How Harvard and Yale Beat the Market

What Individual Investors Can Learn From the Investment Strategies of the Most Successful University Endowments

Matthew Tuttle

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470473757
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

Praise for How Harvard and Yale Beat the Market

"How Harvard and Yale Beat the Market is a must-read for anyone managing his own or other people's money. It demystifies new investments such as hedge funds and principal-protected products. This engaging handbook belongs in every investor's library."

—Deborah Weir, Parker Global Strategies, author of Timing the Market: How to Profit in the Stock Market Using the Yield Curve, Technical Analysis, and Cultural Indicators

In today's volatile market, investors are looking for new ways to lower their risk profile. For author Matthew Tuttle, the best means of achieving this goal is to look towards large university endowments—which attempt to capture consistent returns while maintaining a low level of risk.

How Harvard and Yale Beat the Market explores the benefits of endowment investing and shows you how to structure your individual investment endeavors around an endowment-type portfolio. While the average investor doesn't have access to many of the money managers and vehicles that high-profile endowments use, you can still learn from the investment strategies outlined here and implement them in your own investment activities. Filled with timely tips and practical advice from an expert who designs portfolios based on endowment investment strategies, How Harvard and Yale Beat the Market will put you in a better position to achieve investment success.

PART I

INVESTMENT 101

AN INTRODUCTION TO THE ENDOWMENT PHILOSOPHY OF INVESTING

Before we talk about how individuals can invest like endowments, in Part I we need to discuss the current financial environment and its implications for investors (see Chapter 1). In Chapter 2 we will explore why investors make the mistakes they do and how they can avoid them. Chapter 3 will then start to lay the groundwork for thinking about your portfolio the same way endowments do. In Chapter 4 we will discuss the two types of money managers that endowments use. In Chapter 5 we will introduce you to the endowment portfolio theory, and in Chapter 6 we will show you how endowments outperform the market.

CHAPTER 1

The Current Environment and the Need for New Thinking

As I write this chapter 2008 is almost over—good riddance! This year was a game changer for the investment industry as the three main pillars of investing—buy and hold, traditional asset allocation, and indexing—are either broken or teetering. For years, investors have been told to buy and hold solid stocks, companies like Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, Wachovia, GM, etc., might go down but they will never go bankrupt. Because of what happened in 2008 we can never say that again. Traditional asset allocation says that investors should put some money in small stocks, medium-sized stocks, large stocks, and bonds, that way they will have some protection if one area is going down, hopefully another will be going up. In 2008 there were no safe havens, just about everything went down. A diversified portfolio may have provided some protection, but you still would have been down a huge amount. Index fund advocates argue that most active money managers don’t beat their index so investors should just buy index funds. During the lows of November 2008 an investor who bought an index fund 10 years ago would have had a negative 10-year return. I used to tell people that I don’t know where the market is going to go but since we have only had two negative 10-year year periods in the market since the depression, it should be up in 10 years. I can no longer say that.

What happened?

We all probably remember the 2000-2002 market crash, but since then things were fine in the markets, until the summer of 2007. It all started with signs that there were problems in mortgages made to people with less than stellar credit ratings, the so-called subprime mortgages. Since this was only a small part of the mortgage market, most people thought it would blow over without much carryover to other areas. They were wrong. When a couple of Bear Stearns hedge funds that had been invested in subprime went belly-up, people started to get worried. The Fed, as it always seems to do, came to the rescue and lowered interest rates. This caused a strong rally in the stock market, until October 9, 2007. Since then, and as of this writing, the market is down nearly 20%; Bear Stearns and Lehman Brothers are bankrupt; Fannie Mae, Freddie Mac, and AIG had to be bailed out by the government; and Washington Mutual failed. What happened and is this a small blip or the continuation of something much larger?

What people learned after October 9th is that the subprime mess was much worse than expected. Mortgage companies had gone crazy giving loans to anyone with a pulse and many times with no money down. Real estate investors saw home prices increasing with no end in sight and leveraged up. Financial magazines were full of articles about how people were making tons of money flipping properties, buying them with a subprime mortgage and no money down, and then selling them shortly after for a profit. In the meantime, the banks making these mortgages sold them to Wall Street firms who packaged them into bonds to sell to institutional investors. Somehow, the Wall Street firms got the credit rating agencies to give the bonds high credit ratings (meaning a low chance of default). The combination of high ratings and higher interest rates meant that there was no shortage of buyers. Many Wall Street firms and other investors leveraged up by borrowing money short term and buying tons of this packaged subprime debt. Things were going great until the bottom fell out.

Housing prices couldn’t go up forever, and they didn’t. They started going down, which put tremendous pressure on subprime debt as more and more people had negative equity on homes and investment properties. It also turned out that making no money down loans to people who had no real way of paying them back probably wasn’t the best idea (go figure). Once these cracks started to show, it created a ripple effect. Firms that had borrowed money to buy subprime loans started seeing the value of the debt going down. This caused the banks, many of which were the investors in this stuff, to start calling in loans. With the loans being called, the investors had to sell stuff to pay them back, but there were no takers for subprime debt. So instead of selling the debt, they either went under or started selling what could be sold, things like high-quality stocks. This caused the stock market to go down as many long/ short hedge funds were short low-quality stocks and long the same high-quality stocks that people were selling like crazy. These funds were also leveraged, and they were forced to buy back the low-quality stocks and sell the high-quality stocks, making things worse. It turned out that most of the people who ran these long/short hedge funds either used to work for Goldman Sachs or used the same quantitative screens that Goldman Sachs uses. That meant that everyone was long the same stocks and short the same stocks; when one fund got into trouble, every fund got into trouble. Also, most of the banks and brokerage firms were invested up to their ears in subprime debt and they were hurting. This finally resulted in the collapse of Bear Stearns in 2008.

