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					                                                                August 2006 Vol. 7 No. 1

              NMS EXCHANGE                         
T H E N M S M A N A G E M E N T I N V E S T M E N T B U L L E T I N F O R T H E E N D O W M E N T & F O U N D AT I O N C O M M U N I T Y
                                                       Challenges Facing Today’s Institutional Investors
Nancy M. Szigethy                                      by D. Ellen Shuman, Vice President and Chief Investment Officer, Carnegie Corporation of New York
Founder and Chief Executive Officer
                                                                                   Serving as the        imposing hefty fees and expenses that
IN THIS ISSUE:                                                                     Chief Investment      shift incremental risk to the investor.
Page one                                                                           Officer of an         Caveat emptor.
                                                                                   endowment or          The three execution challenges that have
   Challenges Facing Today’s Institutional
   Investors                                                                       foundation is an      become far more pervasive are:
     by D. Ellen Shuman                                                            incredible pri-
     Vice President and Chief Investment Officer                                   vilege. We work       1) increased pressure on limited staff
     Carnegie Corporation of New York                                              with talented            resources;
   About NMS Management                                                            colleagues, invest    2) reduced flexibility to manage the portfolio;
                                                                                   with the best            and
Page two                                                                           and the brightest
   Are Hedge Fund Fees a Bargain?                      and contribute to the betterment of society,      3) rising management fees and expenses.
   And Other Conundrums of Balancing                   whether educating tomorrow’s leaders or           Whether these trends continue or the
   Active and Passive Management                       supporting the philanthropic mission of our       pendulum swings back at some point is
     by Randolph B. Cohen
                                                       own institution. Carnegie Corporation of          anyone’s guess.
     Associate Professor of Finance
     Harvard Business School
                                                       New York, established in 1911, has a              Staff Resources
     & Kerry J. Stirton                                particularly inspiring mission: “the advance-
     Managing Director                                 ment and diffusion of knowledge and               Globalization. You’re going where?
     Stellation Asset Management                       understanding.” As a grant-making founda-         Portfolio globalization is requiring signifi-
                                                       tion, the Corporation seeks to carry out          cantly more travel outside of the U.S. as
Page three                                                                                               we seek new investment opportunities,
                                                       Andrew Carnegie’s vision of philanthropy,
   In the Search for Alpha, Don’t Forget               which he said should aim “to do real and          particularly in emerging markets. For example,
   Your Beta                                                                                             within the past twelve months this author has
                                                       permanent good in this world.”
      by Velios A. Kodomichalos                                                                          been to every BRIC country, something that
      Director, Private Equity & Real Assets           Having said all this, the job of the Chief        would never have occurred five years ago.
      Pepperdine University                            Investment Officer is becoming more               Managers are also being stretched in this
Page four
                                                       challenging with the passage of time.             regard as developed markets have become
                                                       Competition for investment talent has             more efficient.
   It’s Different This Time
                                                       created staff turnover and pressure on
      by Jeffrey E. Heil                                                                                 Compressed time frame for decision making.
      Chief Investment Officer                         compensation. Demand for superior
                                                       investment talent among managers with             You’re closing when?
      Doris Duke Charitable Foundation
                                                       specialized investment strategies is reducing     With investors clamoring for allocations, GPs
Page five                                                                                                are closing follow-on, and even new, funds
                                                       our willingness to share investment ideas
   The Convergence of Investment                       with our peers, dampening the open                very quickly, putting additional pressure on
   Strategies and Asset Allocation Policies            spirit of collegiality that has been              the staff to prioritize carefully and act swiftly.
     by Cathy Iberg
                                                       characteristic of the endowment and               Staff retention.
     Managing Director Marketable Alternative
     Investments and Deputy CIO
                                                       foundation culture. Superior managers             Competition from the sell side, including
     The University of Texas Investment                (and many mediocre ones) definitely have          funds-of-funds, family offices and institutions
     Management Company (UTIMCO)                       the upper hand when it comes to                   creating or expanding the investment
Page six                                                                                                                                ...continued on page 10
   Long-Run Goals, Short-Run Actions and
   the Trick to Unification
      by David R. Brief
      Chief Investment Officer
                                                       About NMS Management
      Jewish United Fund/Jewish Federation of          NMS is a membership-based organization that       unbiased educational forums, NMS promotes
      Metropolitan Chicago
                                                       works to fulfill the needs and aspirations of     high standards of competence and ethics. As
Page seven                                             the endowment and foundation community            part of its mission, NMS provides its members
   Open Architecture as a Disruptive                   through the development and education of an       with the business tools, networks and access
   Business Model                                      outstanding network of investors and business     to senior-level investment officials that are
     by Gregory Curtis                                 professionals. Believing that most successful     essential to making critical business decisions,
     Chairman                                          business ventures are built on trust, and trust   in a non-commercial setting of peers. NMS is
     Greycourt & Co., Inc.
                                                       can only be developed through relationships,      the bridge to the latest investment ideas and
Back cover                                             NMS strives to facilitate relationships through   information applicable to the endowment and
   NMS Upcoming Forum Schedule                         its membership platform. As the chief source of   foundation community.
                                                                           NMS EXCHANGE

Are Hedge Fund Fees a Bargain?
And Other Conundrums of Balancing Active and Passive Management
by Randolph B. Cohen, Associate Professor of Finance, Harvard Business School
and Kerry J. Stirton, Managing Director, Stellation Asset Management

