Executive Summary
This white paper addresses a number of challenges wealthy Asian families face regarding capital preservation over multiple generations. Methods of analysis include macro and performance analyses, as well as peer comparison. The results of our analysis suggest that the Endowment Approach is the preferred way of investing in order to preserve purchasing power over time. In particular, we find that allocating capital to external managers is a more efficient way of successfully managing capital and retaining investment talent to oversee that capital.
Recommendations discussed include:
Adopt the Endowment Approach as your investment methodology.
Implement slowly and patiently.
Hire a small group of capable people to manage your family’s wealth.
Control not by blood, but by a proper incentive structure.
Separate, physically and psychologically, “endowment assets” from other assets
Involve family members in the long-term aspects of the policy-making process (only).
Prepare for the worst and do not act emotionally.
Introduction
“Wealth does not pass three generations” ~ a Chinese proverb
This Chinese aphorism reveals the challenge of preserving wealth over time. Inflation, generally a constant annually, erodes the “real” value of assets. While many people may believe that inflation is of negligible concern, it can be potent. Exhibit 1, below, demonstrates the purchasing power of one billion dollars that erodes from a 3.7% inflation rate and a 5% spending policy. To preserve the “real” value of this billion dollars, an annual return of 8.7% is required. What would happen if that money were only invested in fixed-income products such as the U.S. 10-Year Treasury note with a 2.31% return per annum.? In 10 years, the billion dollars would be worth half as much.
Exhibit 1: Real Buying Power of $1 billion with 5% Spending and 3.7% Inflation Rate [1]
Our recommendation applies to wealthy families globally who underestimate the adverse effects of inflation on buying power and who unwittingly mismanage their fortunes, often focusing too much on short-term gains.
For instance, Chinese investors today hold almost 10% of the global billionaires’ wealth [2]. By observing their investment patterns over the past 20 years, we believe Chinese families are among those with the highest risk of losing their wealth. Traditionally, Chinese families have invested a disproportionate share of their wealth in local real estate and have neglected to consider the potentially disastrous effects of rising inflation combined with a burst of the growing asset bubble. It is important for them to diversify their investments across multiple asset classes and markets.
For these reasons, this paper presents the advantages of the Endowment Approach and, in particular, the investment strategy developed by Yale University. By capitalizing on alternative types of illiquidity premiums and allocating capital to external managers, the Yale Investments Office has generated superior returns over the past 20 years (see Exhibit 2)[3].
Exhibit 2: Cumulative Performance of Yale Endowment [4]
The Miracle, The Fall
“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” ~ Warren Buffett
First, let us consider the wealthy Japanese families of the late-twentieth century. During the 1980s, Japan’s economy experienced an incredible boom. From 1985 to 1989, the Nikkei stock index tripled in value, reaching an all-time high of 38,957.11 yen. By 1993, half of the world’s billionaires were Japanese, and they held almost 13.6% of the global wealth of billionaires. Today, that figure has shrunk to only 1.4% [5]. On the other hand, while there were no billionaires in mainland China in 1993, today’s top-earners in China hold 8.1% of the world’s private wealth [6]. What caused this extreme reversal in fortune for wealthy Japanese families? Put simply, these Japanese billionaires mismanaged their fortunes.
As Japanese real estate appreciated, Japan’s wealth grew. This extreme and rapid appreciation of real estate and stock market valuations, however, createdan enormous asset bubble. During the 1990s, the Nikkei index saw sharp declines, and real estate in Japan quickly lost value. By 2004, Tokyo residences were worth only 10% of their 1980s peak value [7]. Similarly, the value of Japan’s most prized land in Tokyo’s Ginza business district lost 99% of its value [8]. Moreover, twenty years after the 1989 peak, the Nikkei index closed at 7,054.98 on March 10, 2009, a full 82% lower. Due to the combination of falling real estate values and the depreciation of Japanese equities, many Japanese billionaires saw their fortunes disappear. Billionaires could have seen their fortunes grow through intelligent, diversified, and calculated investments that compounded over the years. Instead, their wealth is lower today than it was in 1989. While billionaires in the rest of the world grew wealthier, Japanese billionaires only experienced wealth stagnation and loss.
Exhibit 3: Japan – Billionaire’s Wealth vs. Commercial Land Price [9]
Will The Dragon Fall?
