During the late 1990s and the three-year bear market that ended in 2003, large, institutional portfolios–which were traditionally invested in stocks and bonds–suffered. They missed the huge gains in venture capital and private equity in the second half of the 1990s, bought into technology and In-ternet stocks just before they crashed, and were criticized for being unimaginative, stodgy and prone to debilitating committee-think.
At the same time, two new tribes of heroes were rising in the investment world–hedge funds and college endowments. In the devastation of the bear market, hedge funds prospered. For the five years that ended March 31, 2003, a hedge fund at the middle of the pack earned 7.8 percent a year, and one in the 75th percentile returned 12.7 percent. By contrast, the S&P 500 had a negative total return (including dividends) of 3.6 percent per year.
The other heroes were the endowments of major colleges such as Yale, Harvard and Stanford. Yale’s endowment has grown 17 percent a year for something like 20 years now, and has transformed the economics of the university. Its chief investment officer, David Swensen, has become big money’s Warren Buffett. All these schools emphasize absolute return strategies (hedge funds), private equity, venture capital and real assets (timberland, oil and gas, real estate, commodities). These asset classes are much less liquid than good old stocks and bonds, but they are good diversifiers–they don’t go up and down with the stock market.
Licking their wounds, owners of big money–whether pension funds, endowments or wealthy families–began asking their investment managers why their performance was so lousy compared with Yale’s or Harvard’s. Their response was to pour money into the asset classes that the new heroes had exploited: hedge funds, private equity and venture capital. Everyone wanted to be another David Swensen. In the huckster tradition of Wall Street, supply rises quickly to meet the new demand. Of course, inevitably the new supply is of lower quality. The range between the top quartile and the median fund in all three asset classes is very large, and there is no asset class that too much money can’t spoil. Expect far less inspiring future returns from all three, particularly private equity.
As for real assets, the supply of oil and gas deals and timberland is very limited. What was readily available was commod-ities, so money poured into that asset class and into commodity-trading funds (CTFs). Traditional hedge funds also began buying commodities because that’s where the action was.
At the time, commodities were emerging from a vicious bear market that began in the late 1970s. Throughout the 1990s, the long decline in prices and onerous environmental regulations discouraged companies from opening new mines or adding new capacity. But then demand for oil, steel, coal, nickel, iron ore and aluminum skyrocketed in the developing world. Suddenly commodity users found to their dismay that they had to bid up prices in competition with a new class of buyer–investors. Even worse, some of the investors were outright speculators. Put simply, CTFs buy what is going up and sell what is going down, and devil take the hindmost. The collision between real buyers, the hedge funds and the asset-class investors sent commodity prices halfway to the moon.
In recent weeks investors have begun to worry that central banks are raising interest rates even as growth is slowing in the United States and is still fragile in Europe and Japan. In other words, the banks are making a “policy error” that could result in a slowdown, even a global recession. The result has been panic selling of equities, commodities, gold and silver. The selling has little to do with the fundamentals of these assets, and a lot to do with who owns them. I think it’s a cyclical bear market within a bull market in both commodities and emerging markets, but, of course, I could be wrong. If so, the herd will once again have zigged when it should have zagged.