                                                         or investment approach that most long-only         adjusted return and portfolio construction
                                                         fund managers adopt in large investment            perspectives. Consider two types of equity
                                                         funds. Expressly speaking in terms of slight       market, type A (think of a relatively liquid,
                                                         “underweights” and “overweights,” versus for       efficient market) and type B (an illiquid,
                                                         instance the S&P 500, these managers often         relatively inefficient market).
                                                         hug their benchmark for safety’s sake. It is
                                                                                                            Market type A includes the US and
                                                         common for managers to have 90% of their
                                                                                                            Canada, Western Europe and Japanese large
                                                         returns explained by the returns of simple
                                                                                                            capitalization markets. Type B includes small-
                                                         benchmark portfolios like the S&P 500 and
                                                                                                            cap stocks, emerging markets and special
                                                         the Russell 2000. Investors end up on the
Although the breezes of change have been in                                                                 situations. Of course, these markets form a
                                                         receiving end of a product that, for 90% of
evidence for a number of years, it remains true                                                             continuum, but for simplicity here we will just
                                                         its substance, is effectively an index fund.
that most pensions and institutional investors                                                              think of them as two classes.
                                                         They pay about 1% of total invested assets,
maintain outsized allocations to active long-
                                                         yet they only receive 10% “attempts at alpha”      An ALO portfolio dominated by A can
only (ALO) managers, with comparatively
                                                         and 90% beta in their specific capital market.     certainly be well diversified, as A markets
high fees. The question is: Why? Evidence that
                                                         Underlying this reality is a massive distortion    make up 90%+ of world equity market
long-only managers are unable to outperform
                                                         in what fees are really being paid for active      capitalization. But domination by A markets
after fees has long been in plain view. And the
                                                         security selection.                                in a portfolio nearly guarantees that true alpha
economic advantages of passive index funds
have been touted for over a decade, this being                                                              will be small, since A markets are so efficient.
                                                         Institutions can now purchase very low-fee
especially true in strong markets.                                                                          It is very difficult—on a sustained basis—to
                                                         index funds at 10 bp or less. So a $100 index
                                                                                                            find securities that are meaningfully mispriced
                                                         fund allocation costs about ten cents—a .1%
The thesis of this article is quite simple:                                                                 and whose true value can be ascertained by
                                                         fee on that money. Yet if you buy a typical
Responsible pensions and institutional money                                                                individual research and hard work.
                                                         $100 mutual fund product at a 1% fee, but
managers should work to develop deliberate
                                                         90% of what you are really buying is an            An active long-only portfolio dominated by B
and optimal allocations to passive and highly
                                                         index-fund type product, you are effectively       can generate significant outperformance over
skilled active investment vehicles, and they
                                                         paying 90 cents (the dollar of fees minus the      time, because these markets are so inefficient.
should eliminate commitments to structurally
                                                         10-cent cost of indexing) on only $10 (10%         The problem with a portfolio dominated by
underperforming long-only active managers,
                                                         of the original $100) of truly active security     B markets is that it is almost certainly going
unless the evidence of ability to generate
                                                         selection. The cost for the active component       to be poorly diversified—when compared to
alpha (rare) is clear, and the duration of
                                                         of the allocation is therefore a 9% flat fee—not   the available world of stocks and market
the outperforming track record is compelling.
                                                         9% of performance, but 9% of the assets            capitalization—and therefore have high
Active hedge fund managers who aim their
                                                         that are truly being actively managed. No          volatility and a low Sharpe ratio. This is
sights directly at alpha generation are a
                                                         wonder ALO managers have so much trouble           because type B markets make up a rather
much better deal, as are passive index funds
                                                         outperforming passive benchmarks—the fees          small percentage of world equity market
that secure market exposure or beta at a
                                                         are so high, for so little active management,      capitalization. Thus, even if ALO fees were
cheap cost (and, perhaps, a small subset of
                                                         that only a genius could overcome them.            low and active-manager quality playing in
low-fee, active long-only funds that fill a
                                                         ALO managers have found a fee structure that       B markets were high, a combination that is
similar niche). Darwin has seemingly been
                                                         makes the 1.5% management fee plus 20%             not really available in practice, there is not
forgotten for decades now, but his insights
                                                         of profits charged by hedge fund managers          an optimally attractive portfolio that can be
should be decisively resurrected in the money
                                                         appear a relative bargain. Not only are hedge      created from ALO fund managers.
management business.
                                                         fund fees sure to be much lower on average
The Nature of Performance and Fees, Across               (per dollar of true active management), but        Fortunately, however, a blend of passive long-
Passive and Active Approaches                            the fees are tied to performance in a way that     only funds and active long-short managers can
As is well known, active long-only fund                  serves to better align incentives and save         provide institutional investors with the best
managers typically underperform the                      the pain of paying very high fees for poor         of both worlds. This example, like most of
performance benchmarks against which they                performance. So by consciously unbundling          the discussion here, will focus on stocks, but
are compared. The problem is not that the                one’s investment dollars between passive (i.e.,    similar logic applies in fixed-income and other
average large institutional money manager has            index) funds and skilled active managers (e.g.,    asset classes. Consider a portfolio which has
no skill because, at least in equities, the data         hedge funds), a superior economic outcome          80% invested in a globally diversified, long-
suggests otherwise. The stocks selected by such          will typically be obtained. The fees aspect of     only, passive portfolio, with the other 20% in
managers typically outperform by over 100 bp             this allocation approach is only one part of the   market-neutral absolute return equity strategies
per year. The problem is that these active long-         equation, though, and perhaps not even the         that use long and short positions in an attempt
only managers do not generate enough alpha, or           most essential.                                    to generate outperformance. The passive
enough excess return, to overcome the negative                                                              portfolio might simply reflect the world equity
                                                         The Active Long-Only Trap                          market portfolio, or it may embody macro
effects of high fees and expenses in their funds.
                                                         Entirely aside from the issue of fees, active      opinions through tilts toward one country
The fee issue is closely linked to the style             long-only funds are rarely attractive from risk-   or another. But unless the tilts are extreme,
                                                                                                                                           ...continued on page 9

                                                                                  page 2
                                                                             NMS EXCHANGE

In the Search for Alpha, Don't Forget Your Beta
by Velios A. Kodomichalos, Director, Private Equity & Real Assets, Pepperdine University
                              As     investment           policy portfolio agreed to by the investment                       At this stage, the other outcomes provide a
                              professionals, our          committee.                                                         different risk-reward profile from the expected
                              main link to our                                                                               return of the policy portfolio. This brings
                                                          Active management complicates the relative
                              respective invest-                                                                             us back to the goal and expectations of the
                                                          analysis of the actual portfolio against the
                              ment committees                                                                                committee: to deliver the policy portfolio in
                                                          policy portfolio. If care is not taken, erroneous
                              and boards is the                                                                              terms of risk and return.
                                                          inferences may be made and acted upon.
                              strategic     asset
                                                                                                                             Some rationales for the other outcomes:
                              allocation and its          To illustrate the point, let us assume that
                              corresponding               the portfolio has the following return                              • Lower return for less risk: Management took
                              policy portfolio.           characteristics, set in Figure 1:                                   less market exposure than mandated and was
                              Of course, the                                                                                  not sufficiently rewarded to make up for the
policy portfolio is simply the Figure 1                                                                                                   lower risk.
strategic asset allocation providing     Asset Class          Asset           Actual         Weighted       Benchmark          Policy     • Same return for less risk: Invest-
benchmark returns. It enables the                          Allocation         Return          Return          Return         Portfolio    ments returned sufficient alpha
committee, among other things,                                                                                                            to make up the shortfall in
to benchmark and measure, on a Class 1                       15%              11%             1.65%             10%            1.5%       benchmark exposure. Manage-
relative basis, fund and manage-                                                                                                          ment was mandated to take a certain
ment performance. However, what         Asset
                                                             25%               5%             1.25%             6%             1.5%       risk and benchmark exposure; this
is this link really about? The stra- Class 2                                                                                              was not achieved. In most cases,
tegic asset allocation is likely to     Asset                                                                                             the acquisition of alpha is far more
                                                             10%              15%              1.5%             10%            1.0%
be the one major exercise in which Class 3                                                                                                expensive than the acquisition of
both investment committee and Asset                                                                                                       beta. This is one of the consolation
                                                             15%              20%              3.0%             14%            2.1%
management are truly simul-             Class 4                                                                                           prizes. If the risk budget could not
taneously engaged. Among other          Asset                                                                                             be completely consumed to max-
things, it provides a guide for                              35%               8%              2.8%             10%            3.5%
                                        Class 5                                                                                           imize returns, then this is the
allowable investments, as well as Total                                                       10.2%                            9.6%       fallback position, reaching expected
embodies the expectation of the                                                                                                           returns using less risk.
committee as to levels of exposure, risk to be            On the face of these returns, the portfolio                         • Greater return for less risk: This could be
taken by management and the likely reward                 performed relatively well, delivering 60 bp of                      an extrapolation of the previous outcome.
expected from taking on a particular general              returns in excess of the benchmark. However,                        Management may argue that achieving
risk profile.                                             was alpha delivered, and, if so, was the alpha                      benchmark returns with a lower risk profile
                                                          delivered due to taking more risk, taking                           is a desirable outcome. This is a tactical shift
Traditional View of Allocating Assets
                                                          greater market exposure or just strong active                       away from the committee’s policy portfolio
Under the traditional view of strategic asset
                                                          manager performance? We just cannot tell at                         expectations in terms of risk budget, which
allocation, management makes investments
                                                          this point.                                                         it expects to be spent and suitably rewarded.
in proportion (on a dollar-weighted basis), as
                                                                                                                              Both this and the previous outcome have
set out in that allocation. For example, let us           When a portfolio has multiple investments
                                                                                                                              agency risk attached on the basis of the
assume that we have a portfolio with five asset           per asset class and, in particular, active
                                                                                                                              opportunity cost of not taking the full risk
classes and the following allocation:                     management within the asset classes, there
                                                          are nine possible risk-reward outcomes that
Asset Class 1: 15%       Asset Class 4: 15%                                                                                   • Greater return for more risk: Management was
                                                          may arise:
Asset Class 2: 25%       Asset Class 5: 35%                                                                                         rewarded for taking on more risk; however,
Asset Class 3: 10%                                    Actual Return                                                                 the committee is likely to be concerned
                                                            vs.                        Actual Risk vs. Policy Portfolio             about risk tolerance.
If the portfolio were invested passively
                                                     Policy Portfolio
in benchmark-returning investments,                                                                                               By allocating on a dollar-weighted basis,
this portfolio would, subject to some                     Lower                 Less               Same               More        unless invested in the benchmark,
transaction costs, match the expectations                 Same                  Less               Same               More        management loses the ability to control
set out in the strategic asset allocation and            Greater                Less               Same               More        benchmark exposure in the portfolio.
mirror the policy portfolio. However, for                                                                                         This changes the risk-reward profile of the
many reasons, management does not invest                  It is clear that the three highlighted outcomes                    actual portfolio, making it difficult to deliver
passively. (In some cases the benchmark is                are the most undesirable outcomes of the nine                      on expectations (the         policy portfolio).
not even investable.) This produces a result              and the center is the scenario of returning                        Management has trouble with a dollar-based
that differs from that expected of the policy             the policy portfolio. The lower-middle result                      allocation because of difficulty in providing
portfolio. Issues of tracking error, different            (same risk for greater return) may be the                          coherent information on relative performance.
market exposures (betas), alphas and other                most desirable outcome, because management                         Management needs to know the market
risks are introduced into the portfolio. At this          undertook the risk level mandated by the                           exposure of its various investments in order to
point, we do not know whether the risks intro-            committee and returned more than expected.                         have a clear understanding of the return drivers
duced into the portfolio are good or bad; all             The lower-left outcome of greater return and                       of the portfolio and gain the ability to provide
we know is that the portfolio is delivering a             lower risk may be a good outcome but not a                         an attribution of returns.
different risk-reward profile than that of the            desirable scenario. (See the discussion below.)
                                                                                                                                                            ...continued on page 8

