American university endowments have long been held up as models of a new form of investing.  The so-called “Yale model” is standard fare at industry conferences and the recent travails faced by Harvard’s endowment have scratched a Schadenfreude itch felt by many commentators.  Way back in January 2007, The Economist raised the possibility that these beacons of alternative investing may someday have to pay the piper (see related post)…

“Simply putting 20% into hedge funds is no longer enough. The big test of their prowess will come when lax credit conditions tighten. John Griswold of Commonfund thinks that some investment committees, stuffed with alumni, may be starting to lose track of the risks their endowments are taking.”

Investment committees may indeed have been aware of the risks they were taking with alternative investments.  As a result, they under-weighted the traditional risks of long-only equity (known by previous, more cautious generations as “playing the market”) and instead invested in alternative strategies.

According to new data from The National Association of College and University Business Officers (NACUBO) and Commonfund, that move paid off handsomely in 2009.  The average return from domestic equities was -25.5% while the average return from international equities was -27.6%.  Meanwhile the average return from hedge funds was only -12%.  Thankfully, hedge funds (a.k.a. “marketable alternative strategies”) represented about a quarter of the average portfolio on a dollar-weighted basis).

Returns for alternative investments ranged from a high of 12% for hedge funds to a low of -36.7% for “commodities and managed futures” (note: we surmise that long-only commodities accounted for most of this since managed futures indexes were generally flat on the year).

Taken as a whole, these numbers reflect pretty well on university endowments.  Their equities beat the S&P 500 and their hedge funds bettered most hedge fund indexes by around 8%.

For the first time, alternatives represented over half (51%) of all endowment portfolio assets. But as usual, this number was much lower among smaller institutions.  (See table below from NACUBO – click to enlarge).  In fact, big endowments appear to invest 3 times as much of their portfolio in alternatives.

However, there is one category where smaller endowments lead their larger brethren – the proportion of their alternative investment allocation going to hedge funds (vs. private equity and other alternative investment classes).  As the following table shows, the proportion of capital allocated to hedge funds is 50% greater among small endowments than it is amongst large ones.

Data in the full version of the report shows that the equal-weighted average allocation to “marketable alternative strategies” (the closest proxy to last year’s “hedge fund” category) was 13.5%.  So hedge fund allocations seemed to actually grow last year (by virtue of losing less, rather than necessarily attracting more dollars, we’re guessing).

Marketable alternatives aside, the overall “alternative strategies” category commanded over 60% of the assets of mega-endowments (a number that was noted recently in this Reuters article by two AllAboutAlpha.com contributors – Mebane Faber, CAIA, and Michael Crook, CAIA).

Commonfund’s Bill Jarvis tells us that this year’s survey asked more detailed questions about exactly which types of alternative investment strategies were being pursued by endowments.  He explained to us that the pace of evolution of alternative investments was such that old labels such as “hedge fund” no longer suffice.

While the reorganization of the alternative investments categories does make an apples-to-apples comparison with last year’s “hedge funds” a little difficult, it does signal that previously disparate asset classes such as hedge funds, private equity, real estate and commodities are finally coming together under the “alternative investments” umbrella.  And as Jarvis points out, it also shows how dynamic this asset class has become as it grows beyond its hedge fund roots.

According to a June 2009 research note on “How Institutional Investors Think About Real Estate” by the Harvard Business School, institutions invest in real estate,”…because of its returns, the high cash flow component of its returns, the dampening of the volatility in a portfolio and as an inflation hedge.”  The note concludes that real estate is, “…an increasingly important component in the portfolios of institutional investors.”

Despite the bath taken by some real estate investors in 2009, a recent survey of institutional investors seems to corroborate this conclusion.  bFinance, the UK-based consultancy surveyed European and North American institutions in December 2009 to see how their views had changed since May of that year.

The firm asked investors if their target asset allocation had changed since May 2009.  It then measured the difference between the “increased” and “decreased” responses (sort of like the political pollster’s ubiquitous “favorable/unfavorable” rating).  Guess who’s the popular kid this year?

“Property” was the winner with nearly 20% more investors saying they had increased target allocations than had decreased it.

