How Smart is the Smart Money?

Every year the Nobel Prize is awarded to leaders in the fields of physics, chemistry, medicine, literature, peace and economics. Along with the honor of the award is a cash prize of 8,000,000 Swedish Krona (about $1.2M). These cash prizes are funded by the Nobel Foundation, an investment pool that was the result of Alfred Nobel’s desire to create a legacy and reward advances in these fields.

At the end of 2012, the  Nobel Foundation was valued at 2,900,000,000 Krona, roughly $450 million in US dollars. The foundation has a stated goal for a 3.5% real (after inflation) return on assets, which is in line with the spending policy of the foundation, a 3-4% annual target. These are very reasonable assumptions, and not too dissimilar than what many retirees would want from an investment portfolio: a growing stream of income, sustainable withdrawals that can keep pace with inflation.

I’d say it is safe to assume that a portfolio valued at $450,000,000 has access to some pretty good resources. Hopefully world-class investment consultants and institutional level asset managers. Maybe they would even take input from some Nobel Prize winners?  Reports are that the Nobel Foundation pays 0.60% in annual asset management fees. With names in the portfolio like T. Rowe Price, Aberdeen, RAFI and Carlyle, (not to mention numerous hedge funds and private equity funds surely charging more than 0.60%) this seems at least believable.

These bright minds, these world-class consultants, these institutional asset managers, surely if any portfolio can outperform a passive investment strategy, it’s a $450,000,000 endowment that provides awards to some of the world’s best and brightest. Right? 0.60% of $450,000,000 is a staggering $2.7 Million.  Hopefully they are getting some good advice and stock picking for $2.7 Million.

The Nobel Foundation has a stated investment policy of 20% fixed income, 55% equities and 25% “alternatives.” A 50-55% allocation to equities would be considered prudent with most and in line with research supporting endowment-style perpetual distributions, so this is perfectly reasonable.

Unfortunately it appears that the managers of the Nobel Foundation fall prey to many of the mistakes of individual investors. The most obvious of these is a backwards-looking, knee-jerk reaction to market volatility.

In 2007, according to the Foundation’s 2011 annual report, the portfolio had a 12% allocation to alternative investments, including private equity and hedge funds. Through and after the bear market in 2008 and 2009 the foundation increased this allocation from 12% to 24%,  28%, and finally 33%, reducing the portfolio’s exposure to stocks as you will see in the chart below.  These were not simply market value changes – in 2011 the target allocation to alternatives was 30%.  So, like many individual investors and their advisors, the Foundation committee ran way from volatile markets after a market decline.  See below:

And how did this work out?  From 2009 to 2013 the global equity markets rallied, coming off of generational lows.  At the same time, the Nobel Foundation investment committee was moving money out of stocks after a decline and into alternative investments, the same fear trade so many individuals gave into.  Here’s how the foundation performed from 2008 through 2012.

(From the 2012 Annual Report)

(From the 2012 Annual Report)

Not great.  What else could they have done at the Foundation?  What if they simply owned a portfolio that was 50% a global stock market index fund, and instead of putting money in alternatives, they put the remaining 50% into a bond index fund. Here’s how that stacks up against a passive portfolio of 50% global stocks and 50% US bonds.

Nobel vs. Passive

 

The Foundation portfolio underperformed this simple passive mix of Vanguard Investor-class mutual funds every year.  From 2008 to 2012, the annual underperformance was 0.14%, 8.10%, 4.87%, 3.19% and 2.23%, respectively. The Foundation underperformed in the down markets of 2008 and 2011 and failed to keep up with the recovery in 2009 and 2012.

We can’t say exactly where this performance came from, as the Nobel Foundation is private and only releases a spattering of information in their annual report.  But it is safe to say that changing the endowment’s asset allocation in the middle of a bear market and paying up for expensive, poor performing hedge funds are certainly not adding to results.

Individual investors can learn a lot from the missteps of a $450 Million endowment.  Bear markets are painful, but not nearly as painful as the consequences of selling at the bottom in search of some kind of magic bullet investment strategy.  Simple is often more successful than complex, and it can be much easier to control your behavior with a relatively simple portfolio than with a complex one.  Costs and fees matter a great deal. Your behavior matters a great deal. Access to institutional investment managers, consultants, private equity firms and hedge funds appears to not matter one bit.

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