                                                                                       page 3
                                                                            NMS EXCHANGE

It’s Different This Time
by Jeffrey E. Heil, Chief Investment Officer, Doris Duke Charitable Foundation

                           To most investors,             international trade and the true emergence            Meanwhile, the wealth generation in formerly
                           those are almost               of the developing economies), along with              poor, third-world countries continues to make
                           always famous last             more competent central banks and generally            headline news (from 1995 to 2004, China’s
                           words. But, how-               deregulated economies (sounder policymaking           economy alone grew from $700 billion to $1.9
                           ever rare, some-               that no longer tries to naively set interest rates,   trillion, creating $1.2 trillion of wealth), along
                           times there are                currency exchange rates and price levels),            with the accompanying, unprecedented levels
                           situations when                that have led to smoother economic cycles             of investment of that capital into developed
                           change is real and             and, in particular, lower inflation. Inflation        nations’ real estate, stocks and bonds.
                           lasting, i.e., it              in the US has decreased from persistently
                                                                                                                Returning to the issue of whether there is less
                           really is “dif-                high single-digit levels throughout the 1970s
                                                                                                                structural risk in investments today, some
                           ferent.” Such a                and 1980s, to an average closer to 2% over
                                                                                                                people remain focused on the simple thesis of
situation that many are questioning today is              the last ten years. More importantly, average
                                                                                                                fear and greed—that investors today are greedy,
whether investment returns will remain                    inflation in the developing economies has
                                                                                                                and when the risk that they have been ignoring
structurally lower going forward, or whether              moved from high double- and triple-digit
                                                                                                                comes back to bite them, everyone will move
more risk will be added back into the markets.            levels to the high single digits. Lower infla-
                                                                                                                into a fearful stage. Along with this view, they
                                                          tion stabilizes interest rates and the discount
Many investors will very quickly concur that                                                                    will argue that there has been, and always will
                                                          rate used to value assets. It also stabilizes
we are indeed in a lower-return environment.                                                                    be, a more or less constant degree of un-
                                                          projected and actual monetary and economic
In fact, numerous quantitative analyses show                                                                    certainty in investing for the future. I believe
                                                          conditions. Less volatile investment multiples
that the equity risk premium has fallen from a                                                                  the more pertinent debate is whether the
                                                          applied to more stable global economic growth
fairly long-term high, as computed by firms                                                                     current lower risk premium has overshot the
                                                          means lower investment return volatility.
like Ibbotson, Sinquefield in the 1980s and                                                                     proper or fair risk-return tradeoff. Like any
early 1990s, of around 6%, to around 4.5% in              Second is the fact that investment portfolios         question of this nature, there will be a
the late 1990s, to about 3.5%, as suggested by            have become more diversified and efficient,           significant band of uncertainty around the
many research firms today. But when the                   and thus less risky. The availability and             market’s central expectation of risk.
discussion goes a little deeper, for instance why         widespread use of low-cost, risk-hedging swaps,
                                                                                                                If we have overshot the risk premium re-
we should expect lower returns, there is                  derivatives, futures, options and short-selling
                                                                                                                duction, then the markets will eventually
suddenly a lot more dissension. There is really           hedge funds have both reduced risk as well
                                                                                                                need to correct. This is the basis for many
only one reason why future expected returns               as improved diversification. Investors cannot
                                                                                                                market bears who would argue that risk has not
should ever be structurally lower, and that is if         expect to be rewarded through higher returns
                                                                                                                changed so much, and therefore returns must
future expected risk is lower. And, when you              for risks that are now more easily reduced
                                                                                                                be higher to provide fair compensation. In
put it that way, suddenly people are not so               through these diversifying and hedging
                                                                                                                their view, current multiples are too high
inclined to agree. To be fair, there are actually         instruments.
                                                                                                                and must come down in order to bring about
two reasons why future expected returns could
                                                          Thirdly, investment portfolios have become            higher future returns per unit of risk. If, on
be lower: lower expected risk, and more
                                                          more tax-advantaged, thus creating more               the other hand, current risk premiums are
demand than supply for investment assets
                                                          return per unit of risk. Just eight years ago,        correctly reflecting the above structural
(thus driving the prices up and the returns
                                                          the capital gains tax rate was 28%. Today it is       changes, i.e., current expected returns are
down). I happen to think that both forces are
                                                          15%. Simple math tells us that a once                 adequate for expected risk, then the market
at work today, which is troubling because,
                                                          acceptable pretax return of 10% only needs to         is fairly valued. Of course, the bull market
while less risk is a valid driver of lower return
                                                          be 8.5% today for the same net yield.                 view is that risk premiums should be even
and can be dealt with accordingly, too much
                                                                                                                lower—and therefore multiples higher—
capital chasing too few assets is not a valid             Before we assess the validity and potential
                                                                                                                meaning the markets are undervalued.
reason to accept a lower return.                          magnitude of the above factors, we need to
                                                          address the other possible driver of a lower risk     What is important, whether the market needs
To be perfectly clear, what we are talking about
                                                          premium, which is simple supply and demand.           to correct or not to get to the proper level of
here are future returns that could continue to
                                                          There seems to be a sea of liquidity in the           future expected returns, is that the result of
be structurally lower because of positive
                                                          world today that is chasing increased returns.        accepting the validity of some degree of a long-
macroeconomic factors that lead to a decreased
                                                          Of course, this ends up pushing investors to          term, lower-risk environment means that the
risk premium for investment assets. This is as
                                                          actually settle for lower returns per unit of risk    correspondingly lower returns must be factored
opposed to cyclical market corrections
                                                          as they chase return, which drives up prices          into long-term financial market assumptions.
resultant of negative, temporary economic
                                                          by pouring capital into the same securities.          Typical endowment and foundation portfolios,
conditions such as rising interest rates or
                                                          The primary drivers of this increased capital         and even most pension funds today, have
declining earnings. Let’s consider what appear
                                                          are longer living and working populations, as         return targets of about 8%. Therefore, a
to be some valid structural economic changes
                                                          well as dramatically increasing wealth in the         reduction in the risk premium from 5.5% to
that could be driving the lowered equity
                                                          developing economies. Life expectancy has             4% means a 19% lower return from which to
risk premium over the last few years.
                                                          increased from 65 to 75 years in most developed       fund set liabilities and spending requirements.
Structural Drivers of Lower Risk                          nations, which has led to greater income
                                                                                                                Investing in a Low-Return World
                                                          generation along with a concurrent need for
First and foremost is the mixture of improved
                                                          increased savings to fund a longer retirement.        Regardless of what people say in the debate on
global productivity (driven by greater
                                                                                                                                               ...continued on page 9