“Sales dry up, prices fall, new starts dry up ... in other words, falling asset prices undercut the basis for both past and future lending, and you’ve got a real system-wide problem.” ~Patrick Chovanec
Today, there are worrying signs that wealthy Chinese families are following in the same footsteps of Japanese billionaires from 30 years ago. Chinese billionaires have become wealthier as real estate values have appreciated quickly. Furthermore, we are currently observing an asset price bubble forming in China, and we may see a similarly drastic depreciation of real estate prices. Millions of properties lie vacant and unsold, and economists suggest that buyers are awaiting a real estate market correction. Such a situation is a major problem for the Chinese wealthy because their investments are not diversified and are heavily concentrated in real estate. Non-financial assets represent 65% of Chinese high-net-worth (HNW) individuals’ portfolios, and a full 50% of their assets are in real estate [10]. In contrast, non-financial assets represent only 22% of American HNW individuals’ portfolios [11].
If China experiences depreciation in property values similar to that which occurred in Japan during the 1990s and early 2000s, Chinese HNW worth individuals will see the value of their fortunes plummet. Furthermore, real estate investments are highly sensitive to fluctuations in interest rates and economic conditions, so it is unwise to invest excessively in real estate.
If we track the growth of Chinese and Japanese fortunes by the appreciation of property, we observe a troubling pattern. China appears to be headed for its own real estate bubble. We expect to see a severe drop in real estate values in the coming years (see Exhibit 4).
Exhibit 4: Hong Kong – Billionaires’ Wealth vs. Commercial Land Price [12]
The Challenges
Asian families hoping to preserve and grow their wealth face numerous challenges. As discussed previously, Chinese investment portfolios are overly concentrated in real estate and other non-financial assets, while public equities represent only 4% of Chinese portfolios [13]. Families are counting on property values to continue growing at high rates, which is not a reasonable expectation. Moreover, one needs to be appropriately experienced in order to invest directly in real estate and manage the collection of rents. Many Asian families who endeavor to manage their own assets do not have the necessary skills and experience to manage their properties effectively.
Furthermore, Chinese households hold 22% of their wealth in cash [14]. Cash and non-financial assets, namely real estate, comprise 87% of their investment portfolios. If property values fall, as they did in Japan, Chinese HNW individuals could see enormous investment losses. As we saw previously, investing primarily in real estate is risky and imprudent. Additionally, if inflation rises, the value of cash decreases, which would drive down the value of family fortunes substantially. Another challenge Asian families looking to invest their wealth face is their reluctance to relinquish control of their investable assets. In fact, 67% of family offices in Australia, Hong Kong, Japan, Malaysia, the Philippines, and Singapore are run by a family member. In the United States, that figure is only 43% [15].
The Endowment Approach
Now that we have considered the investing mistakes of many Japanese families in the late twentieth century, we examine an investment team that has been consistently successful over the past 30 years: the Yale Investments Office.
Colleges and universities hope to preserve their vast fortunes over time. University endowments in the United States range from a few million dollars to almost forty billion. Institutions rely on these funds to maintain their physical spaces and fund academic innovation. Thus, it is incredibly important for such institutions to have endowment funds that both preserve and grow their wealth at a rate that outpaces inflation.
Yale University has had extraordinary success in managing its endowment of $24 billion, consistently outperforming peer institutions. Chief Investment Officer David Swensen has designed an investment approach that relies primarily on external managers with a total return approach. He has kept fixed income and cash a much lower component of the portfolio than other managers and has capitalized on illiquidity premiums by investing in natural resources, private equity, and real estate managers.
Since 1994, the Yale Investments Office has generated a 13.4% annualized return. In the same period, the S&P 500 Total Return index has generated 9.23% annually. Yale has also outperformed its peers as shown in Exhibit 5.
Exhibit 5: Yale’s Performance Exceeds Peer Results [16]
One notable aspect of the Yale Investments Office is that it is substantially smaller than other institutional investors in terms of the number of employees – especially for the large sum of money it manages. The Yale team has achieved superior results by allocating its capital to external managers, who employ a diverse set of strategies and invest in a variety of asset classes.
