As CEO of Morgan Creek Capital Management, Mark Yusko advises institutional investors of all stripes and invests in assets across all major classes. The $8 billion fund of hedge funds shop takes an “endowment-style approach” to investing and to find out more about that approach and about current trends among institutional investors—particularly family offices—FINalternatives Senior Reporter Mary Campbell recently spoke to Chapel Hill, N.C.-based Yusko.
How sophisticated are family offices these days in terms of alternative investments?
As with all groups, it’s tough to generalize about family offices. There are some very, very sophisticated family offices, and I think there are less-sophisticated family offices. You see the entire spectrum from people who are still very heavily invested in traditional assets and for whom alternatives are something new, to family offices that essentially look like large institutions and have full teams that are specialists in different segments.
Generally speaking, wealthy families, particularly those with dedicated family offices, have been more sophisticated than the average investor when it comes to embracing and adopting alternative investment strategies. Wealthy families were some of the early adopters of hedge funds, in the ‘70s and ‘80s. They have also always been very up to date and positive about private investing because many of them secured their wealth in the private markets running businesses. If you could generalize, you could say that, on average, family offices tend to be more sophisticated than other types of investors because they have more experience directly in those markets—private equity, real estate, energy, natural resources, commodities—or they had developed networks that were quite strong in helping them get to know the hedge fund area.
How would you compare family offices to say, pension funds or endowments?
In the pension world, again, it’s very bifurcated. You’ve got some very sophisticated pension funds with big staff who have been big users of alternative strategies; you’ve got other pensions where they’ve got no alternatives, no hedge funds, no private, no energy, no commoditie¬s—all traditional investments. In the latter case, it is normally a function of having very little staff—I’ve run into a multi-billion dollar pension fund with one-and-a-half full-time employees, no support team, no resources; they’ve got a consultant, but that consultant has more expertise in building traditional portfolios. They don’t have a large, sophisticated board either, which has been a way that some institutions get exposure to alternatives, so they have ended up not being large users of alternative investments at all.
You say those involved in family offices often have business backgrounds. Bearing in mind that it’s hard to generalize, does that background make them more comfortable investing directly or do tend toward investing in funds of funds or managed accounts?
You can generalize a little bit: If you’re a single-family office with very limited dedicated staff, and the family members are still engaged in the business, it’s unlikely you’re going to have the time to do the due diligence on investment fund managers. Often, they’ll hire a consultant and the consultant will help them pick managers or they’ll be in funds of funds. I often say you have to “resource it or outsource it”—if you don’t have the resources to do due diligence, you’ve got to find someone else to do it. But there are plenty of family offices that are highly sophisticated, have dedicated teams and have plenty of resources to do due diligence and they will go direct.
The challenges of going direct are sheer volume—there are lots and lots of managers out there, thousands of them, and they all claim to be in the top quartile—sometimes it seems like I’ve never met a manager who wasn’t top quartile—and the risks of making a mistake are higher. A group where a friend of mine worked had a fund of funds, and a client terminated it because they wanted to save the fees. It hired seven individual managers. Unfortunately, one of those managers went to zero, and they lost 14 years of fees in one month.
One of the things that I think is a misconception about funds of funds is that they’re just another layer of fees. The reality is that fund of funds are a form of active management. People used to say, "I would never buy a mutual fund because I could buy stocks directly." Well, there’s more money in mutual funds today than there is directly in stocks.
Why is that? Because most people don’t have the time to do research on individual companies, and if you buy an individual company and it goes bankrupt, that’s a permanent loss of capital. It's very similar in the fund of funds space.
Another issue is that you have to have adequate asset size to get proper diversification. You may have a $20 million family office and want to go direct, but many managers have a $10 million minimum. Two managers wouldn’t be a very effective portfolio. You don’t have enough diversification. You’re probably much better off in a fund of funds model where you can get proper diversification across styles and strategies.
Ultimately, there’s room in the marketplace for all of these structures and strategies, and that’s why they all exist. If you’re a super-large, multi-family office with lots of investment staff, you probably can go direct. If you’re a small family office with limited capital and limited resources, you probably want the benefit of consultants or funds of funds or commingled vehicles.
Do you see any trends in the type of alternative assets that family offices are interested in these days?