                                                                                     page 4
                                                                      NMS EXCHANGE

The Convergence of Investment Strategies and Asset Allocation Policies
by Cathy Iberg, Managing Director Marketable Alternative Investments and Deputy CIO, The University of Texas Investment Management Company (UTIMCO)

                           Over the last            institution’s investment program in a variety of     exposure to a given asset class coupled
                           twenty years, asset      ways. A consistent definition of a hedge fund        with other subjective measures to help us
                           allocation policies      or an absolute return strategy does not exist.       decide where each investment mandate best
                           have      provided       Oaktree Capital’s Howard Marks has insisted          fits within the policy portfolio framework,
                           the     framework        that no asset class or investment technique          in addition to input from our board’s
                           for institutions to      possesses a natural or embedded rate of return.      risk committee.
                           allocate capital         Absolute return may mean to one investor
                                                                                                         In the future, we believe that risk-based
                           across various asset     that an investment should post a positive
                                                                                                         allocation policies will provide a better guide
                           classes. With the        return regardless of what the market is doing,
                                                                                                         to execute our investment program within a
                           growing       popu-      and to another it may be defined more in
                                                                                                         board-approved framework, but the method-
                           larity of alter-         terms of the predictability of the return stream.
                                                                                                         ology in which to do this is still evolving.
native investments over the last five years,
                                                    It seems to me that the rule book governing          Risk may be broadly defined by the
particularly hedge funds, classifying invest-
                                                    asset allocation policies may no longer fit the      combination of market and active risk. By
ments within an institution’s asset allocation
                                                    needs of an institution’s investment program,        way of example, Bridgewater Associates
policy has become increasingly challenging as
                                                    as the definitions used to categorize invest-        provides a tool and a methodology to under-
exposures defined by the policy may bear little
                                                    ments no longer work very well. If an insti-         take this exercise. Ultimately the sizing
resemblance to the investments that are
                                                    tution finds a talented investment manager           of the active risk component is dependent
classified within it.
                                                    that does not fit neatly into one of its asset       on the level of confidence conferred by
In a keynote presentation entitled “Are             allocation buckets, discarding such opportunity      an institution’s board to the CIO and staff
Policy Portfolios Obsolete? And if So,              because it cannot be classified makes no sense.      to execute. Institutional investment pro-
Why?” at the NMS Investment Management              At UTIMCO, our private equity, hedge fund            grams that have broader mandates and
Forum for Endowments & Foundations in               and public market mandates are headed by             fewer constraints will require greater staff
January 2003, Peter Bernstein suggested             different individuals who report directly to         resources and skilled individuals to successfully
that institutions should throw out the rule         the CIO. Increasingly, the selection of              execute them going forward. h
book regarding asset allocation policies, as        investment managers and their classification
this traditional guide is no longer functional.     within our asset
Mr. Bernstein’s view was that an institution’s      allocation
investment program must be more un-                 framework has
structured, opportunistic and ad hoc in its         presented chal-
selection of investments. Coming into 2003,         lenges,      most
the most successful institutions had already        notably between
embraced non-traditional sources of return          the public mar-
by placing their bets on manager skill and          ket and hedge
less so on what the market would give               fund mandates.
them in return. Fast forward to today and           Classifying
we find that more and more institutions             investments
are investing in opportunistic and un-              with managers
structured investments like hedge funds.            that have hedge-
                                                    fund-like fees,
This shift appears to be in full force as           use leverage
the popularity of these strategies continues.       or hedge some
Institutions are putting non-traditional            market risk in
types of investments in the traditional equity      our traditional
and fixed-income asset class buckets. By            public market
way of example, activist managers that              portfolio raises
charge hedge-fund-like fees might be more           questions with
appropriately classified within an equity           respect to why
asset class versus a hedge fund asset class.        such managers
UTIMCO’s investment policy has an allocation        are not aligned,
to directional and absolute return hedge funds      instead, with
and broad definitions for each. As hedge            our hedge fund
funds continue to expand their investment           portfolio. In or-
mandates by investing in private equity, the        der to address
classification of these investments within the      this issue on an
hedge fund asset class raises questions, as         interim basis, we
most institutions, including UTIMCO, have           have proposed
a private equity asset class allocation as well.    a framework
Activist managers, levered long mandates            that quantifies
and distressed debt may be classified within an     a m a n a g e r ’s

                                                                             page 5
                                                                             NMS EXCHANGE

Long-Run Goals, Short-Run Actions and the Trick to Unification
by David R. Brief, Chief Investment Officer, Jewish United Fund/Jewish Federation of Metropolitan Chicago

                               Who is gonna make it?                regarding perpetual horizons.                    consider what transpired subsequent to
                               We’ll find out in the long run.                                                       the initial investment. Based upon the 5%
                                                              In the long run, as the Eagles
                               --The Eagles.                                                                         distribution policy, the initial portfolio could
                                                              astutely observe, we will learn
                                                                                                                     throw off $500,000 of annual support. But
                                                              “who is gonna make it,” and
                           In the long run, we’re all dead. those who succeed will do so by                          in less than three years—short-term by any
                           --John Maynard Keynes.                                                                    measure—this amount had fallen 85% to
                                                              sustaining economic prosperity.
                                                                                                                     barely $75,000. Even a decline lessened by
                                                              We tend to measure prosperity by
                           Who would have examining variables such as total returns                                  prudent diversification could still prove
                           guessed that the and asset values, but in this habit we                                   fatal to an institution such as a foundation,
                           combined wisdom find a classic trees-versus-the-forest problem.                           whose survival depends heavily on endow-
                           of a best-selling In the context of endowments and foun-                                  ment distributions. Herein lies the meaning of
California rock band and a famed British dations, the only valid measure of prosperity                               Keynes’ admonition that long-run intentions
economist contained the key to solving is the amount of ongoing support that                                         cannot override short-run realities.
a conundrum that hinders the productivity investment portfolios provide to the sponsoring                            We may have shed light on the conundrum
of over half a trillion dollars designated          institutions. This support takes the form of                     put forth at the outset, but we have not
to provide perpetual support to our most annual distributions (or “spending”), almost                                really solved it. Doing so requires the further
cherished and vital charitable, cultural always dictated by policies that place material                             step of twisting a popular aphorism into
and     educational     institutions?      The      weight on short-term investment results. An                      the assertion “if it ain’t broke, break it!”
challenge in question, which daunts the (admittedly extreme) example illustrates the                                 What is “broken” in this system is the
vast majority of endowments and foundations, significance of this.                                                   manner in which institutions have hitched
lies in rationalizing the institutions’                                                                              their proverbial wagons to short-term
alleged long-term horizons with decision- Consider an institution that invested its                                  results. Widely accepted practices do not
making processes that involve investment $10 million endowment in the S&P 500                                        equate to best practices, and the fact that
committees scrutinizing monthly and quarterly on October 1, 1929, and each year withdrew                             most endowments and foundations distribute
performance data and staff members wading 5% of assets. By the end of 2005, the portfolio                            a fixed percentage of assets each year is both
through a 24/7/365 flow of information and would have been worth $213 million. At                                    nonsensical and entirely counterproductive.
feedback. Actions indeed speak louder than that time the annual distribution would be                                Eliminating the insidious causal link between
words, and the clear message one takes from $10.7 million (5% of the $213 million), and                              short-term results and long-term prosperity
ongoing patterns of investment manager              cumulative distributions over the period
                                                                                                                     is the key to allowing institutions to invest
turnover and trend-following asset allocation would total $216 million. While this sounds                            in a manner that reflects their true horizon
drowns out whatever lip service one hears like an unequivocal long-run success,
                                                                                                                                                        ...continued on page 10

   Participants at the NMS Institutional Select Series Roundtable: Investing in Private Markets 2006 enjoyed a tour of the stunning Artesa Winery in Napa Valley.