David Swensen and His Investment Philosophy
Yale’s Endowment Approach was pioneered 30 years ago by the University’s Chief Investment Officer, David Swensen. Swensen received his B.S. in economics in 1975 from the University of Wisconsin-River Falls and his Ph.D. in economics in 1980 from Yale University. As a senior vice president at Lehman Brothers, he engineered the first ever swap transaction. Swensen joined the Yale Investments Office in 1985. His peers and his rivals regard him as one of the leading investors today. His innovative approach to portfolio construction is characterized by a John Maynard Keynes adage he often quotes: “Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.” Swensen’s willingness to take risk when apt has proven to be very fruitful.
Swensen’s investment philosophy is based on five driving concepts: the power of equities, diversification, less efficient markets, external managers, and incentives. First, he firmly supports investing in equities. With higher expected returns than bonds, equities also perform better when inflation is rising or unpredictable. Secondly, he believes in the virtues of diversification as a means of mitigating risk. This belief has led Yale to reduce its portfolio’s concentration in bonds and real estate and to diversify into other asset classes. Thirdly, he actively pursues opportunities in less efficient markets. As a contrarian, he looks to nonpublic markets marked by their illiquidity and fragmentary data. Fourthly, he champions the use of external managers. Yale chooses managers with the utmost discretion and carefully cultivates relationships with each of these outside managers. Lastly, he understands the importance of providing performance incentives for external managers. The managers’ interests should be in agreement with those of Yale. The Investments Office attempts to do this by building innovative partnerships and payment frameworks.
Portfolio Construction
Yale’s portfolio arises as a result of both quantitative analysis and attention to the market.
Exhibit 6: Yale’s Asset Allocation vs. Educational Institution Mean[17]
The Investments Office allocates a considerable portion of Yale’s assets to less efficient market strategies, including private equity, real estate, natural resources, and absolute-return investments. The team’s goal is to dedicate half of the portfolio to these illiquid domains. Alternative assets are less efficiently priced than conventional securities. Thus, through active management and by virtue of a long time horizon, the Endowment is in a favorable position to capitalize on market inefficiencies such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.
It is important to keep in mind that investing in real estate is not intrinsically faulty. It is only problematic when there is an overreliance on the strategy. For example, Chinese HNW individuals hold 50% of their assets in real estate today [18]. This could be disastrous if real estate values were to fall as they did in Japan during the 1990s and early 2000s.
Exhibit 7: Yale Asset Allocation by Liquidity [19]
Conventional Approach vs. Yale External Manager Approach
External Manager Approach
Traditionally, endowments have hired internal managers to execute the investment process. All investing activities, from asset allocation to security selection to market timing, are carried out internally by managers. The Yale approach, on the other hand, proposes a different procedure. Internal managers allocate assets to selected external managers. Then, these external managers are entrusted with security selection and market timing, with very limited interference from the Yale Investments Office. Exhibit 8 juxtaposes the two distinct approaches.
Exhibit 8: External Manager Approach [20]
Example
Exhibit 9 juxtaposes the Yale Investments Office with a large multifamily office. Compared to this large multifamily office, which follows the conventional investment approach, Yale relies on fewer internal investment professionals in total. However, each professional oversees a greater fraction of AUM. This is a result of outsourcing the time-consuming process and expertise necessary for security selection to external managers. Yale’s professionals need only perform due diligence to select managers who are experts in their respective asset classes. Yale can forego hiring additional investment professionals to cover specific assets or industries.
Exhibit 9: Yale Investments Office vs. A Large Multifamily Office [21]
Manager Selection
“Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you. You think about it; it’s true. If you hire somebody without, you really want them to be dumb and lazy.” ~Warren Buffett
When selecting managers, Yale prefers those with exceptional fundamental research aptitude. None of Yale’s managers stress timing of the markets or adhere to merely intuitive investment practices. Managers should be agreeable to the idea of co-investing and being remunerated based on performance. The Yale Investments Office avoids managers who target AUM growth while thriving on management fees and neglecting performance. In other words, Yale values active managers who generate excess returns.
However, according to Swensen, “Anointing winners and losers on the basis of 12 months’ worth of performance is silly in the context of portfolios that are being managed with incredibly long time horizons.”
Managers should have incentives that are aligned with what is in the best interest of the University. If so, Yale will not interfere with the manager’s work and will grant the managers considerable autonomy.
