“Can I do better?” is a question trustees of personal trusts, endowments, foundations and pension funds may ask themselves.
The answer to this question is often “yes,” but the “how” might be surprising to many investors and very disappointing to the sellers of complex strategies, such as hedge funds.
When asked to comment on questions trustees (in this case, retirement plans sponsors) should be asking, the director of a large intuitional investment consulting firm recently suggested in an interview:
“Can I migrate my [portfolio] to be more institutional [to bring more] alternatives…into play?”
“What we’re saying is every [trustee] is wise to take an opportunity to look out at the landscape, consider the opportunities and say, “Can I do better?”1
When hearing this, I wished I could have asked this follow-on question:
Does “more institutional” with more “alternatives,” such as hedge funds, mean better?
I don’t think so.
Keeping It Simple
Consistently backing me up on this is Warren Buffett, who, “went out of his way [again] to trash hedge funds and endorse low-cost index funds”2 at this annual shareholders meeting.
As was widely reported, this isn’t the first time Buffett has advocated keeping it simple.
In a letter to Berkshire shareholders in 2013, he wrote that he has instructed the trustee of this family trust to, “Put 10% of the cash in short‐term government bonds and 90% in a very low‐cost S&P 500 index fund” because he believes the “the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, individuals—who employ high fee managers.”3
In addition to Buffett, many other top professionals such as Peter Lynch and David Swenson, the Chief Investment Officer of Yale, often speak about the prudence of index funds.
I’ve written about this before for Trust & Estates in articles titled, “Are Hedge Funds Prudent for Taxable Investors”4 and “What Would Yale Do If It Was Taxable?”5
Citing work in an academic study done by researchers at the University of Berkeley and analysts at the Aperio Group, I came to the following conclusions:
“The work by Aperio and words of David Swensen [the Chief Investment Officer of Yale] continue to lead us to recommend that all investors, small and large, maintain a high percentage of keep-it-simple, low fee, fully transparent, tax efficient investments.”
As I suspected, when I wrote that the Berkeley and Aperio research suggest, “allocations to Absolute Return (a term used as a proxy for hedge funds) and Active Equity [should] shift to 0.0 percent when factoring in taxes” and that a taxable investor should “never allocate anything to hedge funds when considering hedge funds that have high correlations to equities,” I received some criticism.
Some good hedge fund managers do exist, and trustees should keep their eyes open for outliers, but Buffett’s comments make me think of a quote by my friend Greg Rogers (President and Founder of Raylign Advisory and past Managing Director at a leading institutional investment consultant, RogersCasey):
“For me, what keeps me up at night is overly compensating my portfolio manager friends [performance fees], Wall Street Managing Directors [trading fees] and government coffers [taxes]. A sobering stream of logic goes as follows: if 5% of the 8,000 hedge fund managers can actually deliver on the required returns to overcome fees and taxes over the long-term (this is being very generous), then why do the other 7,600 hedge fund managers exist?”6
Of hedge fund of funds or endowment-in-a-box-style limited partnerships, Greg went on to say:
“In the case of a fund of hedge funds, the investor is asking heroic results from manager selection, strategy allocation and the hedge fund managers themselves – all three competencies have proven to have limited sustainability over extended periods of time, to say the least.”7
What’s the Answer?
Much debate will continue on how trustees should prudently invest funds and on the questions they should ask as fiduciaries.
What does the evidence suggest is the correct answer, though, as to how trustees might “do better?”
Versus the complex models discussed above, maybe the following extreme keep-it-simple chart below offers an answer.
By including this, I’m not suggesting that a trustee should put all of their funds into one or two mutual funds.
To make a point though, over the time periods listed above a trustee would have produced returns that ranked in the top quartile of all U.S. endowments and foundations by buying these simple diversified balanced mutual funds (and this doesn’t even factor in the high tax penalty that should be applied to taxable investment funds).
Unlike, many of the complex models and funds that are often suggested to help trustees to be “more institutional,” simple funds such as the ones illustrated above are low cost, fully transparent, completely liquid and very tax efficient.
In addition, they have what I think is an often overlooked benefit. They’re easy for all (trustees, donors or beneficiaries) to understand.
If you take the advice of Warren Buffett, David Swensen and many others, such as quite a few Noble Prize winners, and take this simple road less traveled, you’ll probably get a lot of “can you do better” questions.
If so, just point to the evidence and consider the following:
“It is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism… For it is in the essence of his behavior that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”8
8. John Maynard Keynes.