5 years later no endowment model

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A l t e r n a t i v e I n v e s t i n g I n A G l o b a l C o n t e x t QuarterlyGlobalARC

W

i n t e r 2 0 1 3

Greece, the Eurozoneand the Global

Financial System Ournterview with FormerGreek Prime Minister

George Papandreou

The Secret Behind

Innovation in YoungHedge Funds

The True Cost o ActiveManagement

An Electricity-backedCurrency Proposal

Five Years Later, Still NoEndowment Model

Longevity Risk: Be CareulWhat You Wish For

Plus, extensive interviews

with Yale’s Robert Shiller and Berkeley’s Barry

EichengreenGeorge Papandreou

Prime Minister of Greece (2009-2011)



Contents Alternative Investing

In A Global ContextQuarterlyGlobalARC

Institutional Investing

Geopol i t ics

Macroeconomics

Alternative Investments

Capital Markets

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David Stewart

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Editor

Christopher Holt

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Americas

Christopher Holt, Toronto

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Europe

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© 2012 Global ARC

Global ARC Quarterly is published

quarterly by the Global Absolute

Return Congress, a Canadian-

domiciled organization that convenes

a global network of institutional

investors and asset managers at

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ISSN 1929-8501 Global ARC Quarterly

www.global-arc.net 2 Editor’s Comment: The most important (and unlikely) lesson from history

3 Letters to the Editor: US pension accounting rules, hedge fund fees &

the UK’s shifting views on Europe

14 Stuck Between Scylla and Charybdis. Our interview with

ormer Greek Prime Minister George Papandreou

22 France’s Dominique Moisi on Europe’s Conicting “Emotional Calendars

4 America’s “Exorbitant Privilege”: Our interview

with Berkeley’s Barry Eichengreen

11 DeKo: An electricity-backed currency proposal

26 How Financial Innovation Will Save Us: Our Interview withRobert Shiller

45 Empty Voting : Is corporate governance now at odds with common hedging strate

46 Quarterly Info-graphic: Pension assets, GDP and old-age

dependency ratios around the world

50 The Wisdom o Groups and the Irrationality o the Herd

51 The University of Chicago’s Raghuram Rajan

on Financial Innovation: A double-edged sword?

32 Five Years Later, Still no Endowment Model

36 The Australian Pension Fund Industry: A CIO’s Perspective

42 Longevity Risk: Be careful what you wish for

55 What Hedge Fund Investors can Learn rom Major League Baseball

8 Direct Investing in Private Equity: The “Canadian Model”

24 The Secret Behind Innovation in Young Hedge Funds

40 Lacklustre Returns Re-ignite Debate

over Investor/Manager Alignment in Hedge Funds

48 The True Cost o Active Management

52 Is This the Year Equity Long/Short Investors Have Been Waiting For?

57 The New Art o Due Diligence

64 The Critique: A hedge und manager with an earul or US public pensions

14

55

24



32 Global ARC Quarterly | Winter 2013

Five Years Later,

Still NoEndowmentModel

Foundation and Endowment Investing (Wiley), the book I co-authored with Lawrence E. Kochard in

January 2008, eatures profles o twelve leading endowment and oundation (E&F) chie investment

ofcers (CIOs). As the fnancial crisis unolded later that year, the so-called endowment model came under

fre due to highly publicized - i also highly generalized - liquidity problems that led to large hedge und

redemptions. On the book’s 5 year anniversary, subjects Donald W. Lindsey, CIO, The George Washington

University; Jonathan Hook, now VP and CIO o The Ohio State University; Daniel J. Kingston, now a Managing

Director with Morgan Creek Capital Management; and Kochard, now CEO and CIO, University o Virginia

Investment Management Co., and several industry observers discuss endowment investing today and the role

hedge unds will play in E&F portolios.

Institutional Investing



Global ARC Quarterly | Winter 2013 33

Cathleen Rittereiser

Larry Kochard, CEO and CIO, University of

Virginia Investment Management Co.

