Yale Model vs. Regulation

August 17, 2011

by Chidem Kurdas

David Swensen, the chief investment officer of Yale University’s endowment, rightly criticizes the behavior of mutual fund companies. Then he wrongly attributes the problems to regulators’ hands-off approach and argues for additional regulation. In fact the companies’ behavior reflects comprehensive rules dating to the Franklin Roosevelt administration. Mutual funds, among the most regulated of  financial services, would not be what they are without the regulatory system that spawned them. It is notable that no matter how much regulation exists, someone will want more.

To improve investment options for most Americans, the rules need to be changed and simplified to allow flexibility, not made even more cumbersome.

This would be consistent with the “Yale model” of investment pioneered by Mr. Swensen and adopted by other endowments. His approach is to invest in a wide variety of markets and strategies, from natural resources to private equity and hedge funds. The latter are not meant for middle-class investors, who typically depend on mutual funds and exchange-traded funds.

But there is one way to bring retail investments closer to the Yale model—-by reducing regulation, not by adding to it, in particular regarding fees. Mutual funds are paid a management fee assessed as a percentage of capital. By contrast hedge funds, often described as lightly regulated in comparison to the heavy-duty regulation of their mass-market cousins, charge a performance fee from profits.  Certain successful hedge funds charge only a performance fee, no management fee—that is, they get paid only if they make money.

Regulation prevents mutual funds from taking performance fees. The result is that their focus is on getting more capital so as to increase their management fee revenue. As Mr. Swensen writes in the NYT:  “In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets— and invest poorly.” So why not give them an incentive to invest better by allowing them to be paid from profits? The Securities and Exchange Commission  could permit a group of actively managed mutual funds to charge a performance fee instead of a management fee.

A manager who relies on performance fee revenue has to, well, perform in order to stay in business. Hedge funds do go out of business, whereas mutual funds that made large losses have survived on client assets. Only managers confident that their strategy has a good chance of showing a profit will agree to performance fee compensation.

Of course, anyone can be sideswiped by markets. Even Mr. Swensen—-in the 2008 crisis Yale and similar  endowment portfolios did not do well because investments that were supposed to be diversified fell into lockstep.  He has argued that the diversified approach shows its benefits in the long run. Individual investors, too, are generally better off investing long-term.  And they’d have a better chance of diversifying if mutual fund rules allowed greater diversity.

The additional rules Mr. Swensen prescribes won’t do this. To encourage investors to pick low-cost index funds instead of high-cost, actively managed funds, he suggests that the SEC  require every actively managed mutual fund offering to be accompanied by an index fund alternative, with a comparison of the two options.

The problem is that investors generally don’t read fund offering documents.  Prepared according to SEC rules, fund documents are so tedious that almost nobody reads them except lawyers, who parse them word by word when there is litigation. Mr. Swensen wants investors to educate themselves, but laudable as that wish is, people are unlikely to devote more time to this purpose. Some have an interest in the topic; most don’t.

The SEC now allows summaries or short versions of fund descriptions that investors might actually read. As a mutual fund client, I’d like to see a crisp one-pager for a fund that charges fees if it makes money.

15 Responses to “Yale Model vs. Regulation”

  1. N. Joseph Potts Says:

    Why not allow anyone who invests for another person (at that person’s invitation) receive payment according to any formula agreeable to both parties?

    This poster’s “relevance” MAY be relevant (I’m not really any judge of that), but ultimately, it’s not that interesting.

    But at least I READ the post, unlike my mutual-fund documents.

  2. Roger McKinney Says:

    Excellent points! I have been reading Ineichen’s “Absolute Returns: The Risk and Opportunities of Hedge Fund Investing” and he clearly shows that hedge funds are far safer than mutual funds because they can hedge against risks.

    It’s unbelievable that the state dictates that only wealthy people can take advantage of the safety and performance of hedge funds while requiring the average investor to suffer from group think in mutual funds.

  3. Jim Says:

    Last time I checked, average mutual fund return for investors was about 3%.

    Which belies the fact that most mutual funds can not beat index funds (with significantly lower fees because it takes about a day to set up an index) over time. Why could they? There is no reason to believe finance majors without any practical experience in companies can actually ‘pick’ stocks. Only the Ponzi hierarchy of auditing firms equals the strange and ineffective organizational structure of Wall St. finance.