As you can see from the chart, private equity rated quite highly, but it will probably come as no surprise to regular readers of this website that “hedge funds” and “funds of hedge funds” sucked eggs, with more investors saying they had decreased their target allocations, than had increased them.

Then again, this could be seen as good news for beaten down hedge funds.  Despite a decrease in allocations in December (that some argue is a seasonal blip), the industry seems to be on the mend.  The new, lower target allocations could portend a ceiling in asset growth – or it could show that even with lower target allocations,  there is still plenty of room for growth.  Time will tell.

In any case, institutional investors may be bottom fishing for real estate opportunities this year.  bFinance quotes the head of the $130 billion California State Teachers’ Retirement System (CalSTRS) as saying:

“We may be able to see the light at the end of the tunnel, but it is really far away right now. There is a lot of commercial real estate debt that will come due in 2010. It will be interesting to see if any of the banks or traditional debt providers will step into this market. There is a lot of uncertainty that they will.”

Looking forward, bFinance also asked investors if the planned to increase or decrease their allocations to various assets over the next year.  Again, real estate won out – with 15% more respondents saying that planned to increase investment levels than decrease it.

But curiously, the bottom feeding had its limits.  Looking out over the next three years, respondents seemed more interested in fishing for infrastructure and commodities investments.

(Note the good news, by the way, for hedge funds in general and for the much maligned portable alpha strategies in particular.)

This interest may be well timed since other research shows that real estate fund fees may become more investor friendly over the coming years.  The European Association for Investors in Non-listed Real Estate Vehicles (INREV) reports that fees based on gross (leveraged) assets and on unrealised gains will become less common (see article in IPE).

In conclusion, bFinance reports that institutional investors will continue to fish for alternative investments of all species:

“The main catalyst in favour of alternatives remains diversification, a staple of the hedge fund industry which has had the misfortune of being marred by a number of high profile scandals. Indeed, pension funds remain more committed than ever to diversifying across asset classes and geography.”

McKinsey & Company, the venerable consultancy, has a thing with geese.  In 2003, the firm published a report on the then-recovering asset management industry called “Will the goose keep laying golden eggs? (October 2003)“  Then, last month, it produced another report on the beaten-up asset management sector asking the same question “Will the goose keep laying golden eggs? (October 2009).”

Who is this mythical goose and what has bestowed it with powers of prognostication not seen since Punxsutawney Phil cornered the market on predicting the onset of spring? More…

Dust in the wind, sand through time, defunct Dubai, Dubailand gone bust: the anecdotes and analogies are endless (and beautifully illustrated in these poignant photographs taken by Lauren Greenfield as the real estate market was crumbling.)

Poor headlines aside, what has occurred once again in emerging markets, or at least in one Emirate in the emerging world, has set off what many worry could be yet another chain of unfortunate debt-defaulting events affecting banks, financial markets and everything in between. Does anyone remember Russia, Ukraine, Pakistan, Ecuador, Argentina, Moldova, and Uruguay, or going back even farther, Turkey? More…

Since well before the days of Gordon Gekko, regulators and policymakers have pondered whether vulture capitalists add value or simply destroy what little hope is left for ailing companies.

In general, research seems to suggest that private equity firms (of both the vulture and non-vulture persuasion) add significant social value (see AllAboutAlpha.com coverage) by reducing, not increasing the rate of bankruptcy of target companies.  Other studies have found that activist hedge funds are also associated with more successful outcomes – but mainly because they know how to pick the winning situations before diving in (see AllAboutAlpha.com coverage).  And further research suggests that activist hedge funds serve an important role in keeping management honest – a role some say should be played more aggressively by institutional investors (see AllAboutAlpha.com coverage).

A study released last month adds to the evidence that activist hedge funds add long-term value.  In an unfortunately titled paper (given recent blow-ups) called “Hedge Funds in Chapter 11″, Wei Jiang of Columbia, Kai Li of the University of British Columbia and Wei Wang of Canada’s prestigious Queen’s University (disclosure: am an alumnus) argue that the involvement of activist hedge funds in distressed situations is a predictor of better outcomes.