                                                                                    page 6
                                                                      NMS EXCHANGE

Open Architecture as a Disruptive Business Model
by Gregory Curtis, Chairman, Greycourt & Co., Inc.

                             Open architecture       Examples of disruptive business models             brought to grief by earlier disruptive models,
                             financial advisors      obsolescing existing competitors, even             the dominant firms did nothing (or, as we will
                             offer institutional     huge, powerful ones, are legion. Looking           see, very little) while the aggressive new firms
                             and other in-           at the past, for example, consider Henry           ate their lunch.
                             vestors objective,      Ford’s introduction of the assembly line into
                                                                                                        Why didn’t the traditional financial advisors
                             unconflicted            the auto industry, which eliminated dozens
                                                                                                        immediately embrace open architecture?
                             advice because          of competitors in one fell swoop; the
                                                                                                        There are numerous reasons, of course, but
                             they have sepa-         introduction of the telephone, which nearly
                                                                                                        let’s focus on the most important of them,
                             rated the busi-         eliminated the telegraph (and marginalized
                                                                                                        using examples provided by Christensen.
                             ness of giving          then-powerful Western Union); the intro-
                             advice from the         duction of the tabletop copier not by Xerox,       Reason #1 – Big firms can’t do small
business of selling proprietary investment           IBM or Kodak, but by Canon and Ricoh;              things. When a disruptive business model
products. This advisory platform has powerful        the introduction of the personal computer,         is introduced, it is often a “stealth” model,
appeal to investors. But in this article I           not by IBM or Digital (who had pioneered the       introduced on such a small scale that even
will focus not on the impact of open                 minicomputer), but by dozens of theretofore        though existing competitors are well aware
architecture directly on investors, but              unknown companies; the introduction of             of it, its footprint is too small to be of
rather on its impact on the financial                discount brokerage, not by the giant full-         interest. By the time it has become clear that
services industry—in other words, on                 service firms but by Schwab and others             the market for the new model is huge, it is
open architecture as a disruptive business           (causing most of the full-service wirehouses       too late for the existing competitors—the new
model. Investors searching for advisors              to disappear).                                     firms own the business.
today will find that the open architecture
                                                     Open architecture is a disruptive business model   This situation has prevailed in the open
revolution has had a profound effect on the
                                                     that began to appear in the financial services     architecture world from the beginning—the
way that even the most traditional financial
                                                     industry in the mid-1990s. As is usually the       global market for open architecture services
advisors now do business. Understanding
                                                     case with disruptive models, open architecture     was simply too small to be appealing to
the impact of open architecture can help
                                                     was invented and launched not by the tradi-
investors make more informed decisions                                                                                                ...continued on page 11
                                                     tional com-
as they navigate their way through the
                                                     petitors in the
financial services minefield.
A “disruptive business model” is one that            p e n s i o n
blindsides existing competitors in an                consultants,
industry so completely that they are                 investment
largely unable to defend against it,                 banks, tradi-
essentially ceding industry leadership to a          tional banks
new generation of firms. Disruptive busi-            and trust
ness models were first identified by J. L.           companies—
Bower and Clayton M. Christensen                     but by thereto-
in their classic 1995 Harvard Business               fore unknown
Review article, “Disruptive Technologies:            s t a r t - u p
Catching the Wave” (1995). The theory                boutiques. The
of disruptive innovation has been described          existing firms
by Christensen, who has become the dean              had known
of disruption theory, like this:                     since at least
                                                     the mid-1970s
“We view disruptive innovation as a
                                                     that conflicted
dynamic form of industry change that unlocks
tremendous gains in economic and social welfare.
Disruption is the mechanism that ignites the
                                                     which conflicts
true power of capitalism in two ways. First, it is
                                                     of interest were
the engine behind creative destruction. . . .
                                                     endemic, were
Disruption allows relatively efficient producers
                                                     harmful to
to blossom and forces relatively inefficient
                                                     investors and
producers to wither. This destruction, and the
                                                     needed to be
subsequent reallocation of resources, allows
                                                     replaced with
for the cycle of construction and destruction to
                                                     a new model.
begin anew, enhancing productivity, lowering
                                                     Yet, like the
consumer prices, and greatly increasing economic
welfare." [From Clayton M. Christensen,
                                                     firms in other
Sally Aaron, and William Clark, “Disruption
                                                     industries that
in Education.”]
                                                     had been

                                                                             page 7
                                                                        NMS EXCHANGE

In the Search for Alpha, Don't Forget Your Beta (continued from page 3)

