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Asset allocation always matters

John Rekenthaler  |  07 Jun 2017Text size  Decrease  Increase  |  

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Picking the right managers makes for a fine start--but it is not the end, says Morningstar's John Rekenthaler.

 

MIT's finance classes are difficult, but its discussion of the university's endowment fund is not. This February, MIT Investment Management Company (MITIMCo) published an easy-to-read explanation of why it is remarkable. (As with Warren Buffett, MITIMCo excels at humblebragging.) The reason is straightforward: The organisation finds superior portfolio managers.

(Note: Today's column relates to one from November 2015: "Three Lessons From Yale's Endowment Fund." Although this article stands on its own, it also serves as a companion piece to its predecessor. As MITMCo President Seth Alexander worked for a decade at Yale before being recruited as MIT's chief, the two universities' funds bear several similarities.)

From the letter: "Our primary goal is to identify exceptional investment managers who we believe will be excellent long-term fiduciaries for investor capital. We are particularly focused on identifying those traits that allow investment managers to thrive across long time horizons in a variety of market conditions: an absolute return orientation, prudence, patience, high ethical standards, a focus on high-quality assets or assets priced at a significant discount to fair value, a good selection of limited partners, and superb investment judgment."

 "Once we have identified exceptional managers, we size our allocations to them based on our conviction in the manager's ability to generate compelling risk-adjusted returns, the attractiveness of the manager's holdings, the liquidity of the strategy, the strength and transparency of our relationship with the manager, the manager's ability to diversify the returns of our overall portfolio, and other relevant factors.

"At times, we will be unable to identify a sufficient number of compelling investment ideas to invest our entire portfolio. In these environments, we are happy to hold cash and wait for opportunities to re-emerge."

A familiar tune

MITIMCo's self-description sounds much like how retail fund shareholders--and the financial advisors who served them--operated during the 1980s and 1990s, before index funds were in fashion. They collected butterflies; that is, they created their portfolios by buying one star manager at a time, picking up first this fund, then that fund, until their gathering was complete.

As with MITIMCo, retail fund investors gave the most money to managers who inspired the greatest confidence. Also as with MITIMCo, they monitored their asset allocations such that the portfolio didn't stray too far from a target; if an opportunity did not arise, they were willing to let cash accumulate.

The process might have been similar, but the results were not. During the trailing 10 years through 30 June 2016 (university endowment funds release information only sporadically), MIT's Endowment Fund gained 8.3 per cent annually, as opposed to 7.4 per cent for the S&P 500, 5.1 per cent for the Bloomberg Barclays US Aggregate Bond Index, 1.6 per cent for the MSCI EAFE Index, and a whole lot of nothing for cash.

That's quite something, to form a portfolio that beats all of its major components: US stocks, US bonds, foreign stocks, and cash. If the typical fund investor had enjoyed such success, indexing would be an afterthought.

The question

Which leads to the question: How on earth? During a decade when most fund managers could not match benchmarks after expenses, and when only a few, across all investment categories, were able to best those hurdles by as much as 1 percentage point per year, MIT's endowment fund finished more than 3 percentage points ahead of a composite benchmark of the major global asset classes. It beat the Cambridge College and University Median by an annual 320 basis points.

That showing is ... remarkable. It's one thing to select a single extraordinary fund, a fund that places among its category's very top performers in a prolonged time period. It's quite another to do so again and again, in a well-diversified portfolio, while almost entirely avoiding clunkers.

With all due respect for MITIMCo's skill at identifying superior portfolio managers, which may indeed be formidable, the success of MIT's endowment cannot owe solely to that factor--perhaps not even mostly. The fund must also have owned the right asset classes.

MITIMCo disavows its ability to add value through asset allocation, stating that its "capital allocation decisions are driven from the bottom up". Fine, but whether the result was achieved intentionally or as a by-product, the effect exists.

The answer

And indeed, asset allocation was a driving force in generating the fund's returns. MITIMCo does not release the endowment fund's holdings, but MIT's annual Report of the Treasurer offers some clues.

In June 2016, the university held only 15 per cent of its net investments in cash and bonds, with the remainder in equities, real estate, and real assets. As that report includes $4 billion of university assets that lie outside the endowment fund, and which presumably are invested more conservatively, it's likely the fund itself held an even lower fixed-income percentage.

As for the equities themselves, the fund was slowed by its large foreign allocation, as overseas stocks currently account for more than 35 per cent of its stock position. So, full credit to management for being able to steer the fund past the US stock indexes while possessing a big stake in lagging foreign securities--that's a bet that might well reverse for the next 10 years and help the fund in a big way.

On the flip side, however, the fund had a similar-sized (or larger) position in private-equity and venture-capital funds, and those asset classes crushed the S&P 500.

How this all played out cannot be known from the outside; there is far too little information to conduct accurate performance attribution. Suffice to say, however, that MIT's endowment fund benefited from its asset allocation as well as its manager selection.

No matter how skilled its staff was at identifying managerial talent, if the fund had not been predominantly in equities, juiced by the higher-returning, higher-risk investments of private equity and venture capital, it could not have thrived as it did.

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John Rekenthaler is Morningstar's US-based vice president of research and has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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