How much better?  When the trio compared the returns of Chapter 11 cases where hedge funds as major creditors with returns from Chapter 11 cases where hedge funds were absent, they found that hedge fund involvement was good news… More…

By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

In his recently released paper, Paul Kedrosky of the Kauffman Foundation discusses current state of the U.S. venture capital industry and ponders whether its burgeoning size is limiting investors’ returns from the asset class. LPs have continued to allocate increasing amounts of capital to VC funds, despite the precipitous decline in performance over the past five years: the 10 year returns for the industry, as calculated for the author, are barely ahead of the Russell 2000 Index, and will turn negative in 2010 as dotcom bubble returns are excluded. The lackluster performance is a fairly recent phenomenon – the string of low to negative returns began in 2004 – which Kedrosky attributes to three potential causes.

Maturing Sectors

First, the “bread and butter” sectors for VC, IT and Telecom, have vastly matured over the past two decades. While open source technology and vastly lower networking costs have decreased the barriers to entry for IT startups, venture investments in the sector have yet to show a commensurate decline. In 2008, tech-related investing still accounted for more than half of VC investment on a dollar amount basis.

No Cash-Flows, No Thanks

Some point to the decline in IPOs in a post-Sarbanes-Oxley world as the main culprit behind the recent performance woes. While, in the past five years the annual number of VC-backed IPOs has declined to almost half of the late 90s average, it is still in line with pre-dot-com levels. Kedrosky argues that, relative to the late 90s, the market has become less willing to stake early-stage companies with negative cash-flows – a phenomenon which should not be expected to reverse. The problem, it seems, lies not with the exit market itself, but with VCs ability to bring attractive offerings to the market. More…

A report issued last month by Watson Wyatt says that “In light of the economic crisis, corporate pension funds are taking steps to reduce their exposure to risk…”

It might come as a surprise that this de-risking is being carried out by actually increasing idiosyncratic (alpha) risk while simultaneously decreasing systematic equity (beta) risk.

The series of pie charts from the report below show that the percentage allocation to alternatives increased by about 6% last year and is pegged by Watson Wyatt to rise another 12% in 2010.  Meanwhile, allocations to equities fell by 12% over the past year (helped by the downdraft in equity values) and are forecast to fall by another 6% in 2010. More…

By: Michael Newman, CAIA, AllAboutAlpha.com Editorial Board

In its semi-annual report on the Asset Management and Capital Markets businesses, M&A specialist Jeffries Putnam Lovell highlighted the continued increase in divestitures as a percentage of overall M&A activity affecting the asset management business.  Traditionally, independent buyers and sellers tend to dominate deal activity, but as the report makes clear in numerous charts and tables, divestitures and strategic acquisitions by pure play asset managers have been the primary deal makers as of late.  In doing so, the report raises important questions about the future of the asset management industry and alternative investment managers in particular.

Overall Environment:

The report begins by detailing the dearth of deal activity, which is still significantly below 2008’s already muted levels, by most measures.  As the chart below highlights, transaction activity, as measured by deal value or number of transactions is down significantly.

Outliers:

The report is also quick to remind us that these already low figures are themselves markedly distorted by two major outliers: the Barclays Global Investors deal and the Société Générale deal.  Without these two mega-deals, deal value would have been a pittance as would ‘transacted AUM’ (highlighted in the chart below): More…

By:  Konstantin Danilov, CAIA, AllAboutAlpha.com Editorial Board

A recent survey of institutional investors done by London-based Preqin (Research Report: Fund Terms After the Crash) is indicating that a new trend is emerging in private equity investing. After a period of several years during which investors slowly conceded more and more negotiating power to the GP, the balance of power has began to shift back to the LPs. This is not surprising, given the developments over the past year and the current investing environment. Many investors have begun to question whether private equity is really a unique asset class with excellent diversification benefits, or just a form of extremely opaque, highly leveraged equity investing. Further, the fundraising environment remains highly competitive as many potential investors are facing an unprecedented liquidity crunch, and have neither the ability nor the willingness to invest in new funds.

Tipping the Scales

As the aura surrounding private equity managers began to fade in late 2008, investors began to reassess the lenient terms and conditions granted to GPs during rosier times. While little could be done regarding existing funds, new offerings provided prospective LPs with ample opportunity to seek more favorable terms and conditions going forward. It seems that a significant amount of institutional investors were able to take advantage of this opportunity; the survey result shows that 43% of respondents felt that the balance of power in negotiating new fund terms and conditions has shifted towards the LP during the past six months. More…

Thinking of starting a business in the asset management industry?  Say, a company that develops methods for constructing investable hedge fund indices?  Or maybe an outfit that lends money to asset managers in exchange for a share of its revenues?  Well, you can forget about it.  This week, U.S. patents were awarded to companies that have developed somewhat novel ways to do both.

