“There are some really extraordinary opportunities in the credit world,”

Were I an investor, I would actually do this:

"By Oliver Staley

Jan. 2 (Bloomberg) -- Yale University, whose endowment dropped $5.9 billion in six months because of the recession, is pursuing a recovery by acquiring distressed debt.

“There are some really extraordinary opportunities in the credit world( I AGREE ),” said David Swensen, the school’s investment chief, in a phone interview from his office at the New Haven, Connecticut, university. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels( I AGREE ).”

Swensen, 54, increased Yale’s endowment to $22.9 billion on June 30, from $1 billion in 1985 when he assumed the job, making it the second-wealthiest university in the U.S. The school estimated on Dec. 16 that the fund had fallen 25 percent, to $17 billion, because of the global financial crisis. Swensen, who has updated his 2000 book on investing for re-release Jan. 6, said periodic losses are inevitable in a portfolio tilted toward stocks and built to grow over many years.

“There isn’t an investment strategy that can produce the kind of long-term results we’ve generated at Yale that isn’t going to post the occasional negative return,” Swensen said in the Dec. 30 interview. “I don’t think people should disregard the book because of the market trauma of the last few months. We’re not even done with the current fiscal year. Judging a long-term investment strategy based on the results of a five- to six-month period is foolish beyond words( I AGREE ).”

‘Flight To Quality’( OR FLIGHT TO SAFETY )

Among Swensen’s core principles identified in “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (Free Press, 408 pages, $35) is the importance of diversifying holdings while focusing on equities. In a recession, the advantages of diversification get overwhelmed( I AGREE ) by investors’ selling equities in favor of U.S. Treasury bonds in a “flight to quality,” he said.

“When you have a market in which any type of equity exposure is being punished, it’s going to hurt long-term investors,” he said.( TRUE )

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.( I WONDER WHY? )

Yale, one of eight schools in the elite Ivy League in the northeastern U.S., dates from 1701. The school, which has about 13,100 students, trails only Harvard University in wealth. Harvard, in Cambridge, Massachusetts, had an endowment valued at $36.9 billion on June 30 before reporting losses of about $8 billion, or 22 percent.

Ph.D. in Economics

Swensen earned a Ph.D. in economics at Yale before working for Lehman Brothers Holdings Inc. and Salomon Brothers, now a unit of Citigroup Inc. When he took over Yale’s endowment, the fund contributed $45 million, or 10 percent, to the school’s annual budget. In the current fiscal year, which will end on June 30, the endowment is expected to contribute $1.15 billion, or 45 percent of Yale’s revenues, he said in the book.

The distribution from the endowment is based on an average of five years of returns, so the consequences of any loss this fiscal year will be blunted by the gains of previous years, Swensen said.

“We’re projecting no decline in endowment support for the operating budget,” he said.

Since the budget is due to grow in coming years, Yale President Richard Levin has said the school is projecting an operating shortfall of $100 million for fiscal 2010, increasing to more than $300 million four years later. The school estimates no growth in the endowment in fiscal 2010, with increases resuming in 2011.

Slashing Spending

To begin closing the budget gap, the school will slow increases in salaries, and cut budgets for non-faculty staff pay by 5 percent through attrition. Yale said it will reduce other expenses 10 percent over two years by slashing spending on consultants, travel and energy while delaying construction.

Until financial institutions resume lending( FEAR AND AVERSION TO RISK ), the economy will remain stagnant, Swensen said.

“I don’t think the Fed or the administration has figured out how to fix credit markets( BAGEHOT'S PRINCIPLES ),” he said. “We are going to experience economic and financial stress as long as the credit markets are broken and it’s not until we start seeing the credit markets functioning properly will we be able to see a path to economic recovery.”

Swensen advocates federal guarantees for deposits in money- market funds as a way to encourage investment in the vehicles that buy corporate debt( A GOOD IDEA. AS I'VE SAID, YOU'RE GOING TO NEED EXPLICIT GOVERNMENT GUARANTEES TO STOP A CALLING RUN. ).

Swensen’s book is updated to stress the importance of organization and governance for investment firms.

Bernard Madoff

Concerns over governance helped Yale stayed clear of Bernard Madoff, the financier accused of a $50 billion fraud. One reason was an inability to see where investors’ money was going, Swensen said.

“If we can’t sit down with the people making the decisions, and understand what it is they’re doing and how they’re doing it, we’re not going to invest,” he said. “We’re not going to have anything to do with it.”