    The dirty secret is that between social security (a Ponzi scheme, not an investment) and mutual fund regulation, most folks are effectively barred from significant return on capital, which is the principal vehicle for the rich to get richer.

  4. chidemkurdas Says:

    N. Joseph Potts–
    Re “Why not allow anyone who invests for another person (at that person’s invitation) receive payment according to any formula agreeable to both parties?”

    In the abstract, yes, but in reality we’re extremely far from such a world. So the practical question is how to reduce at least some of the handicaps we face as mutual fund investors. And most Americans are mutual fund investors.

  5. chidemkurdas Says:

    Roger McKinney–
    I’ve always found Ineichen’s work very useful. He’s really an excellent source, combing deep financial experience with analytical sophistication.

  6. chidemkurdas Says:

    Jim–
    Yes, there is much to be said for index investing rather than actively managed funds. Every once in a while someone does persistently beat market indexes. But that does not happen much in a mutual fund setting, the way it functions under current regulation. A mutual fund manager who does beat the index typically moves to a hedge fund or starts his own. Allowing performance fees in mutual funds would help them retain good managers.

  7. Roger McKinney Says:

    Potts, with the ridiculous regulatory situation, the best that the average investor can do is invest in indexes after a depression and then get out and into bonds before the next one. If he is sophisticated enough, he can use options to hedge against a decline himself.

    But the main thing is to know the ABCT intimately so he can anticipate a good time to get out of the index fund and into stocks.

  8. chidemkurdas Says:

    Roger McKinney–
    Timing the market is notoriously tricky. I’d say that for most investors the part of your program to
    “then get out and into bonds before the next one.”
    is not realistic.

  9. Roger McKinney Says:

    I think timing is possible if you study the stages of the ABCT closely. You won’t be able to pick the tops and bottoms, but you can do far better than buy and hold.

    The alternative is to diversify between stocks, cash and bonds in which you’re always losing money in two of the three, then you lose a lot when the stock markets tanks every few years.

    Don’t get me wrong. I don’t think people should day trade or even try to time corrections in the market. They should get into the stock market somewhere after the big drop related to a recession and stay in for several years until the ABCT signals that we’re in the later stages of a boom. Interest rates will be high at that point so it will be a good time to get into bonds.

    Then stay in bonds for about a year until it appears that we have hit the bottom of the recession.

  10. Roger McKinney Says:

    PS, I had very good results following the ABCT before and after the latest crisis.

  11. chidemkurdas Says:

    It’s an interesting idea to base investment decisions on Austrian Business Cycle Theory. It fits the latest business cycle well. From the investment angle, though, the details would matter–like what bonds you bought and when you did so. Perhaps you bought Treasuries.

  12. Roger McKinney Says:

    Actually, I should have bought treasuries, but I got into cash.

    I got into cash in June of 2007, about 6 months before the stock market peak. My trigger was news that companies were setting record profits. Then can do than only because of inflation.

    When the Fed starts raising rates and the yield curve goes negative, and profits in retail/consumer goods are high you know it’s time to think about getting out of stocks. Don’t try to pick the top. That’s too dangerous. It’s better to leave money on the table than to lose any.

    I got back into stocks in late March 2009. That wasn’t the bottom, but it was close enough.

    I got into manufacturing and tech stocks, per the ABCT and made a 26% roi in about 6 months.

  13. chidemkurdas Says:

    I’m very impressed by your getting into cash in June 2007. As I remember, some of the indicators were hard to read. The yield curve, in particular, flattened in 2005. What this meant was much discussed at the time and Alan Greenspan described the unusual behavior of long-term interest rates as a “conundrum”.

    Eventually it may have seemed that the flattening was not of significance and yield curve movements were widely ignored. Your going to cash based on Austrian Business Cycle Theory is a clear reading of evidence that at the time was not much heeded by investors.

  14. Roger McKinney Says:

    Well I don’t want to steal credit from luck, either. My trigger at the time was profits. The mainstream news channels were all trumpeting record profits, especially for retail. I figured that signaled a reversal of the Ricardo Hayek.

  15. chidemkurdas Says:

    Yes, big profits were in the news at the time. Great contrarian move anyway– though you’re not trying to be a contrarian, you have to be to apply ABCT in practice.


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