Daniel J. Kingston, Managing Director, Morgan

Creek Capital Management and former CIO,

The Kauffman Foundation

Donald W. Lindsey, CIO,

George Washington University

Morgan Creek’s Kingston reinorces the book’s

main point. “To my knowledge, there is no clear

consensus on what characterizes the classic

Endowment Model 1.0. Beore it was the belie

in researching and fnding illiquid assets and

getting the illiquidity premium by investing in

hedge unds. Instead o just ocusing on illi-

quidity, what is absolutely true is that you also

want to be diversifed.” For many, the model

boiled down to “simply adding more alternative

assets, taking more equity risk, and capturing

the illiquidity premium. To me, that was just a

specifc implementation, and not representa-

tive o the generalized model.”

Kochard agrees. “I don’t think there’s one

model. Previously it tended to just be conused

with a high allocation to alternatives. To me it

is a tendency to have smaller pools o capital

and a better decision-making structure. By

not needing to manage quarter-to-quarter,

endowments have a tendency to be bench-

mark agnostic, by investing in smaller and

more concentrated managers. Also, we do not

allocate to neat buckets; the approach is less

siloed. That hasn’t changed.”

What has changed, he says, “endow-

ment and oundation investors are now more

thoughtul about liquidity risk, they’re keeping

more o an eye on it. While they are continu-

ing to invest in illiquid investments, they are not

doing it to the max. They are also going out o

the way to have a close relationship with the

university, and to understand the risk tolerance

o their institution.”

Lindsey echoes Kochard’s last point. “The

investment program really should be custom-

tailored to the fnancial profle o the school.”

Additionally, E&F investors and boards should

not be thinking, “What do I put together to

be competitive with Ivy League schools?”

Lindsey says, “I that’s your thought process,

you’re doomed to ailure. You should be think-

ing about the right risk/return profle or this

university given its fnancial metrics, and make

sure you have the right governance structure

in place to make that happen. Do away with

the idea o a model that is appropriate or all

endowments, there just isn’t one.”

Hook concurs. “We don’t think it’s necessar-

ily dierent rom other institutions like a pension

plan. In our model, we ocus on the long-term,

given our perpetual asset pool, and try to

remain exible. Maintaining exibility is a bit

Jonathan Hook, VP and CIO,

Ohio State University

more important and probably more necessary

than beore 2008. That does not mean we won’t

lock up capital and make illiquid investments,

but within our ramework we want to be exible

and fnd opportunities i and when they come.”

“I’m not sure there’s a consensus on

Endowment Model 2.0 either,” Kingston says,“but there are two hallmarks. First, there’s more

ocus on liquidity. Second, there is more ocus

on downside protection. Those are useul con-

siderations, but they don’t really characterize a

model. Instead, at Morgan Creek we believe it

means giving greater consideration not just to

the long-term, but also to all the various time

horizons. It’s fne to be a long-term investor, but

one doesn’t get there without going through

the short and intermediate horizons.” This

involves considering momentum signals in the

short term, being somewhat tactical over the

medium term, and using more illiquid invest-

ments or the long term.

Because o the perceived illiquidity premi-

um, E&Fs were among the earliest institutional

investors to commit to hedge unds, including

Lindsey. That has changed or him.

“Specifcally in GW portolio, we have been

reducing exposure to hedge unds, both equity

long/short and other strategies that involve

credit instruments. There are a couple o rea-

sons or diminishing that exposure. We have

come through a long period o poor returns in

the equity markets. For the last 13 years stocks

have done nothing. Looking orward, the like-

lihood o the next 10 being like the last 10 is

not that great. I you’re trying to make a rate

o return to grow purchasing power o your

und, or where you need to be I see long-only

equity exposure being much more important

today than 10 years ago. Back then, ater going

through an extended bull market and then the

tech meltdown, investors realized you could

have huge drawdowns. Adding hedge unds

then in my view was more oriented to con-

trolling downside risks than getting outsized

gains.” Lindsey also cites concerns about trans-

parency and market volatility or his viewpoint.

Lindsey’s contemporaries and industry

observers, however, still believe in hedge unds,

despite their 2008 experiences and recent con-

cerns about hedge und industry dynamics.

As Kingston puts it, “In 2008 the systemic

deleveraging was an extremely difcult envi-

ronment in which to manage assets. It was

impossible to avoid. Unortunately, we all know

that diversifcation benefts do not protect you



34 Global ARC Quarterly | Winter 2013

rom systemic risk. In general, hedge unds

handle downside protection well, because they

think appropriately about both the long and

short perspective.”