Exhibit 10: Manager Selection Added Value [22]
Yale invests in a limited number of managers with whom they establish long-term partnerships that typically endure for ten or more years. Yale Investments Office maintains close relationships with its managers and applies innovative fee structures to establish appropriate motivation. These partnerships are not only designed to be advantageous for Yale, but are also beneficial for managers. Yale is often regarded as one of the most important clients for many managers.
In fact, every so often, Yale is the first client for its new managers when it provides them with seed capital. This was the case with Hillhouse Capital Group. Yale seeded Hillhouse with $30 million in 2006. As of December 2014, Hillhouse was managing over $18 billion [23].
Based on our observations, other important criteria for Yale to consider when selecting managers include:
Integrity
“Young and Hungry,” or employee-owned
Single strategy
Significant general partner co-investment
High conviction, concentrated, long-term
Bottom-up, security-specific investment approach
No short-term trading
There can be significant value added if managers are selected prudently, as shown in Exhibit 10.
Conclusion
Both family wealth and endowments are permanent capital. For both, inflation is a problem in the long-term. Exhibit 1 illustrates that with a 3.7% inflation rate and 5% spending policy, the real buying power of $1 billion deteriorates rapidly unless there is an 8.7% return per annum.
The success of the Yale Approach suggests that wealthy Asian families can adapt Yale’s sensible investing approach to overcome the “three generation problem.” To reach this objective, Asian families do not need to operate a large organization. Instead, a family or its family office should hire a small team of capable investment professionals who are driven by an appropriate incentive arrangement and leverage the expertise of external managers to diversify its portfolios.
Authority should not be determined by family lineage, and most family members should be involved in the long-term policy-making process. Implementation should be undertaken slowly, especially for a private equity portfolio. The family should be prepared for the natural volatility of investment markets and refrain from acting emotionally during down cycles.
Additionally, they should physically and psychologically separate “endowment assets” from other assets. According to the 2014 Yale Endowment Update, “The spending rule is at the heart of fiscal discipline for an endowed institution. Spending policies define an institution’s compromise between the conflicting goals of providing support for current operations and preserving purchasing power of endowment assets.” Asian families should apply this concept in a way that caters to their needs.
By adopting the Yale Approach, Asian families, and Chinese families in particular, can attempt to avoid the devastating losses that Japanese billionaires incurred in the 1990s. Indeed, the potency of the endowment approach has already been validated.
Originally published in 2015-07
[1] Cook Pine Capital and Star Magnolia Capital
[2] Forbes, Bloomberg, Cook Pine Capital and Star Magnolia Capital
[3] Yale Endowment Updates, Harvard Business School Case Study “Yale University Investments Office: February 2015,” Berkshire Hathaway Annual Report 2014, Star Magnolia Capital; all annual data from July 1 to June 30 except for Berkshire (January 1 to December 31)
[4] Cook Pine Capital, Star Magnolia Capital
[5] Forbes, Bloomberg, Cook Pine Capital, Star Magnolia Capital
[6] Forbes, Bloomberg, Cook Pine Capital, Star Magnolia Capital
[7] http://www.thebubblebubble.com/japan-bubble/
[8] Ibid.
[9] Cook Pine Capital, Star Magnolia Capital
[10] Credit Suisse, “China Banks Sector, Follow the money: Fewer Bricks Please,” 4 June 2015
[11] Ibid.
[12] Cook Pine Capital, Star Magnolia Capital
[13] Credit Suisse
[14] Ibid.
[15] Wharton Global Family Alliance, “Single Family Offices: Private Wealth Management in the Family Context”
[16] Yale Endowment Update 2014
[17] Yale Endowment Update 2014
[18] Credit Suisse Asia Pacific/China Equity Research “China Banks Sector”04 June 2014
[19] Yale Endowment Updates, HBS Case Study “Yale University Investments Office: February 2015”, Star Magnolia Capital
[20] Cook Pine Capital, Star Magnolia Capital
[21] Yale University Investments Office, Cook Pine Capital, Star Magnolia Capital
[22] Source: Yale Investments Office Endowment Update 2013
[23] Hillhousecap.com
*Special thanks to Cook Pine Capital’s summer interns, Denis Fedin and Angela Yang, for their contributions to this white paper.