If Madoff’s victims had read his book, Swensen said, Madoff, who relied on money from so-called funds of funds to feed his operation, “never would have been funded.”

“The reason I don’t like funds of funds is that they facilitate the flow of ignorant capital( SEEMS APT ),” Swensen said.

In general, most investors should stick to passive investments such as index funds that track the market, since attempts to outperform it are often unsuccessful( I AGREE ). For every winner there is a loser, and even the winners pay for much of their gains in fees and commissions, he writes in his book.

Contrarian Investing

“Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win,” he wrote.

Building Yale’s endowment required sticking to a contrarian investing philosophy, a high-performing research team, and the ability to coax “uninstitutional behavior( HUMAN AGENCY EXPLANATION ) from institutions,” Swensen said.

“Nobody said this was easy,” he said. “You’ve go to do an enormous amount of work to get it right.”

To contact the reporter on this story: Oliver Staley in New York at ostaley@bloomberg.net."

He makes some very good points.

"In fact, it was always pretty improbable that funds of funds were doing lots of due diligence. "

John Carney on Clusterstock answers a question that should be asked:

“What is the actual purpose of Fund of Funds” famed money manager and financial blogger Barry Ritholtz asks.

The idea that fund of funds perform due diligence, the forensic accounting and deep background checks on hedge funds has been blown out of the water by the revelations of Bernie Madoff’s scam. Funds of Funds poured money into Madoff's Ponzi scheme, apparently never bothering to check if it was a legitimate operation. ( UNREAL )

In fact, it was always pretty improbable that funds of funds were doing lots of due diligence. ( WHY ? )

To understand why it was improbable, just take a look at some of the biggest and most popular hedge funds. Do you think that Stevie Cohen lets the managers from a fund of funds run through his books, review his strategies and inspect the SAC Capital offices? How many fund of funds folks do you think have been able to grill the folks at Renaissance Technologies Corp? Interview the physicists at Citadel?

Exactly. These fund of funds folks are not only not doing due diligence. They can’t. ( GOOD POINT )

So what is it that a fund of funds does to earn its fees? What investors are buying when the hand over money to a fund of funds is the opportunity to get in on the returns of some of the biggest names in the hedge fund world with a relatively small investment. Many of the most prominent funds are closed to new investments or require enormous initial investments. But a fund of funds will let you in for, say, as little as $500,000. You probably couldn’t get Ken Griffin, the founder of Citadel, to even answer your calls with a $500,000 check. ( YIKES )

That’s what the funds of funds are selling: access. Of course, as some of the gilt rubs off the hedge fund business, this access may have diminishing value. Do you really want to pay extra fees just to have Citadel lose half your investment? Perhaps some will actually begin to perform actual services for investors, such a due diligence investigations, in order to gain or keep market share. And perhaps, as hedge funds get more desperate for assets under management, the hedge fund managers will actually allow them to perform those services."

This is just unreal. Investing 101.

"It would be very hard for most hedge funds to operate Ponzi schemes, as Mr Madoff is alleged to have done."

I have to admit to being a defender of Hedge Funds, even though, like CDSs and CDOs, I wouldn't invest in them myself ( largely due to lack of resources ). Here's John Gapper in the FT with some interesting news:

"The alleged fraud of $50bn at Bernard Madoff’s investment advisory business will send a scare through the fund-of-funds that put investors’ money in hedge funds in return for a fee, but the implications for hedge funds are less obvious.

His business, although hedge fund-like, was not structured like most hedge funds, and there would have been more safeguards if it had been. It would be very hard for most hedge funds to operate Ponzi schemes, as Mr Madoff is alleged to have done.

This paradox cropped up in the New York Time story on the scandal on Friday. Early in the piece, it said:

The collapse of Mr Madoff’s firm is yet another blow in a devastating year for Wall Street and investors. While Mr. Madoff’s firm was not a hedge fund, the scope of the fraud is likely to increase pressure on hedge funds to accept greater regulation and transparency and protect their investors.

Further down, however, it added:

Mr Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JP Morgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.

Well, indeed. Long-running financial frauds often depend on the same person having control of the front and back office - not only making trades but having oversight of clearing and settlement. If Mr Madoff was engaging in fraud, as alleged, it was very helpful not to have others checking on his trades.

The problem is less for hedge funds than for funds-of-funds. Some, including Fairfield Greenwich Group and Tremont Capital Management, directed money to Mr Madoff’s fund management arm and got fees for it, but do not seem to have grasped what was going on."

I think that it's very important to be specific and accurate in using terminology. This is not a Hedge Fund Problem according to Gapper.