Not a day goes by that I don't get an email from an investment firm promoting the attraction and growing popularity of alternatives—offering research, white papers, news clippings and other sources demonstrating the value of alternatives as a serious and important investment strategy for today's environment.
When David Swensen made his bold bet on alternatives in 1985, the strategies were far outside the mainstream of how college endowments and other large institutions invested their money. Despite the fringe status of the strategies, Swensen saw their validity and attractiveness and made it the centerpiece of the Yale Endowment. Fourteen years later he eloquently explained his thinking and his process in the excellent and thought-provoking "Pioneering Portfolio Management." By the time the book was published, he was already famous—and with over $500 billion invested worldwide, alternatives were no longer a secret.
Swensen's recommendations to readers were noteworthy for pretty much ignoring the single most popular subject on investors' minds then and now: performance. He wrote: "In selecting partners, due diligence efforts center on assessing the competence and character of the individuals responsible for portfolio decisions. Developing partnerships with extraordinary people represents the single most important element of alternative investment success."
Swensen knew that as alternative investment strategies became more popular it would become harder for investors to generate attractive returns without either taking on excessive risk or finding those few managers who possessed the right combination of talent and temperament (while still taking on new investors); of course he was urging his readers to focus on the latter.
The public perception of what is popularly known as "the Yale Model" focuses exclusively on the specific asset classes in which Yale chose to invest. Character and competence are squishy and subjective attributes that don't lend themselves to being quantified; while performance and correlation are clear, well-defined and easily quantifiable. Understandably that became the common basis for evaluating Swensen—but that focus led investors to discount the most important and valuable aspects of the Yale Endowment's approach.
In his foreword to "Pioneering," Charles Ellis anticipated this unfortunate outcome: "Public interest naturally centers on David Swensen's fine results—observers conventionally citing the unconventional structure of the portfolio and the superior returns realized, but usually overlooking the complementary strength of the long- and short-term controls used to avoid, minimize, and manage risk."
It has been just under 30 years since Swensen began his tenure running the Yale Endowment. In preparing for this column I pulled "Pioneering" off my shelf to reacquaint myself with his arguments—and ended up rereading much of this wonderful book. What was notable to me in the second reading was not so much that he was an early mover into alternatives (which he was), but that he was exceptional in so many important ways that have little to do with alternatives as such and everything to do with intelligent investing. Swensen's observations from 1999 are a perfect counterpoint to Wall Street's growing push to convince investors that now is the time to invest in alternatives.
Alternative Lure
According to Morningstar, in the 12 months ending Oct. 31, investors added $24 billion to actively managed alternative strategy funds, small in terms of the $353 billion added to all long-term strategies (including index funds), but more than a third of the $73 billion (net) that went to all active funds. John Rekenthaler noted that active managers have never been in worse repute—and so it appears that, at least for now, they are casting their lot with alternatives as the way to shore up both their tarnished reputation and their assets under management.
A recent report from McKinsey & Co. estimated that alternative investments will contribute up to 40% of the global asset management industry's revenues by 2020. The report concludes that the demand for alternatives is driven by powerful structural forces leading investors to seek consistent and uncorrelated risk-adjusted returns. They also report that investors are increasingly disillusioned by traditional asset classes.