I would say the biggest trend right now is that families are looking for yield. Everybody wants yield, any way they can get it, whether it’s MLPs, REITs, or high-yield bonds—anything that’s got yield is suddenly attractive. There's a common misperception that somehow yield is better, or more important, than capital gains or total return. I’m not quite sure why there’s this incredible focus right now on yield but it is truly amazing. You’ve got groups out there raising mezzanine funds that are promising double-digit yields and people are frantic to commit to the fund even if they have to lock their money up for multiple years.
Another interesting trend is the taste for long equity. Why do investors suddenly want long equity? The simple answer is because long equity did really great from 2009 to 2012. That’s classic human behavior—human beings always buy what we wish we would have bought. The fact is that long/short underperformed in 2009 and 2010 and it was kind of a jump-ball in 2011, but over that three-year period long/short has trailed long-only, so now, suddenly, everybody wants long-only instead of long/short just about the time, as we’ve seen here in April and May, when you may need long/short more than ever. It’s just human nature and it is one of the primary reasons why the average investor only made 2% over the past 20 years while equities returned 8%
Do you often have conversations like this with investors?
Always. It’s a combination of human nature and the behavioral biases that we all have. It’s also impacted by the media; it’s a lot more fun to write stories about things that are doing well than things that are doing poorly, and people do tend to jump on what’s hot. How many millions of gallons of ink were spilled talking about Facebook upcoming initial public offering? I’ve heard stories of people who sold real assets, real things—oil and gas wells and art—so they could buy Facebook in the IPO. One guy said, "I want to be able to tell my grandkids that I was part of the Facebook IPO." I had to ask, "Really?"
Another thing we are hearing is investors saying, "I want to talk about bonds. Everybody’s buying bonds today." So I’ll say, "Why do you want to buy bonds?" The response is always, "Because they’ve had great returns over the last 10 years." But if you need to make 7% returns, you can’t buy bonds because bonds are only going to make 2%. Ten years ago, the yield was 7% and 20 years ago the yield was 12% and 30 years ago the yield was 17%, but those days are gone. Today the yield is 2% and that’s all you can expect to make.
What type of investments should family offices be looking at these days?
Traditional fixed income is not a good place; we think you should be rotating toward absolute-return and market-neutral strategies where you have a chance to make single-digit returns, but you have a positive correlation to interest rates.
Pure long equity is unlikely to do that well near term, for similar reasons for why you’ve made no money in long equity over the last five years. I think you want to be more in long/short equity rather than long-only equity because there’s going to be a lot of creative destruction and destructive creation in those markets that good, active managers can take advantage of on both the long and the short side.
Another way to make money is to take advantage of the illiquidity premium; we think overweighting private equity, private real estate, private energy and private debt is a tremendous opportunity. We're counseling all of our family office clients that that’s where they should be significantly overweight today. And probably our most popular opportunity right now is what we do in a mixed portfolio of all private strategies on a global basis, from Chinese growth capital to Brazilian farms to apartment buildings and townhouses in Florida, so very interesting private opportunities where we think we can make low-teens returns over the next decade.
In face of what’s going on right now in Europe is the answer simply, stay out of Europe?
No. There are a couple of things you can do to take advantage of the troubles in Europe. You can actually actively profit from turmoil. You can short European financials or Japanese companies related to government expenditures, because their budget deficit problems are just monstrous. You can go short over-levered businesses in the U.S. We think the banks in Europe are a disaster, so we’re finding managers that do a good job shorting those businesses to make money. One of our favorite managers out in California is up 20% this year, all of it from the short side—he hasn’t made much money on his longs but he’s just killing it on the shorts because there’s just so much dispersion between good companies and bad companies now because the stimulus is wearing off.
To protect yourself against financial upheaval, you have to have less in financial assets than real assets; you want to overweight real assets, you want to have at least a portion of your assets in a good currency, like gold, as opposed to other currencies like the yen, euro and dollar, which are locked long-term in a long-term race to the bottom. You want to focus on places where there’s growth and own productive assets.
Editor's Note: Mark Yusko is giving the keynote speach at the FINforums Annual Hedge Fund Summit, which takes place on September 20, 2012 in New York City. For more information and to register, visit www.finforums.com.