2014 / Behavior

Learn from the mistakes of the Harvard Endowment

It’s been more than five years since the lows of the 2008-2009 financial crisis. I can still remember the conversations I had with clients and prospects during that period. They were, understandably, panicked. They had just taken a once-in-a-lifetime beating in the market. Many were so rattled that all they wanted to do was pull out of the market altogether.

Every other financial advisor across the country was having the same conversation. Desperate to keep clients on board, financial firms searched for a solution that would offer the same opportunity for return that equities provide, but without the volatility and risk.

To find that solution, they looked to the Ivy League endowments. After all, if anyone could master investing, it would have to be the collective brain trust at places like Harvard and Yale. For years, Ivy League schools had been using something called alternative investments to generate outsized returns with very little volatility.

Advisors across the country started recommending that their clients shun equities in favor of alternative investments. The pitch for alternatives was very simple - If it’s good enough for Harvard and Yale’s endowments, it should be good enough for you, too.

Five years later, the results are in….

From 2009 to 2013, the S&P 500 has had an average annual compounded return of 17.91 percent.

Over that same period, the NASDAQ had an average annual compounded return of 22.95 percent.

What about alternative investments? Surely, alternatives must have outperformed equities over the past five years. Right?

Not so fast. From 2009 to 2013, alternative investments have had an average annual compounded return of 1.3 percent.

That means that a $100,000 investment would have generated just a little more than $1,000 in return over each of the past five years. How can that be? How can the investments favored by Harvard and Yale – who have access to the brightest investment minds in the world – have gotten completely trounced by something as simple as the S&P 500 index?

Given the performance of alternatives over the past five years, you’d think that advisors would have lost faith. You’d be wrong.

Every week, I sit down with prospects who have alternatives in their portfolios. Sometimes it’s as little as five or ten percent. Other times, it’s 50 or 75 percent or even the entire portfolio.

Why? Why would advisors continue to recommend investments that consistently underperform equities?

To understand why alternatives have found their way into investors’ portfolios, you first have to understand what alternatives are. Then you have to understand the difference between volatility and risk and why many advisors are making a fundamental mistake in their distinction between the two.

What are Alternative Investments?

The alternative investments asset class is a hodgepodge made up of things like hedge funds, private equity, long-short funds, and even real estate. The types of investments in the alternatives class have little in common with each other except for the fact that they’re not equities and that they’re favored by Ivy League endowments.

If you read things like “long-short funds” and aren’t sure what that means, don’t worry. You’re not alone. It’s often difficult to get a read on exactly what these “alternative investments” actually invest in. It’s not as simple as opening up a prospectus and reading what their holdings are.

Don’t plan on getting much help from your advisor either. While there may be some advisors who do their due diligence on these investments, they’re likely not in the majority. To compensate for their lack of knowledge about the workings of these investments, many advisors fall back on the standard selling point….

These investments are used in the endowments for schools like Harvard and Yale to manage volatility.

Volatility vs. Risk: An Important Distinction

Volatility is the key word when it comes to any discussion about alternative investments. The idea is that alternatives provide equity-like returns without the wild volatility that’s sometimes seen in the equity markets.

The past five years have shown us that the idea that alternatives provide “equity-like” returns is dubious at best. What about volatility, though? Do alternatives really reduce volatility?

The real question is this – Does it matter whether they reduce volatility?

Volatility is not the same thing as risk. Volatility is short-term fluctuation in the market. Risk is the possibility of permanent loss.

It’s an important distinction because it drives decision making. If, like most investors, you have an investing time horizon that is decades-long, one or two bad years shouldn’t drive you to shun equities and embrace an entirely new asset class. You have years to regain those losses and profit from the long-term growth that equities have consistently provided for more than 100 years.

The financial crisis was an example of short-term volatility. It was extreme volatility, but volatility nonetheless. That volatility fueled the returns that we’ve seen over the past five years. An astute advisor may have looked at that time as the single greatest buying opportunity of his or her lifetime.

Alternative investments may be preferred by the smart guys at Harvard and Yale, but that doesn’t mean they’re right for individual investors. In fact, if we’re looking at the hard data, the answer is pretty clear: equities win.

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