by Midnight Freemason Contributor
Phillip Welshans
Part 5: Asset Allocation
This material has been prepared for general and educational purposes only. This material does not provide recommendations concerning investments, investment strategies, or account types. It is not individualized to the needs of any specific investor and is not intended to suggest that any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material. All investments involve risk, including possible loss of principal.
This topic is divided into two posts. The first will tackle the first question of “What asset classes can we own?” and will talk a bit about a very popular model of endowments use these days for that purpose. The second post will talk about what this means for Masonic lodges and how you may want to think about your asset allocation.
Asset Allocation: A Buffet of Securities
There's almost no limit to what you can invest in these days. Investing can be as simple or as complicated as you want to make it. Think of it like you're going into a Golden Corral3 and at one end of the buffet are your standards: common stock, bonds, government securities like US Treasury bills, mutual funds, and some cash equivalents like CDs or money market funds. In the middle you see some fancier offerings you might be less familiar with but which look appetizing: alternatives1, ETFs covering equities, bonds, and even currencies; REITs2 and other real estate beyond residential (multifamily apartment buildings, commercial real estate, etc.), and precious metals like silver and gold. At the end of the buffet are the items you've only read about and that only Golden Corral Rewards members (the professionals) will deal with regularly: derivatives, esoteric mortgage bonds like MBS4, direct private equity, hedge funds, managed futures, and short selling, among others. Maybe you look over at the dessert table and see stuff you know you shouldn't risk eating but are so tempting like CDS5, cryptocurrency, art, and levered or inverse ETFs6.
So many choices! So many ways to get rich! An equally wide array of ways to go bust! It's all so exciting, yet also daunting. It's a bit like Walter Donovan and Indiana Jones in The Last Crusade when the ancient knight directs them to choose a grail, but to be cautious: "While the true grail will grant you everlasting life, the false grail will take it from you." It's not quite life or death, but certainly, your lodge's financial livelihood hangs in the balance, so making choices based on fact and information is key. Being honest about your and your lodge's risk tolerance, financial knowledge, and goals is paramount. Donovan had no actual historical knowledge about the Grail, and it cost him. Indy, by contrast, was able to use his years of study and factual research to make his best, and ultimately successful, guess.
For the majority of lodges, you'll be perfectly fine sticking with the more vanilla options from the buffet: stocks, bonds, and some alternatives as you define the term. And by and large, you'll be able to get all these through some form of commingled vehicle like a mutual fund. Indeed, if we look at how endowments as a class are invested, most do hold a majority of their assets in stocks and bonds, although the appeal of alternatives has risen dramatically in recent years. The largest endowments have increased their exposure to alternatives from around one-third in 2002 to 57% in 2017, according to one comprehensive study.7 The reason for this is two-fold. First, returns on stocks were markedly lower over that time period than they were for the ~50 years before that. The old rule used to be you could count of stocks to generate about 8% annualized over the long term. However, after the internet bubble burst in 2001, and especially after the financial crisis in 2008, returns on common stocks have been well below that and expected returns (what investors think stocks will return in the future and what they use to allocate to different asset classes) have been equally lackluster. Many endowments have therefore fallen short of meeting their return goals over the last decade or so. As a result, endowments have sought higher returns in other, alternative, asset classes, to make up the difference.
The Yale Model
The second reason for this shift is related to the first. David Swensen8 became head of the Yale University Endowment in 1985 and held that position until his death from cancer in 2021. During his tenure, he and his colleagues in New Haven revolutionized how endowments think about and manage their assets. Swensen, in partnership with colleague Dean Takahashi, developed The Yale Model for endowments. The model calls for a portfolio to be divided into several buckets of asset classes to encourage diversification, which is not really revelatory. However, where Swensen and his colleagues departed from conventional wisdom was in recommending against holding too much in either stocks or fixed income and instead focusing on owning larger allocations of less liquid9 alternative investments like private equity and hedge funds. The idea was these assets tend to be more illiquid than stocks and bonds and so their prices can vary more widely which creates a better opportunity for outsized returns. This assumes, of course, that one owns illiquid assets that appreciate in value! Rather than trying to select those investments themselves, however, Swensen posited that an endowment should spend its time selecting the best managers of those investments, and so the Yale Model is also premised on an endowment spending most of its time and resources on manager selection. Unsurprisingly, the Yale Endowment became notoriously choosy and selective in which managers it would invest with, and having Yale as a client became almost akin to a Michelin star for an investment manager.
