University of Toronto investment fund down...strategies seem risky to me

The Globe & Mail reports that the University of Toronto's pension and endowment funds lost $1.5 billion last year:

It's a fitting backdrop, since UTAM's work is directly linked to the financial well-being of the campus. The 14-person operation runs $2.8-billion of staff pensions and $1.5-billion of endowments, which traditionally produces tens of millions of dollars annually for student aid and faculty posts.

But this year the money has stopped flowing after investment losses reached $1.5-billion for 2008 and the university was forced to cancel a planned $62-million endowment payout, representing about 5 per cent of its operating budget.


An examination of its performance shows the vaunted investment fund was clobbered by a sharp reversal in the dollar, an untimely shift away from bonds, and a focus on hedge funds, including $5-million it lost through an indirect investment with Bernard Madoff, the Wall Street financier since jailed for fraud. The currency hedging strategy – essentially counting on the loonie to stay above parity – was one of the hardest hits of all, costing the fund as much as $600-million.

The fund seems to have been influenced by the investment techniques of Harvard and Yale—these two are to passive institutional investing as Warren Buffett is to value investing—and invested in somewhat riskier strategies. However, the big mistake seems to be their inopportune currency hedging. A lot of people, including Francis Chou of Chou Funds, started hedging at the worst time. I don't think there is a right answer to currencies. I personally do not hedge—too costly for me but even if I had a choice I wouldn't—but try to invest with a macro outlook. In general, it is really difficult to predict currencies and I wouldn't worry about it. The only time you should be careful is when investing in emerging markets, which tend to have very volatile economies and, more importantly, unstable governments. If you are into risk arbitrage, you should also consider currencies (since the returns tend to be low and fixed and the currency fluctuation can wipe out 30%+ of your potential return.)

Another big mistake made by endowments and other funds is their switch away from bonds. Historically, endowments, and even insurance companies, have allocated a big chunk of their portfolio to bonds. Doing so depressed returns but provided safety. But, given the bull market in stocks in the last few decades, most have moved away from bonds. This came back to haunt a lot of these funds—baby boomers also got killed with this trend away from bonds.

Anyway, the surprising thing to me is how much the UofT fund managers have allocated to alternative assets:

Hedge funds now account for the largest portion of UTAM's investments in “alternative assets,” which also include holdings such as private equity, infrastructure, commodities and real estate. The university's pension fund had 46 per cent of its assets in this “alternative” category at the end of last year – up from just 18 per cent the year before – while equities accounted for 39 per cent of the holdings and bonds 15 per cent.

That mix is significantly more aggressive that the average fund of UTAM's size. Data show an average Canadian pension fund with more than $1-billion in assets held 46 per cent equities, 29 per cent bonds and 25 per cent alternative assets in 2008.

Wow, their pension fund has almost half (46% to be precise) their holdings in alternative assets. I have a really, really, bad feeling about this! This looks like a risky strategy to me. This is just speculation but my opinion is that a lot of unrealized losses are concentrated in those alternative assets, such as hedge funds, but more likely private equity and real estate.

To illustrate the unrealized losses, think about all those overvalued, over-leveraged, companies that were purchased by private equity near the peak. A lot of those companies, unfortunately, will go bankrupt. The forecast cash flows, which likely was off high profit margins, won't materialize and there is no way they can service the high debt. Well, I suspect a lot of these private equity investments haven't been written off yet. These losses will only materialize over time, as businesses fight until the last possible moment.

Similar arguments can be made hedge funds that invested in commercial real estate, credit card loans, certain corporate debt, and so on. All of these areas have the potential to post sizeable losses in the future. I'm not predicting it but it does make me question what UofT's alternative investments are exposed to.


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