Deepak Gurnani CIO, Head o Hedge

Funds, Investcorp International, observes,

“Now that liquidity issues have somewhat

ebbed, we are actually seeing endowment

and oundation investors adding more capital

and looking or new opportunities. Because

returns in general across asset classes and in

hedge unds have come down, investors have

to stretch or yield.”

“The period since the spring o ’09 has

been perhaps the greatest equity market rally

that nobody really believes,” says Ted Seides,Co-CIO and President, Protege Partners. “No

institutional allocator will tell you they think

equities will deliver 10% a year over the next 5

years. In order to meet spending needs, they

need to turn to active managers that seek to

generate returns independent o market tail

winds. Good hedge unds have done that or

a long time.”

Kochard’s hedge und investing approach

has not changed. “Everyone has unique insights

and advantages in sourcing managers, we

ocus on equity long/short. We tend to avoid

some o the more complex arbitrage strategies,

because we have less ability to understand the

risks vs. the returns, and thereore less ability to

get comortable with the strategies.”

More specifcally, he says, “We try to invest

with managers that really understand business-

es well, frms with unique insights into thinking

about businesses and their long term potential.”

Although Kochard has heard criticisms o

equity long/short managers - “hard to short,

unds are too big” - he says, “With that said,

we have enough capability to source manag-

ers and we have investments in enough good

unds that return capital when they get too big.”

Hook acknowledges the high level o rus-

tration or many investors in equity long/short

strategies. “The last ew years have been very

tough, some olks have excelled, but I’d say

the majority have not.” Compounding the

issue, he says, “rom year to year a dierent

group has excelled.”

One manager had a difcult 2011, but

bounced back with “exceptionally good” 2012

perormance. “Positions in the portolio by and

large haven’t changed very much.” So this may

be the time or E&Fs to think long-term and

exhibit patience.Seides makes a case or exhibiting patience

on another ront, hedge und ees. “The recent

scrutiny relates directly to sub-par peror-

mance the last 2 years. On one hand it’s a air

critique. But on the other hand, it’s not a long

enough period o time to know i the peror-

mance challenges are cyclical or secular.”

An important point investors miss in the ee

argument, he says, is “the degree to which the

level o interest rates creates a real headwind or

hedge unds today, rom a nominal return per-

spective.” In higher rate environments, hedge

unds earn a healthy short rebate; whereas, in

the current environment, engaging in shorting

costs money. “I you believe that hedge unds

will deliver through a cycle, you could argue

that this is a time when allocators should be

soter on managers, who need ees to stabilize

their business. Actually, the scrutiny should be

the opposite. When interest rates are high and

managers earn high nominal returns just or

showing up, ee scrutiny should reach an apex.”

Lindsey identifes another issue. “There

were many inefciencies to be exploited in

the 1980s and early 1990s, because competi-

tion wasn’t great. Now I think there’s too much

capital, so I think it’s a losing sum game. So it’s

very, very difcult to put together a portolio

o hedge unds that will meet your objectives.

Competition is great, too much capital is chas-

ing the same inefciencies, and they are arbed

away immediately.”

Certain managers may have too much

capital. Gurnani says, “Our analysis shows

larger, established hedge unds have under-

perormed smaller managers, and importantly,

that occurred during difcult market periods.

With some exceptions, larger managers have

struggled and will continue to struggle to pro-duce returns and deliver alpha, especially in

challenging markets.”

Perhaps this is a natural evolution. The

hedge und market has changed since E&Fs frst

started investing in the 80s and 90s, Kingston

notes. “In the 90s, there were many more

macro and arbitrage strategies. Today they are

a much smaller piece o the market, and equity

long/short has grown into the largest segment

because they lack barriers to entry. Because the

environment is dierent, and the make-up o

hedge unds is dierent, we have to expect that

prospective returns will be dierent.”

So or E&Fs, where will returns come rom?

Gurnani identifes our components o

hedge und return: risk ree rate, market beta,

generic strategy return and manager alpha.

With the risk ree rate close to zero and market

beta low, “manager alpha and lower ees are

critical.” Gurnani expects those needs to drive

two big market trends. E&Fs will allocate to

“smaller emerging managers that will provide

alpha” and in order to “strike a better ee deal



Global ARC Quarterly | Winter 2013 35

or get better economics.” He also predicts

more E&Fs will allocate to hedge und replica-

tion strategies or low cost exposure. He adds,

“The biggest challenge will be to convince

boards and directors to do something di-

erent, but I think many proactive CIOs have

already started making these changes.”