A Different View                                      benchmark. One obvious solution is to patch conversation could not be undertaken based
In simple terms, management must                      the gap with futures contracts where available on the information from Figure 1.
continuously measure the market or                    (portfolio completion). This is easy and cheap
                                                                                                          On the flip side to this scenario is the agency
benchmark exposure of each asset class to undertake and is a form of rebalancing, as
                                                                                                          problem. Management might boast that the
in the portfolio. One condition for this set out in Figure 3.
                                                                                                          portfolio’s returns were better than the
is, of course, that the benchmark for this
                                                      It should be noted that Asset Classes 3 and 4 benchmark, with less exposure to the markets.
analysis is investable and passive investing
                                                      had to be shorted to bring the benchmark Although on the one hand this is admirable,
is available. Otherwise, the discussion may
                                                      exposure in line with the asset allocation          how does this meet the expectations of the
only help explain relative performance against
                                                                                                                                      policy portfolio? The
the benchmarks. We
                            Figure 2                                                                                                  presumption is that the
acknowledge         that
                                                                                                         Return        Weighted       policy portfolio (or
this concept most             Asset Class      Asset     Actual    Weighted   Beta to    Benchmark
                                                                                                    Attributable to      Policy       asset allocation) is not
easily relates to the                       Allocation Return       Return  Benchmark      Return
                                                                                                      Benchmark        Portfolio      just about return expec-
traditional marketable
                            Asset Class 1      15%        11%       1.65%      0.85          10%         1.3%            1.5%         tations but also desired
long-only securities.
                                                                                                                                      market risks. This issue
This excludes alter- Asset Class 2             25%         5%       1.25%       0.4          6%          0.6%            1.5%
                                                                                                                                      needs to be resolved
native assets (i.e.,        Asset Class 3      10%        15%        1.5%       1.5          10%         1.5%            1.0%         with the committee as
hedge funds, private
                            Asset Class 4      15%        20%        3.0%       1.1          14%         2.3%            2.1%         part of the investment
real estate, timber and
all forms of private        Asset Class 5      35%         8%        2.8%      0.75          10%         2.6%            3.5%
equity), as they do not     Total                                   10.2%                                8.3%            9.6%         In order to make this
tend to have investable                                                                                                               analysis worthwhile,
benchmarks. However,                                                                                      there are a number of matters that should be
                                                      (and this could be done through futures or
REITs and commodities can be included                                                                     addressed. These might include:
                                                      ETFs). Similarly, all but the transactions for
because of the availability of investable
                                                      Asset Classes 2 and 5 may be too small and • Decide on the measure of beta: Choose one and
                                                      not worthwhile on a cost-benefit basis. In stick to it, as no choice will be perfect.
Now let us return to the five asset class             the example, we have only dealt with the • Distinguish alpha, beta and active premium.
portfolios described above and look at how positive performance. If historical betas hold, • Develop a process of analysis.
monitoring market exposure provides a much this portfolio may have some downside                          • Develop a decision-making process: After
clearer return analysis. (See Figure 2.)              protection, although that is not clear from going to the effort of analysis, it would be
                                                      the present analysis. Regardless, it provides good to do something with it.
It is clear that there is substantial tracking
                                                      management with tactical information. • Do the work before the time to decide or trade:
error in the portfolio. In particular, this view
                                                      The investment decision now turns on                Benchmark matching is not always easy. For
shows the portfolio’s implicit tactical asset
                                                      whether tracking error is desired and, if           example, although the Russell 2000 has a
allocation as revealed by
                                                                                                                                 futures contract, it is not as
the beta and shows that Figure 3
                                                                                                                                 liquid or abundant as the
the portfolio exceeded                                           Weighted                            Futures
                                                                                                                   Returns       S&P 500 futures contract.
the benchmark by 190 bp           Asset       Asset     Actual    Return     Beta to   Benchmark Allocation
                                                                                                                    from         So might it be easier (in the
because of the lower risk         Class    Allocation Return from Asset Benchmark         Return       to
                                                                  Classes                          Benchmark                     event of adding to domestic
profile (as opposed to the
                               Asset                                                                                             equity) to add S&P 500
60 bp under Figure 1).                        15%        11%      1.65%       0.85         10%       2.25%          0.2%
                               Class 1                                                                                           futures and a small- to mid-
However, due to the lower
                               Asset                                                                                             cap ETF?
market exposure, the                          25%         5%      1.25%        0.4          6%       15.0%          0.9%
                               Class 2                                                                                           • Ensure someone owns the
portfolio only exceeded
                                                                                                                                 process: Other priorities will
the policy portfolio by 60 Asset
                                              10%        15%       1.5%        1.5         10%      (3.33%)        (0.5%)        get in the way, so someone on
bp. The issue arises that Class 3
                                                                                                                                 the management team has to
the portfolio is balanced Asset
                                              15%        20%       3.0%        1.1         14%      (1.50%)        (0.2%)        own the process and be able
on a dollar-weighted           Class 4
                                                                                                                                 to focus decision makers on
average, but its market        Asset          35%         8%       2.8%       0.75         10%       8.75%          0.9%         the decisions at hand.
sensitivities skew the         Class 5
allocation away from the       Total                              10.2%                                             1.3%         We all have personal
desired allocation.                                                                                                              opinions as to whether the
                                                      so, how much; whether market exposure                                      portfolio should be com-
Although management
surpassed the policy return target, alpha was         is generally cheap or expensive; what the pleted and how. Ultimately, it is up to both
                                                                                                          the committee and management to establish
used to patch a shortfall in beta (benchmark portfolio is paying for beta; whether the
                                                                                                          the policy, the policy portfolio and the process.
exposure). It may well be that management portfolio should be completed or rebalanced;
is good at selecting managers, but the mix            and what the method of beta collection should The important issue is to make an informed
                                                                                                          decision on the portfolio’s market exposure.
of managers in each asset class does not be. In addition, the analysis of a proposed
                                                                                                          So when the focus is on alpha, remember that
provide accurate coverage of the asset class investment becomes a little deeper. This
                                                                                                          beta has a role to play as well. h

                                                                               page 8
                                                                      NMS EXCHANGE

It's Different This Time (continued from page 4)

a proper risk premium, actions may be speaking      interest in purported advanced investment            this risk must be fairly priced and uncorrelated.
louder than words. Over the last few years,         techniques such as portable alpha strategies,        To do so means that investors must first have
investors have chased return, almost oblivious      which offer the allure of creating return simply     a very thorough understanding of the risk that
to risk and high fees. Hedge fund assets have       by combining alpha from one asset class with         is in their portfolios. This should be based on
doubled to reach a trillion dollars, and risky      beta returns from another.                           some sort of a risk budgeting approach to
assets have outperformed quality assets as                                                               portfolio construction, optimally aided by
                                                    For investors focused on capturing increased
investors chase return. This pursuit of return                                                           separation of alpha and beta sources of return,
                                                    return for their portfolio and who feel risk
shows up in the dramatic outperformance of                                                               with their very different risk profiles (alpha
                                                    premiums will remain lower than historic
emerging-market and small-cap stocks, high-                                                              being manager risk and beta being market
                                                    averages, there is really no magic bullet such
yield debt, a flat yield curve and the tremendous                                                        risk). Then investors need to stay fully aware
                                                    as portable alpha, or simply investing in
growth in structured products such as CDO                                                                of, and truly understand, the expanding field of
                                                    potentially overpriced, riskier assets. The most
funds (where the true underlying risk is almost                                                          asset classes and investment strategies as they
                                                    direct route is to simply add back some of the
unknowable to the final investors). Another                                                              look to fit new exposures into their portfolios.
                                                    volatility that supposedly has been removed
example of investors’ pursuit of return is the                                                            h
                                                    via the aforementioned structural changes. But

Are Hedge Fund Fees a Bargain? And Other Conundrums of Balancing Active and Passive Management (continued from page 2)
this portfolio will have the vast majority of its   leaves total fees for the equity portfolio of 80     chosen selection of, say, 200 or 300 of these
weight in large markets, and indeed in large-       bp. This is a very reasonable price to pay for       stocks will provide almost all the diversifi-
cap stocks within those large markets. Being        a high-performance, low-volatility portfolio.        cation the index would offer. A fund manager
passive, this portfolio will not outperform a       And, of course, if the managers don’t perform        could potentially offer a very attractive
benchmark with the same country weights,            well, the overall portfolio fees will be far below   alternative to fill the slot occupied by the
but it will benefit from the long-run upward        what most active managers charge.                    passive portfolio in the example above, with
drift of equity markets. (Plausible estimates of                                                         a product that charges fees only slightly
                                                    Is There Hope for Active Long-Only?
the premium for stocks over fixed income over                                                            higher than passive (say 20 or 25 bp), offers
                                                    It would appear that perhaps there is no role
the next century are in the range of 3% per                                                              diversification only slightly less (and volatility
                                                    remaining for the ALO manager—the bundled
year, meaning money invested in stocks will                                                              only slightly greater) than the index itself
                                                    product they offer simply is not attractive
grow to an amount 20 times larger than the                                                               and attempts to select a large group of stocks
                                                    when a tailored portfolio can be created from
same amount invested in bonds.) And it will                                                              that will outperform by perhaps 50-80 bp.
                                                    well-chosen parts. And, indeed, our view is
get this benefit in the lowest-risk, lowest-cost                                                         Essentially such a manager is saying, “Why
                                                    that many ALO managers are offering a
way possible.                                                                                            not throw out the least attractively priced 200
                                                    product that has little appeal even at a very
                                                                                                         or so stocks and just buy the rest?” The idea
Now consider the other 20%. Suppose it is           low price, and none at all at the fees currently
                                                                                                         that such a strategy could work is inherently
invested with managers who buy $1 and sell          being charged.
                                                                                                         plausible, and if the implementation uses a
short $1 of stock for each dollar they manage.
                                                    But there is a kind of ALO product that              low-cost methodology (e.g., a quantitative
The managers selected should be working
                                                    still has a valuable role to play in the money       approach), it may be possible to run the
in the most inefficient, “type B” markets in
                                                    management business. After all, one might            business profitably with very modest fees.
which top-quality managers can be found.
                                                    usefully ask: why should the passive part of the
This means not only foreign markets, but                                                                 The primary lesson here is that active long-
                                                    portfolio be passive? Consider the S&P 500
also small-cap, special situations, activism or                                                          only products have a number of hurdles to
                                                    index. This set of stocks makes up over one
anyplace else managers are likely to be able                                                             overcome before they earn a place in a well-
                                                    third of the world’s market capitalization and
to turn skill into profits. Obtaining this talent                                                        designed portfolio. A portfolio that obtains
                                                    so, as a group, deserves substantial representa-
will require paying the supposedly high fees of                                                          its beta in the best place for beta and its alpha
                                                    tion in any portfolio lest an opportunity
hedge fund managers—say 1.5% management                                                                  in the best place for alpha is the ideal choice.
                                                    for diversification be lost. Of course it is
fees and 20% of profits. If these managers do                                                            But smart, efficient ALO managers can offer
                                                    among the world’s most efficiently priced
a tremendous job and create 10% returns with                                                             products that provide beta in a way that may
                                                    stocks. But that is not to say that skilled
no market exposure, they will earn a fee of                                                              be even more appealing than the passive
                                                    analysis (quantitative fundamental, perhaps
1.5% + 10% x 20% = 3.5%. 350 bp on 20%                                                                   products that have traditionally been the best
                                                    even technical) cannot find reasons for
of the portfolio is 70 bp; adding in 10-20 bp                                                            choice in that space. h
                                                    preference among the group. And a well-
for global passive products, multiplied by 80%,