The Yale Model was incredibly successful and made Swensen a celebrity within the niche world of investment management. His model was adopted by much of the endowment and foundation landscape to such a degree that The Yale Model is today often just called The Endowment Model. The exception has become the rule. But Swensen and his colleagues were always keen to point out that much of Yale's success could not be replicated. The model could be adopted easily enough, but Swensen and co. enjoyed first-mover advantages10 and as a result had their pick of the choicest private investments before the rest of the world caught on and piled in. Additionally, very few endowment offices could compete with Yale to attract the top talent necessary to pick the best managers successfully and consistently. And the size of Yale's endowment meant that it had a bigger cushion to absorb the inevitable mistakes.
So, while it's important, I think, to understand the Yale Model, what it espouses, and why it became so popular, it's also important to understand its limitations and why, in my opinion, no Masonic lodge should try to emulate it. All the advantages Yale (or any large endowment) enjoyed that made the model work for them, will conspire against almost every other kind of investor. Your lodge probably has far less to invest than an Ivy League university. It probably lacks the financial resources to set up an office staffed with professionals who can consistently pick the best managers (and who need to be paid accordingly). There are also many more players in the alternatives space today than 20-30 years ago; more investors all looking for the same diamond in the rough. The chances of you finding them versus someone like Yale or Harvard's staff of analysts, is I'm sorry to tell you, very low. And when you inevitably make a bad investment, your lodge's smaller fund size means there's less margin for error and the mistake will hurt more.
This is not to say there is no role for alternatives of any kind in a lodge portfolio. Rather, it is to say that the bar for investing in alternatives for your lodge should be very high and carefully considered. And if your lodge is working with a financial adviser to manage your assets, you should be very cautious if they come to you proposing a large allocation to alternatives.
2. Real Estate Investment Trusts, a type of commingled vehicle allowing investors to own shares of companies that manage different types of properties.
3. Some people are big fans of buffets: https://www.goldencorral.com/rewards/
4. Mortgage-Backed Securities. Fixed income securities made up of thousands of individual residential mortgages and resold. One of the big culprits of the Global Financial Crisis in 2008. Also comes in CMBS, or commercial MBS, which are mortgages of office buildings, apartments, and so on.
5. Credit Default Swaps. Essentially derivative contracts valued on the creditworthiness and likelihood of a company or country defaulting on its obligations. Another esoteric financial instrument that contributed to the 2008 crisis.
6. Levered ETFs use leverage to amplify their returns. Great when it works out, but very painful when it doesn't. Inverse ETFs are ETFs that essentially short stocks. Both are highly volatile and completely unsuitable for anyone but professional traders (my opinion, not advice!).
7. Commonfund and the National Association of College and University Business Officers looked at allocations for endowments with at least $1 billion under management and compared 2002 and 2017.
8. Swensen wrote a book about his approach to investment management if you’re really interested. Called Pioneering Portfolio Management: An Unconventional Approach to Institutional Investing.
9. Liquidity refers to how much a security or asset trades and therefore how frequently its price is updated. A stock like Microsoft is extremely liquid, with about 28 million shares traded on average every single day. You can be reasonably sure the price of MSFT stock is very accurate. An office building, however, is very illiquid and its price only gets updated when someone sells it or chooses to revalue it. That doesn’t happen often, so it makes valuing the building tricky and volatile.
10. Typically, the first company or market participant to adopt a successful strategy will benefit from being the first, at least for a while. This is because the market is unexploited and there are no competitors. This advantage doesn't last: the success of the first mover encourages others to get in on the action but in doing so, they reduce or outright eliminate the opportunity and the outsized returns enjoyed by the first mover decline and become eventually pedestrian.
~PW
Phillip Welshans is Senior Warden of Palestine Lodge #189 in Catonsville, MD under the Grand Lodge of Maryland A.F. & A.M. He is also a member of the Maryland Masonic Lodge of Research #239, and the Hiram Guild of the Maryland Masonic Academy. As a member of the Ancient and Accepted Scottish Rite, S.J. in the Valley of Baltimore, he has completed the Master Craftsman programs and is a member of the Scottish Rite Research Society. His interests are primarily in Masonic education, particularly the history of the Craft, esotericism, and the philosophy of Masonry.
Phillip Welshans is Senior Warden of Palestine Lodge #189 in Catonsville, MD under the Grand Lodge of Maryland A.F. & A.M. He is also a member of the Maryland Masonic Lodge of Research #239, and the Hiram Guild of the Maryland Masonic Academy. As a member of the Ancient and Accepted Scottish Rite, S.J. in the Valley of Baltimore, he has completed the Master Craftsman programs and is a member of the Scottish Rite Research Society. His interests are primarily in Masonic education, particularly the history of the Craft, esotericism, and the philosophy of Masonry.
No comments:
Post a Comment
Note: Only a member of this blog may post a comment.