Hook looks actively at emerging managers,

and says “we have not had a problem commit-

ting to a airly new manager, i they meet all the

criteria. There’s always a group coming out o a

big hedge und and starting their own frm, and

we will meet those managers early.”

When evaluating emerging managers,

Kochard advises to “stick to your knitting.

You develop pattern recognition capabilities.You know managers you want to invest in and

those you don’t. We have an edge in equity

long/short by having a. access to get in to a

und and b. knowledge o new unds being

raised. A new manager spins out o an existing

manager, and you know whether that is a yay

or a nay. Do something well, and build o o

that in whatever direction that takes you.”

Kingston agrees. “At Morgan Creek, Mark

Yusko and I agree with one o the underly-

ing themes o David Swensen’s second book,

‘don’t try this at home.’ A large part o picking

newer managers is understanding what you

are doing. It takes a lot o expertise.”

Seides advises investors to “be thorough in

implementation” when investing in emerging

managers. Investors ought to assess a broad

array o investment opportunities. “No one will

meet with all 6,000 smaller hedge unds, but

meeting just a ew is suboptimal as well.” By

meeting a number o managers, investors will

gain a sense o how a manager they like fts

in the context o the investment landscape.

“Meet a lot, then pick one, and you’ll have a bet-

ter probability o success. I you don’t have the

resources to take the time, it might be worth

outsourcing the program.”

Regarding hedge und replication, Gurnani

says, “There are a number o advantages aside

rom low cost, it is a trigger, but not the only

thing.” Among the other benefts, he cites risk

controls, limited style drit, liquidity, separate

account capability, and no insider trading.

Investors named AQR Capital

Management as a leader in hedge und rep-

lication. David Kabiller, CFA, co-ounder o

AQR and Head o Client Strategies, agrees

with the aspirations o replication strategies,

but says AQR makes a crucial distinction.“Top-down hedge und replication strate-

gies mimic the returns o hedge und indices,”

he said. “While there are some good hedge

unds in those compilations, many man-

agers give you exposures to things you

simply don’t want, like equity-market beta.”

AQR began developing a bottom-up replica-

tion style in 1999 to analyze merger arbitrage. It

produced “systematic, rules-based approach-

es” to capture the “essence” o hedge-und

strategies without capturing equity market

beta. AQR’s approach is capacity-constrained,

but Kabiller notes that “most good invest-

ments have limitations in capacity.”

Turning to other opportunities, Kingston

quotes Stonewall Jackson, “Hit them were

they ain’t”. In other words: “understand where

there’s a lack o capital.” He adds, “Small to

mid mid-market lending strategies still need

capital. Community and regional banks aren’t

making small business loans. Funds that pro-

vide this capital can earn higher interest rates

with low overhead.”

Hook is “looking the most and hardest in rel-

ative value and macro strategies. While it’s been

a hard environment or macro traders, we have

been looking or someone to add in that space.”

“Currently there are no great macro themes

relative to other times in the past”, says Kochard.

“Because everyone is so macro ocused, having

managers that do great research at the com-

pany level, I believe will pay o more over the

next ew years.”

Looking ahead, Hook says, “With the fs-

cal cli hanging out there, my suspicion is we’ll

get ‘something’ done, though the market could

gyrate depending on Congress. Synthesizing

what we hear rom managers, they eel relatively

positive about the US. China is less o a concern;maybe they’re turning the corner. Europe is

looking to everyone else or a bail out. What

opportunities does this present? What things

can we fnd to do? Stay tuned. We are all going

to have an interesting year to work through.”

In closing, Lindsey says, “I eel like there’s

a tremendous amount o opportunity avail-

able to investors today, I think people are too

anchored on the last 10 years; there are attrac-

tive returns to be earned down the road in the

right investments. You have to be long-term

ocused. People have to become accustomed

to seeing the swings. It can be depressing and

discouraging, but volatility is here to stay. You

have to be able to tolerate it and invest through

it, there’s no way around it.”

Cathleen M. Rittereiser is the co-author, with

Lawrence E. Kochard, of the books Top Hedge

Fund Investors: Stories, Strategies, and Advice

(Wiley, 2010) and Foundation and Endowment

Investing (Wiley, 2008)

5 years later no endowment model

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