Royal Bank of Canada, the world’s tenth most profitable bank locked up the patent rights for a long list of business processes relating to the management of investable hedge fund indices and the structured products built upon them (see patent).  In typically passive and arcane language, the patent itself reads like a case study in excessive patenting:

“What is claimed is:  A computer implemented method for balancing an index of a plurality of hedge funds, the method comprising: calculating, by a computer system, a hedge fund weight for a hedge fund included in the index; determining, by the computer system, if the calculated hedge fund weight exceeds a hedge fund weight maximum, the hedge fund weight maximum corresponding to a maximum proportion of the total index that can be allocated to a particular fund; determining, by the computer system, if the calculated hedge fund weight is less than a minimum hedge fund weight, the minimum hedge fund weight corresponding to a ratio of a required capacity or exposure to the net exposure of the index; and adjusting the percentage of the index allocated to the particular fund if the calculated hedge fund weight exceeds the hedge fund weight maximum or is less than the minimum hedge fund weight…”

In other words, RBC Capital Markets now owns the rights to use a “computer system” (?) to calculate hedge fund index weights.  Yet many of the claims stated in the patent document sound remarkably similar to an index methodology white paper.  For example… More…

A paper released by McKinsey & Co. this week concludes that 28% of asset managers are not responding adequately to the recent storm hitting their industry.  McKinsey chalks this behavior up to “depression and denial”.

But wait.  There is hope for the future of the asset management industry.  The consultancy also concludes that 13% of asset management firms are “decisive operators” who have paired back costs and preserved profits (or at least, mitigated a fall in profits).

These conclusions and accompanying prescriptive remedies are contained in a report called “Recovering from the storm: The new economic reality for U.S. asset managers” (soon to be available on the firm’s website, but currently available for free by emailing here).

The chart below taken from the report sums up the state of the world today (click to enlarge): More…

As the Economist pointed out a couple of weeks ago, the shipping industry has seen better days:

“Since the recession bit hard last autumn a lot of attention has been paid to the plunge in the Baltic Dry Index, a composite measure of the cost of shipping bulk cargoes such as iron ore and coal. It fell by over 90% between June and October last year, although it has since recovered slightly and is hovering at just above a quarter of its peak.”

But although an investment in the shipping industry clearly comes with a boat-load of global growth beta, are there any aspects of this sector that might qualify as an “alternative” investment?

Turns out there may be.  A new article in the Journal of Alternative Investments (available free for a limited time here at the Chartered Alternative Investment Analyst Association’s Website) reveals that shipping actually has some quintessential alternative investment properties.

In “Diversification Properties of Investments in Shipping”, Michael Grelck, Stefan Prigge, Lars Tegtmeier and Mihail Topalov take a more nuanced approach to examining this sector – focusing on shipping companies, not the shipping sector in general.  What they find may be somewhat counter intuitive to most.  Shipping stocks do not have a huge equity beta component.  And as a result, they possess the diversification properties craved by alternative investors.

Report the authors: More…

“Innovation” is often held up as the engine of growth for modern economies.  Technological innovation, business process innovation, even social innovation, have carried the hopes and dreams of companies and economies alike.

Then there’s financial innovation.

This new four letter word has been blamed for everything from the economic crisis to the cooler than normal summer in the Northeastern US.  But we contend what some have termed “pure financial innovation” is much different than innovation in the financial services industry.

A new report on the global asset management industry from the Boston Consulting Group makes this point in spades (available here with free registration).  The report argues that after the fiasco of the past couple of years, institutional investors will demand “innovations” such as alternative investments.

Says BCG:

“Institutional investors have sustained substantial losses during the crisis despite highly diversified strategies.  They will likely continue to increase the diversification of their portfolios and seek innovation to help them achieve this goal.”

So what kind of “innovation” will they seek?  The chart below from the report answers this question: More…