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Performance Chasing by Professional Investors

June 16th, 2009 · 10 Comments

As a group, lemmings have a rotten image, but no individual lemming has ever received bad press.
– Warren Buffett

Professional investors, especially those working for University endowments, are supposed to have many advantages that most average retail investors don’t — access to the best research, written investment policies to take the emotions out of investing etc. But when it comes to performance chasing, these professional investors can put small investors to shame.

A recent example can be found in the behaviour of giant University endowments. These professional money managers watched David Swensen (author of Unconventional Success) outperform the stock markets by a wide margin by investing in alternative assets such as hedge funds, private equity, real estate, timber etc. and decided to copy the approach (hat tip to The Wealthy Boomer for pointing to the article):

Princeton, the Massachusetts Institute of Technology, and Bowdoin College hired Swensen protégés to run their endowments. By the 2007 fiscal year, colleges were devoting 42 percent of their endowments to alternative investments, up from 23 percent in fiscal 2000, according to Commonfund, a money manager for nonprofit institutions.

Perhaps unsurprisingly, it hasn’t worked out too well:

Nearly every sort of alternative investment has been slammed, undermining Swensen’s diversification rationale, and his advice to downplay liquidity has backfired. With private donations dwindling and students clamoring for aid, universities that followed the Yale model find themselves in a plight that could be called cash-22. The publicly traded stocks they still own have plummeted in value, leaving the schools overdependent on illiquid alternatives—and constrained by contractual obligations to invest even more. The Yale model assumes returns when private holdings go public, but no initial public offerings are taking place.

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10 responses so far ↓

  • 1 Performance Chasing by Professional Investors | BuyWithoutYourBank.com // Jun 17, 2009 at 1:20 am

    [...] posted here: Performance Chasing by Professional Investors Share with [...]

  • 2 Phil S // Jun 17, 2009 at 8:15 am

    I recall some time ago on BNN, an institutional investment manager (it was too long ago for me to remember who it was) who managed a small cap stock portfolio mentioned that small and micro-caps is the only area where a small retail investor may have the advantage. He went on to explain that many small cap stocks that he likes don’t have enough liquidity to allow him to purchase them, but a small retail investor may place orders for, say, $5k and buy enough of those stocks to significantly affect their portfolio. But whatever the performance of $5K of stocks in a mutual fund worth $200 million isn’t even worth a rounding error.

    So the corollary is that most funds which invest in the stock market are limited to purchasing large cap companies with high liquidity, unless they are able to negotiate a private placement transaction. On the NYSE, it may not be so big of a problem as there are many large caps to choose from, but on the TSX, the choices are limited.

  • 3 Four Pillars // Jun 17, 2009 at 8:57 am

    Good post – those guys are all they same. They get to manage large sums of money because they’ve convinced someone they are “experts”.

    They might as well be doing long-term weather forecasts.

  • 4 Canadian Capitalist // Jun 17, 2009 at 9:52 am

    @Phil: There is a further problem with professional money managers. Their livelihood depends on how they perform versus the benchmark, not over the long term, but over a period of less than a year. Retail investors may have an edge in this regard — we aren’t answerable to anyone (except maybe family), so under performing the benchmarks over a few years may not be a big deal (assuming the retail investor is skilled).

    Still, it is amazing how supposedly professional investors were chasing these illiquid investments, disregarding the risks. And what do they do? They imply the “Yale Model” is broken!

  • 5 Basil2 // Jun 17, 2009 at 2:10 pm

    Small cap stocks have a large (liquidity) spread which makes them costly to trade compared to large caps. Research on small caps outpeforming market usually doesn’t take this cost into account (it may very well be that this cost eats all of the premium). In addition they are more risky by their very nature (i.e. being small cap these companies are much more vunarable to overall economy downs compared to large caps).

  • 6 Silicon Prairie // Jun 17, 2009 at 2:15 pm

    It’s interesting to see that they hired people who had seen how it worked instead of just investing in the same asset classes… some of them must have known the limits but I guess they weren’t paid to do something completely different.

  • 7 Judy // Jun 17, 2009 at 6:00 pm

    props for the Warren Buffett quote. Now I am going to have to read Unconventional Success :)

  • 8 Cam Birch // Jun 17, 2009 at 8:14 pm

    After reading that article I can soundly say that the “Yale” model is very interesting. I know several people who use the same model, yet they did not decide to copy Yale (not large investors). It is a very good way to get rich if you have the time to wait and are good at selecting private firms to build up. Liquidity is only a problem if you invest your day to day money in such things.

    Looking at the failures of these huge funds is interesting because it is quite obvious that the fund managers forgot to keep a buffer (80% invested in one asset class, hillarious). I have always thought a fund manager should be heavily invested in their fund, this makes sure that when they loose money they cry. It stops them from taking stupid risks (I hope) and certainly would make me far more comfortable with investing.

  • 9 Dave Ramsey Post Rebuttal and LinkStuff for June 29 // Jun 26, 2009 at 5:03 am

    [...] Capitalist says that professional investors follow the herd just like us [...]

  • 10 Successful Investing: 10 Tips for Successful Investing | Financial Highway // Jul 23, 2009 at 5:05 am

    [...] advice is to invest in things you know. If you do not understand the investment stay away from it. Performance chasing is always a dangerous strategy since most professionals can not beat the chances are you [...]

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