could and should take.
Now we’re going back to basics. You’re going to have to take some risk. It is evaluating the left-tail/right-tail trade-off in your asset allocation that’s important.
Right-tail events are when wonderful things happen and you get these huge returns but not with great frequency.
Then there is the left-tail risk, when you have extreme events and lose lots of money. People focus on those left-tail events, the very bad scenarios, and try to minimize them or avoid them without thinking about what that costs in terms of your return opportunities. There has to be a balance.
AR: Will people actually learn from the financial crisis long-term or just revert back to chasing returns?
LH: I don’t know. I do know that what we’re seeing is that trustees of these institutions are really much more focused on their own institution now.
It isn’t really as much emphasis on the performance derby. It’s, “Are we meeting our objectives? Are we being compensated for where we’re taking risk? Are we managing this pool of assets consistently with the role that it plays in the capital structure of the institution so we can meet our mission and fulfill our purpose?”
We’ve had a generation of financial innovation. With hedge funds, you have to ask the question: Is it alpha or is it leverage? It has to be thought about carefully.
