Lots of money

In asset management, the first lesson is staying diversified. For the average household investors, the public markets are the place to put their money to work. Equity, bonds, commodities, and, for the more adventurous, derivatives are what one finds in most individuals’ portfolios. But for institutions with hundreds of millions in cash, whether it is college endowments or insurance companies’ pooled premiums, the investment options become more colorful. Private equity, hedge funds, and real estate are three examples of alternative asset classes that institutional investors often turn to in order to complement their public market investments.

The illiquidity and large capital requirements of the alternatives make them inaccessible to the average investor, which are also big risk factors that allow those with the means to invest in them to demand return premiums. While alternative assets behave differently from public securities and derivatives, they are by no means immune to the swings of the economy. Through the course of the financial crisis, institutional investors have had to face the challenge of reevaluating the role that assets like private equity and hedge funds play in their portfolios.

The relationship between risk and reward is frequently evaluated by asset managers when they perform due diligence on potential investments. For large investors, the excess returns that come with alternatives also bring along higher risk. For the managers of private equity and hedge funds, their losses in the crisis bought them an expensive lesson in investing, but most of the surviving funds maintain their fundamental strategies. For the institutional asset managers, their losses gave them enough of a scare that they had to rethink their asset allocation targets.

In the International Monetary Fund’s (IMF) September 2011 Global Financial Stability Report, it notes that “the empirical results and survey responses indicate that asset allocation strategies of private and official institutional investors have changed since the onset of the global financial crisis. Most importantly, investors are more risk conscious, including regarding the risks associated with liquidity.” It seems only natural that this risk aversion might divert interest from the riskier alternative assets. Yet, given the need to diversify and recover losses, there has actually been new interest in alternatives. For example, pension funds surveyed by the IMF increased their allocation in these investments from 10.9% in 2006 to 15.6% in 2010.

Looking at university endowments in the U.S., the amount of money invested with alternative fund managers has actually increased during the crisis. Based on the annual study on university endowments by the National Association of College and University Business Officers, in aggregate, endowments have increased their alternatives allocation from 35% in 2006 to 52% in 2010. This rise is most dramatic for the largest endowments (with $1 billion or more), from 40% in 2006 to 60% in 2010. Smaller endowments, with more limited resources, have expectedly smaller amounts invested outside of equities and fixed income. However, it may be premature to cite this evidence that the crisis increased the demand for private equity and hedge funds. This increase may simply be due to the fact that with the size of endowments decreasing and the illiquidity of alternatives, these institutional haven’t been able to adjust their allocations quickly.

One group in particular caught the attention of the media when time came for assessing damages post-crisis: Ivy League universities. The Yale Model, named after the university, was popular among investment managers of college endowments. It called for a significant allocation to “private- equity and real- estate funds or commodity-related assets”. In the past two decades, this strategy brought great returns to these endowments, especially those of Harvard, Princeton, and Yale. Yale and Princeton allocated 70% of their endowments to these assets, while Harvard had 57% of its money committed. From 1998 to 2008, “the Yale endowment gained 16.3% annually, while Harvard rose 13.8% a year and Princeton, 14.9%. The Standard & Poor’s 500 logged an average annual increase of just 2.9% in that span.” So how did the lauded alternatives fare in the crisis? While the jury is still out as the economy recovers, evidence from the few years after the crisis shows that they endured worse losses than traditional assets. Private equity, real estate, and commodity related investments took average write downs of around 50% (exact loss is difficult to determine as the returns on these investments are realized over the long term).

If the results from the Ivy League are any indication of overall financial conditions of institutional investors, it is hard not to be pessimistic toward alternative assets. They are a source of liquidity risk, and, as the crisis has shown, are not completely uncorrelated with the public market. However, with still large amounts of cash to invest, institutions need a way to include more return drivers in their portfolios. Currently, that means looking outside of the sluggish stock market and at private equity, venture capital, real estate, and hedge funds. It is not that the wound from the crisis is not deep enough to steer the likes of Yale and Harvard away, but instead the need to reenergize investment in companies means potential future benefit for those who have the money to fill the void. Institutional investors may provide the push that the economy needs to get back on track.

Walt Sosnowski is an economist at heart.

He’s a hedge fund manager whose fund beat the Standard & Poor’s 500 Index by more than fifty percentage points in 2008, while the rest of the investing world, still reeling from the United States credit crisis, struggled just to stay afloat.

