Emulating Endowments With ETFs

ETF.com posted an interview with Hossein Kazemi from Chartered Alternative Investment Analyst Association who did a study that concluded that small and medium sized endowments can effectively compete with the larger endowments by using ETFs to replicate the non-market based alternative strategies that funds like Harvard and Yale are known for and getting very similar return streams and portfolio characteristics.

Endowment portfolios are a fascinating topic. I go back with these to the mid-1990’s from what was probably a Businessweek profile of Jack Meyer who ran the Harvard Endowment very successfully for many years. Among other things, Meyer was a huge fan of timberland exposure as an alternative because it tends to have a low correlation to other asset classes. Jeremy Grantham is another very well-known investor who has been partial to timberland over the years.

To the extent, timberland is an alternative holy grail with a low correlation and high returns (not saying it is, please bear with me here) the exchange traded vehicles that target timber one way or another don’t quite offer the same exposure. I looked at two ETFs that track timber-related companies and the problem is that they tend to be cyclical (many of the companies are in the materials and real estate sectors) and so the correlation is fairly high, running 0.70-0.75 most of the time, for something that someone might hope is an alternative to equities. Even lumber futures don’t seem to do the trick, the correlation appears to increase when equities go down, again maybe because it is cyclical.

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Even if exchange traded timber/lumber comes up short as a diversifier I think there are plenty of alternative strategies that can help an investor manage a portfolio’s volatility and correlation. We’ve talked about these before in terms of gold, merger arbitrage, managed futures (pretty good track record of negatively correlating to equities), hedge fund replication and other forms of absolute return strategies.

One word of caution here relates to truly understanding what you own. The increased probability that interest rates will stay lower for longer doesn’t mean there isn’t interest risk. Maybe interest risk here could be a good thing but you have to know that you’re taking it and that comes from understanding what you own or are considering buying. There are exchange traded replicators that do take interest rate risk. Managed futures would very likely benefit if the cash collateralizing the futures contracts was all of a sudden earning 3% versus 50 basis points.

There are a lot of exchange traded products (ETFs, ETNs, traditional mutual funds) that offer access to very sophisticated strategies that when used correctly with the correct expectations can create an endowment effect where endowment effect is defined a strong risk adjusted return.

As I always do in these posts, I would urge moderation. Alternatives probably are not that compelling now as the bull market for equities has raged on but at some point when equities falter, alternatives will become increasingly popular, I will always remember the reader comment who when things were about at their worst said to just put it all in a Hussman fund and forget about it. That sort of sentiment will resurface and it will be just as wrong the next time as it was in the past. Equities have offered the best long term returns so using alternatives becomes a way to get a more nuanced return (usually the objective is a better risk adjusted return) by offering diversification to an equity-centric portfolio.