 The NMS Institutional Select Series
 The NMS Institutional Select Series provides institutional investors with exclusive, closed-door roundtable meetings focused on specific asset
 classes and functions. These smaller, intimate forums are “By Invitation Only” and bring together investors who already have a well-developed
 expertise in a particular area with some of the most successful and renowned investment managers who focus on that “space.” After meeting
 predetermined criteria to participate in the roundtable, investors gather to debate the full range of issues confronting sophisticated investors via
 facilitated discussions. A hallmark of the NMS roundtable is that participants must attend all aspects of the program, including both the sessions
 and social events. NMS does not market or endorse any investment products or services, which enables us to provide entirely independent and
 unbiased programs in a non-commercial setting of peers. NMS has expanded its offerings under the Institutional Select Series to include four
 meetings: Hedge Funds, Private Markets, Real Estate/Real Assets and an exclusive roundtable for CIOs.

                                                                             page 9
                                                                       NMS EXCHANGE

Challenges Facing Today’s Institutional Investors (continued from page 1)

function, is raising the stakes for strong          flexibility of the staff to manage the overall        absorbed by the base fee. And what about
investment professionals. We are all strug-         portfolio, particularly for foundations like the      the prevalence of deal fees for transactions
gling to keep up with a compensation                Corporation that receive no new gifts. We             and for monitoring portfolio companies?
structure that is highly dynamic,                   are asking managers with longer lock-ups to           (Isn’t this why we pay an incentive fee?) This
a problem that has contributed to a high            allow the redemption of annual spending, as           practice is not doing anyone a favor, even
level of staff turnover among institutional         private foundations are required by the federal       when managers appropriately credit these fees
investors.                                          government to spend a minimum of 5% of                against management fees. They are merely
Portfolio Management Limitations                    average assets each year to maintain their tax-       robbing Peter (the portfolio companies) to
                                                    exempt status.                                        pay Paul (the GP), creating the fiction that
Competition for manager allocations. Don’t tell                                                           management fees were reduced, when in fact
your friends.                                       Managers are closed. Yes, really.
                                                    A significant percentage of the Corporation’s         our portfolio companies are just worth that
There is increased interest and willingness                                                               much less. Unfortunately, competition among
among endowments and foundations to invest          marketable and absolute return managers are
                                                    closed, both to existing and new investors,           LPs for allocations, let alone access, to top
in specialized investment strategies, even for                                                            managers means that investors have little
start-up, or “emerging” managers. LPs must          which I suspect is true for many institutions.
                                                    We respect our managers enormously for                influence over the imposition of increased
fight hard for limited allocations, lest we be                                                            fees. At the end of the day this lowers re-
crowded out by our peers. (Who hasn’t been          refusing new capital inflows, but it reduces
                                                    the staff’s flexibility to rebalance the portfolio.   turns, particularly on a risk-adjusted basis.
cut back substantially in recent months?) In                                                              And, of course, fees are rising at a time
the event a first-time manager is successful,       Once we take money away from a manager it
                                                    cannot be recontributed later, which causes           when valuations are at high levels around the
competition in the next fund raise is even                                                                globe (though some have recently become
more intense. To preserve option value and          us to think very carefully before doing so and
                                                    limits our options.                                   cheaper), which does not bode well for future
make investments that will actually move the                                                              returns. Alternative asset investing is not
needle in the portfolio, we should be making        Management Fees and Expenses                          immune to the forces of supply and demand—
a larger commitment at the time of greatest         They’re going up, and up.                             and today we are surely in a seller’s market—
uncertainty, i.e., when managers are raising        Fees in alternative asset classes are increasing      but disappointing returns, risky behavior and a
Fund I.                                             to inappropriate levels in the aggregate. Base        misalignment of interests may very well reset
Longer lock-ups. 3, 5, do I hear 10?                management fees of 2.0% or more in some cases         expectations and—eventually—bring pricing
Managers are imposing lock-ups where none           enrich managers at the expense of investors,          back down to earth.
existed in the past, or are increasing the length   particularly as assets under management               The next decade will be a challenge if these
of the lock-ups. While we think lock-ups are        increase. Moreover, managers are charging             trends continue. h
healthy within reason, they constrain the           expenses to investors that formerly were

Long-Run Goals, Short-Run Actions and the Trick to Unification (continued from page 6)

and maximize the comparative advantage that         an institution. The second avoids situations          foundations, in which ill-defined problems
comes from being a long-term investor in a          that could be deemed either too profligate            make any purported answers speculative or
short-term world.                                   or unreasonably miserly. The third explicitly         hypothetical at best.
                                                    addresses the importance of stability in
Happily, the above premise is not a case
                                                    the budgeting process. The fourth provides            Put one foot in front of the other
of easier-said-than-done. The main obstacle
                                                    insurance against the proverbial “hundred-year        And soon you’ll be walkin’ out the door
is simply abandoning the long-standing
attachment to spending a fixed percentage of
                                                                                                          -Kris Kringle, Winter and friends from “Santa
assets (however smoothed through multiperiod        A “Controlled Growth Distribution Policy”
                                                                                                          Claus Is Comin’ to Town”
averaging). A superior approach to setting          constructed along these lines provides
spending policy involves four simple steps:         clarity with respect to investment policy
                                                                                                          Our North Pole friends remind us that the
                                                    by freeing an institution to pursue the goal
1. Target a year-over-year percentage increase                                                            long run is really a sequence of short-run
                                                    of long-term wealth maximization, while
   in dollars distributed                                                                                 periods, and our challenge is to ensure that
                                                    substantially reducing the risk of short-term
                                                                                                          our short-run actions keep us on the
                                                    dislocation. Creative investors can analyze
2. Establish a budget that constrains                                                                     path to long-run success. Only by taking
                                                    the “liability stream” created by this type
   distributions within a percentage range                                                                an integrated, unified view of the role
                                                    of spending policy and find rational
   of assets                                                                                              that investment portfolios play within the
                                                    investment policy solutions that can
                                                                                                          economics of the sponsoring enterprise can
                                                    maximize success over both the short and
3. Set reasonable caps and floors on year-                                                                we meet this challenge, and in this regard
                                                    long runs. This means rethinking and clearly
   over-year changes in the distribution amount                                                           bridging the existing gap between spending
                                                    defining the role of each asset category
                                                                                                          and investment policies is key. Change is
                                                    within the portfolio mix, along with
4. Specify reasonable risk controls that                                                                  rarely simple, especially when it requires
                                                    adopting innovative approaches to strategic
   minimize the impact of extreme market                                                                  deviation from supposed best practices, but
                                                    and tactical decision making. Solutions may
   downturns                                                                                              certainly the multigenerational prosperity of
                                                    not be easy or formulaic, but they do exist.
                                                                                                          our endowed institutions is worthy of our best
The first step establishes the unambiguous          This is clearly preferable to the framework
                                                                                                          efforts on this front. h
primacy of the variable that matters most to        currently in place at most endowments and

