[This interview originally appeared in the May/June 2012 issue of the Journal of Indexes.]
Mark Yusko is the founder and head of Morgan Creek Capital Management LLC. From 1998 to 2004, he led the endowment office at the University of North Carolina at Chapel Hill. Journal of Indexes caught up with him recently to discuss the nature of alternative investments.
JOI: How would you define the alternative investment concept? What do you see as its boundaries?
Yusko: There are only four primary investments: stocks, bonds, currencies and commodities. What people think of as alternative investments includes hedge funds, private investments, real estate, managed futures—things that are not traditional investments like stocks, bonds or cash.
A hedge fund is literally just a legal structure, and the term “hedge fund” is about as meaningless as the word “mutual fund.” You have mutual funds that invest in stocks. You have mutual funds that invest in bonds. There are mutual funds that invest in commodities and currencies. But if I own shares of IBM in a mutual fund, a hedge fund, a private partnership or a separate account, it doesn’t change the fact that I own shares of stock.
Another way that people think about defining alternatives is by the “structure” of the investment. For example, private equity is considered an alternative investment. But in reality, it’s just a partnership structure instead of a fund structure. In the end, you own equity or debt in a business. I just don’t see the difference.
We tend to think about alternatives such as hedge funds, private equity, real estate, commodities and structured products as vehicles that allow people to get access to strategies that are different from traditional long-only exposure to stocks, bonds and cash and provide diversification benefits to your portfolio.
JOI: Alternatives are seen more as investments for endowments or institutional investors. Has this always been the case?
Yusko: Alternatives were definitely utilized originally by high-net-worth individuals and then much later by institutions like endowments and foundations. It took years for the average institution, like pension funds and insurance companies, to embrace these strategies—and there are still a lot of institutions that don’t have any exposure at all. The investor base in alternatives was a very small group back in the ’60s and ’70s, and it really wasn’t until maybe the last couple of decades that there was any really big institutional acceptance or adoption. Now, there’s fairly wide acceptance of most strategies, but the endowments and foundations have significantly higher exposures than the average pension fund. In fact, there is still a large percentage of pension funds that have hardly any exposure to alternatives.
JOI: What is the role of alternatives in the endowment model, in your opinion?
Yusko: It depends on which part of the alternative market you’re talking about. The endowment model is about taking a diversified global portfolio and building an exposure that is heavily overweight to equity risk in order to achieve a real return above your spending rate (usually around 5 percent). That doesn’t mean stocks per se, but different forms of equity—public equities, private equities, real estate equity, commodity equity, etc.
Then you want to take advantage of the illiquidity premium, which you have with private equity, private real estate, private energy and private debt. If you think about that model, what exposures are you going to reduce to get exposure to alternatives? Well, you’ll have less exposure to traditional fixed income and traditional equities.
A normal endowment is going to have significantly less exposure to traditional equity in particular. If you look at Yale, for example, I think they’ve got 6 or 7 percent domestic equity, maybe double that amount international equity. That doesn’t mean that’s their only exposure to equity. They have lots of exposure to private equity in both domestic and international markets. They have a lot of exposure to real estate equity, commodity equity, hedge fund equity. It’s just that, in an endowment portfolio, or a sophisticated pension portfolio, or a sovereign wealth fund portfolio, you’re going to get exposure to those four risks that I talked about—equity risk, fixed-income risk, commodity risk and currency risk—in different structures.