While all this was going on, oil prices started going through the roof. This is never good for the economy as we need oil to drive our cars, and most industries need oil to run their factories and transport their goods. This hurt the consumer and caused prices to go up for just about everything. To counter the subprime mess, the Fed started lowering interest rates, which is their primary policy tool for combating a slowing economy. However, lower interest rates hurt the value of the dollar because global money flows to the countries that have the highest interest rates. Since oil is denominated in dollars, this caused oil prices to go up even more. Then, just when we thought we understood the crisis and thought it couldn’t get worse, it did. Commodities, which had been rising, fell through the floor. Since commodities were the only asset class that was doing well, the hedge funds had bought into them heavily, this caused many hedge funds to go under, further roiling the stock market. October and November were horrendous months for the market. It was this final nail in the coffin that really impacted the large college endowments and caused them to suffer large losses.

Bernie Madoff

Just when we thought it couldn’t get worse, we got the Bernie Madoff scandal, the largest Ponzi Scheme in history. Mr. Madoff managed $17 billion dollars (or so people thought) and was able to generate consistent returns year after year. In actuality he was using money from new investors to pay returns to old investors, the classic Ponzi Scheme. While Mr. Madoff’s fund was not a hedge fund, hedge fund of funds invested heavily into his company. In this book I talk about hedge funds and hedge fund of funds and recommend them for some investors. While the Bernie Madoff scandal and all of the hedge fund bankruptcies don’t render this strategy invalid, they do increase the need for proper due diligence. There are some helpful lessons to be learned from what Madoff did. While there were many red flags that sophisticated investors should have picked up on, there were some things that should have given individual investors pause as well. For example, my firm manages money. If I want to buy a stock in a client’s account, I call Fidelity Investments who buys the stock and puts it in the client’s own account held at Fidelity. Fidelity then sends the client a confirmation that the stock was bought and at the end of the month, the client gets a confirmation from Fidelity showing how much their account is worth and what is in it. If Bernie Madoff wanted to buy a stock in a client’s account he called Bernie Madoff to place the trade. Bernie Madoff would place the trade in the client’s account which was held with Bernie Madoff. Bernie Madoff would send the client a confirmation of the trade and at the end of the month the client would get a statement from Bernie Madoff showing the value of his account. If it looks like there are too many Madoffs in this equation, you are correct. There was no independent third party to raise a red flag. Hedge funds and fund of funds are still valid investments, like any type of investment, there are good and bad. If you don’t have the level of sophistication to tell one from the other, or don’t have an advisor you trust to help you, then stay away.

The Consequences of Our Actions

The question now becomes is what happened in 2007 and 2008 just an isolated incident that will correct itself, and will it then be back to business as usual? Or, is this the continuation of things that have been happening over time that will fundamentally change our markets? Unfortunately, I would argue for the latter. Now I know what you might be thinking. You have heard before how things have changed only to see them eventually go back to normal. During the technology bubble of the late 1990s, you heard how companies didn’t have to make money anymore and how Internet firms that had no prospects of making money anytime soon could be worth more than well-established companies. A few years ago, a Greenwich, Connecticut, real estate broker told me that Greenwich real estate would never come down because of the great schools, low taxes, and proximity to New York City. You’ve heard it before, but this feels different.

For years we have been living with a global imbalance:

• U.S. consumers purchase goods made in Asia and gas from the Middle East.

• U.S. consumers overextend to purchase these things using credit cards and home equity loans.

• These loans are repackaged by Wall Street as bonds and sold to the same Asian and Middle Eastern countries so that they can invest the proceeds from their sales to U.S. consumers.

This all worked great as we sent money overseas, and it came right back to stabilize our markets. However, this is having, and will continue to have, a number of important consequences on world markets:

1. Inflation. For years, inflation has been kept in check partly by cheap labor in emerging markets. However, as more and more money flows in, it is creating a new middle class. As the middle class develops, they will want higher wages. Wages will then increase, causing prices of goods made in China and other countries to increase.

2. Demand for Commodities. As these economies grow, so will demand for oil and other commodities, further pushing up prices.

3. Infrastructure. As these economies grow, they will increasingly need to build modern cities and other infrastructure projects.

4. Internal Consumption. As the middle class grows, they will want the same types of goods and services that the U.S. middle class wants. This will cause these economies to shift from primarily export based to more of an import focus. This will result in a decoupling of these economies from the developed economies. For years, when the United States sneezed, the emerging markets caught a cold, because our demand for their exports went down. As these economies start to shift and they rely less and less on exports, their economies will decouple from ours.

In the past, emerging market countries would invest their surplus funds in U.S. bonds, primarily Treasuries. This would keep the dollar strong and keep our interest rates low. (This is purely supply and demand: If there is ...