                                                                              page 10
                                                                     NMS EXCHANGE

Open Architecture as a Disruptive Business Model (continued from page 7)

the huge financial powerhouses that then           ing, while open architecture is all about           What is the impact of all this change
dominated the advisory business. These             improving client investment performance.            on investors searching for new advisors?
firms weren’t unaware of open architecture;        Changing the culture of the old-line firms would
                                                                                                       The main challenge for investors is the
they simply saw no reason to enter a               require changing the personnel, starting at
                                                                                                       turmoil that is roiling the industry as a
business that couldn’t possibly have a             the top and working all the way down the line.
                                                                                                       result of the introduction of open archi-
significant effect on their gross revenues
                                                   Reason #4 – A large installed customer              tecture. In a free-market economy, industry
or bottom lines. Meanwhile, the open
                                                   base for the old products is a huge obstacle.       ferment is typically a long-term positive
architecture business has been “branded”
                                                   Like firms in other industries that were un-        for customers, but in the short run
by a group of still-boutique-sized firms
                                                   done by new, disruptive business models,            confusion can reign. Here are a few sug-
that will likely own the market by the time
                                                   traditional financial advisory firms have           gestions for investors who may be searching
the big firms have taken a serious interest.
                                                   thousands of investors who like the product         for advisors in a transforming industry:
Reason #2 – Existing competitors often             they are getting. Many traditional firms
                                                                                                       (1) Investors may find it prudent to avoid
have outmoded cost structures. Sometimes a         are listening to these customers and ignoring
                                                                                                       the few remaining closed architecture
new business model simply can’t be adopted         the “early adopting” customers, investors
                                                                                                       firms. Although some of these firms
by existing competitors because their cost         who have migrated to the open architecture
                                                                                                       are quite competent at managing their
structures are too high. Sears Roebuck & Co.       model. Since the old firms aren’t actually
                                                                                                       conflicts, the model is dying out and the
was an American retailing icon, for example,       losing clients, they have failed to notice
                                                                                                       best professionals are fleeing. The endgame
but its position was undercut by Wal-Mart’s        that their businesses aren’t growing nearly
                                                                                                       for the best of these firms is life as a pure
far lower costs.                                   as fast as they should be growing. Eventually
                                                                                                       asset manager, with no advice offered.
                                                   a tipping point will be reached when the
Because profit margins had for decades been        existing customers of the old firms will suddenly   (2) A healthy skepticism may be appropriate
unusually high in the asset management             see the light, demand open architecture,            for firms that have recently converted to
business, cost structures in the industry          and abandon the old-line firms.                     pure open architecture platforms. Not only
also grew out of control. Enormous sala-                                                               do most of these organizations lack ex-
ries were paid to people of very modest            In the face of the open architecture challenge,
                                                                                                       perience offering investors strategic advice,
talents, and low-margin back-office tasks were     the traditional competitors have typically
                                                                                                       manager recommendations and consolidated
conducted out of Class A real estate space         responded in one of the following ways:
                                                                                                       performance reporting, but many of them
in midtown Manhattan. Open architecture                                                                will badly underestimate the challenges of
                                                   Some competitors have left the business.
disrupted this cozy world in at least two ways.                                                        managing an open architecture business.
                                                   The decisions by huge global firms like
First, by controlling costs, the open archi-
                                                   Citicorp and Merrill Lynch to exit the asset
tecture firms were able to operate profitably                                                          (3) The majority of firms—those now offering
                                                   management business will seem astonish-
in a business the traditional firms had priced                                                         both open architecture and proprietary
                                                   ing to anyone not familiar with the open
themselves out of. Second, open architecture                                                           options—may appear to offer the best of
                                                   architecture revolution. But to those who
disrupted the prevailing pricing model for                                                             both worlds, but in fact these firms tend
                                                   understand the current dynamics in the indus-
asset management. In the pre-open archi-                                                               to suffer from the objection articulated above
                                                   try, it was clear that these huge firms
tecture world, any firm with a brand                                                                   (lack of experience offering open architecture
                                                   simply could not both compete effectively in
name could charge sky-high fees and get                                                                products) and also to have an incentive to
                                                   the business and also manage their conflicts
away with it. In the post-open architecture                                                            push higher-margin proprietary products even
                                                   of interest.
world, only the most elite firms, those                                                                when superior open architecture products are
with the demonstrated ability to add value         Some competitors have adopted the new               on the menu. Many of these firms
consistently across time, could hope to            model wholesale. A few firms, especially            haven’t even invested in the infrastructure
charge the kind of fees that used to be            those who were already also-rans in the             required to offer an open architecture
routine. In the post-open architecture world,      asset management business, have converted           product, but have outsourced this activity.
everyone else is a commodity.                      themselves to true open architecture
                                                                                                       (4) Pure open architecture advisors have
                                                   advisory firms, eliminating their proprietary
Reason #3 – Corporate cultures are hard                                                                great surface appeal, but many of these firms
                                                   products altogether.
to change. If a new business model requires                                                            are new, small and untried. Due diligence
existing firms to change their culture in          Some competitors are still in denial. A             and reference checking are required.
radical ways, it will be unlikely to happen.       few advisory firms still maintain that they
                                                                                                       For investors willing to do their home-
When Charles Schwab and the other discount         can both advise investors effectively
                                                                                                       work and conduct serious diligence
brokers launched their disruptive business         and also sell those investors proprietary
                                                                                                       on prospective advisors, the open archi-
model, we might imagine that the old-line          products. This model is disappearing fast,
                                                                                                       tecture era offers vastly greater choice
wirehouses would have quickly adopted the          but it is not completely gone.
                                                                                                       and many attractive advisory models
new model. But in fact the old-line firms could-
                                                   Most competitors are straddling the fence.          that possess fewer conflicts of interest
n't change, and most of them disappeared.
                                                   By far the most common response to the              than traditional models. But caveat
Open architecture firms and old-line               challenge presented by open architecture is to      emptor still prevails: investors who fail to
financial advisory firms are both engaged          straddle the fence, that is, to continue to         recognize the impact of open architecture
in the financial advisory business, but their      offer high-profit-margin proprietary products       on the industry are likely to come
cultures could hardly be more different. The       while also offering outside managers and            to grief. h
traditional model is all about asset gather-       products.

                                                                            page 11
                                                                       NMS EXCHANGE

                   Mark Your Calendar for Upcoming NMS Management Forums!!!                                                              H

              September 18-20, 2006                                    October 22-24, 2006                                 December 4-5, 2006
     The Fall Investment Management Forum               The NMS Institutional Select Series:                    The NMS Emerging Managers Forum
        for Endowments & Foundations                               CIO Roundtable                                    Four Seasons Hotel Miami
                 (Members Only)                                  (By Invitation Only)                                       Miami, FL
            Four Seasons Hotel Toronto                  The Ritz-Carlton New York, Battery Park
                  Toronto, Canada                                   New York, NY

               January 28-31, 2007                                      March 11-14, 2007                                 April 28-May 1, 2007
       The Winter Investment Management                    The NMS Family Office Forum:                         The NMS Institutional Select Series:
      Forum for Endowments & Foundations                  Challenges in Wealth Management                            Investing in Hedge Funds
                (Members Only)                                       The Breakers                                      (By Invitation Only)
           The Hyatt Regency Scottsdale                            Palm Beach, FL                                         St. Regis Resort
                 at Gainey Ranch                                                                                        Fort Lauderdale, FL
                  Scottsdale, AZ

                                     July 15-18, 2007                                                 July 18-21, 2007
                         The NMS Institutional Select Series:                             The NMS Institutional Select Series:
                         Investing in Real Estate/Real Assets                                Investing in Private Markets
                                 (By Invitation Only)                                           (By Invitation Only)
                                        TBD                                                              TBD

                            ©2006 by NMS Management, Inc. All rights reserved. Reproduction in any form forbidden without permission.

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