HardAssetsInvestor

Written by HardAssetsInvestor.com  |

April 17, 2009

How To Invest Like A Top Endowment

Details

Mebane Faber, portfolio manager at Cambria Investment Management in Los Angeles, explains how to invest like Harvard and Yale.

• How to replicate endowment portfolios using ETFs
• Consider having 20% in hard assets
• The best commodity ETF

 

Mebane Faber is portfolio manager at Cambria Investment Management, an independent investment advisory firm based in Los Angeles. He is also the author of the recently published book, "The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets."

He spoke recently with the editors of HardAssetsInvestor.com about how individual investors can invest like the Harvards and Yales of the world, including why they should consider having 20% of their portfolio in hard assets.

 

HardAssetsInvestor.com (HAI): What's the new book about?

Mebane Faber (Faber): The book takes you through how the leading endowments in the world manage their money. There are already good books out there by endowment managers like David Swensen and Mohamed El-Erian, but I felt like they were lacking. Swensen, for one, says individual investors shouldn't pursue market timing or security selection, and he doesn't mention commodities for individuals either.

I felt there was room for a book that looked at the strategic asset allocation policies of the top endowments, and talked about how individuals can achieve similar results. These endowments have been the best investors, bar none, over the past 20 years: Yale's endowment, to take one example, has delivered 16% returns per year, killing other markets, with about 10% volatility. That's amazing.

I wanted to show individuals how they could create a strategic asset allocation plan using ETFs that would mimic the endowments ... and then how they could improve on that model.

HAI: How exactly are endowments tackling the market?

Faber: The one thing the top endowments do that most investors fail to do is to create a widely diversified portfolio. Endowments invest not just in U.S. domestic securities – stocks and bonds – but in foreign stocks, foreign bonds, real estate, commodities, etc. In general, they have much less U.S. and stock exposure and much more commodity, real estate and alternative investment exposure, by which I mean private equity and hedge funds. The big endowments have almost a third or over a third of their portfolios allocated to alternatives, and large allocations to commodities, much more than a typical investor.

HAI: But individuals don't have access to the same kinds of tools as endowments.

Faber: That's true to an extent, but one nice thing about endowments is that they do publish their strategic asset allocation plans. And the good thing is that you can pretty much match that allocation using exchange-traded funds.

The first thing you do, as you mentioned, is that you net out the private equity and hedge funds, because individuals can't invest in them. There are ETFs that operate in those areas, but they are limited and imperfect.

That leaves you with five asset classes: U.S. stocks, foreign stocks, real estate, bonds and commodities. There are a lot of caveats, but the allocation that endowments have historically made to these is approximately 20% in each.

You can take that simple 20% allocation and backtest it from 1985, which is the start of the "modern endowment" era. And you can do that using major indexes for each asset class, each of which is investable with an ETF: S&P 500 (U.S. equities), MSCI EAFE (foreign equities), NAREIT (real estate), 10-year Treasuries (bonds) and [the S&P] S&P GSCI (commodities).

If you run that portfolio, it returns about 4% less than the endowments, with the same volatility. In other words, you're getting 10+% annual returns on 10% volatility. That's pretty good. It's right at the upper bound you reach on strategic asset allocation over time.

That portfolio has a 0.8 correlation to the endowment portfolios, so you're capturing their beta but not their alpha.