He’s a Buffet-esque value investor. He’s a ruthlessly rational analyst of companies. But his greatest strength is his ability to apply sound economic principals to the playing field where irrationality rules the roost: the stock market. And a fundamental concept of economic theory motivates a big part of Sosnowski’s thinking: sunk costs.

According to Sosnowski, the intelligent investor is the one who ignores his or her past performance and makes sober, emotion-free investing choices. “What’s the right decision today?” Sosnowski asks himself before every investment. “You’ve got to be thinking about the next thing – not what just happened, but what’s going to happen next.”


“Investing is not for you.” Sosnowski vividly recalls balking at those entirely un-prophetic words his guidance counselor told him as a high school junior.

Told that his skills would be better suited if he became an engineer, Sosnowski went to Stanford two years later – and, further ignoring advice, immersed himself in the likes of St. Augustine, Aquinas, and Luther.

Recognizing that he eventually wanted to go into business but knowing that his true love was for history, he earned a history major, specializing in Renaissance and Reformation history and taking a senior study course on the Russian Orthodox theologians. He sprinkled the remainder of his schedule with classes in accounting, finance, and engineering.

Business history has struck his fancy of late. But Sosnowski’s background in history of all kinds has become much more relevant as he’s grown older, he says. “We’re going to a stage in world history right now where really understanding where nations and economies have been the last few hundred years will be important,” he says. “There are some profound changes going on in America, in Europe, and in Japan right now. “There are always changes going on. But I’m talking historical changes.”


Sosnowski never doubted his own aptitude as an investor. Other barriers to entry – the long, painful transition from one industry to another, the often-draconian regulations imposed on beleaguered managers, and myriad other obstacles – prevented Sosnowski from launching his own fund before he was forty.

Fortunately, Sosnowski surrounded himself with people who knew a natural hedge fund manager when they saw one. One day when Sosnowski was in his late thirties, the guy in the office next door, a financially shrewd Dallas lawyer and a recent acquaintance of Sosnowski’s, walked into Sosnowski’s office. “Why don’t you start your own fund?”

Before Sosnowski could utter three syllables about how he didn’t have any investors, he was forced to reevaluate. “I’ll put in $150,000,” the lawyer said.

Sosnowski’s friends weren’t the only ones who saw his talent for investing before he did.

Though naysayers like the evaluator of his aptitude test pushed him away from it, investing intrigued Sosnowski from the start. He bought his first stock as a high school freshman in 1979. But it wasn’t until he was a 26-year-old real estate agent that he had enough cash to start to invest.

So he started researching companies – researching with the same passion that sports enthusiasts pore over major league batting statistics. With no Internet to expedite the process, Sosnowski would order hard copies of 10Ks, 10Qs, and annual reports on companies he was interested in. When other twenty-somethings were as far as could be from financial statements on nights and weekends, Sosnowski found himself analyzing companies.

And then the light bulb went off. “One beautiful Saturday afternoon, when everybody was out running around and having fun, there I am analyzing some company. My wife walks in, and she goes, ‘What are you doing? Can’t you get paid for doing this?’”


The decision to become a full-time investor was easy. The choice to start his own fund was not. Sosnowski admits he has always had an entrepreneurial streak. When he was twenty-five, he’d tried to start a commercial real estate information firm from scratch. “Good idea, but I was undercapitalized,” he says.

With his nascent hedge fund, capital wasn’t an issue. The lawyer who had volunteered to be his first investor helped him find others willing to contribute to get the fund off the ground.

Next on the list was to define his fund’s strategy. This was the part that, consciously or not, Sosnowski had been planning for years.

Sosnowski’s fund runs a long-short equity strategy. But really, Sosnowski’s formula for beating the market is simple: he does more research than the other guys. Still, every investor has to have a couple of guidelines he follows when deciding whether or not to invest in a company. Right?

“There aren’t three top criteria,” Sosnowski explains. “There’s anywhere from ten to 200 criteria. My job is to figure out which of that huge amount of criteria are the two or three key issues. That’s part of the key to investing: to ignore the stuff that’s noise and to figure out what the important things are.”

Figuring out how to value a com  any is the basis of any value investor’s strategy. Sosnowski looks at valuations in a number of ways. First, he looks at a company’s price to earnings, or P/E, ratio. “But there’s different kinds of P/E,” he says. “There’s GAAP earnings, and there are different ways one can adjust GAAP earnings to look at what I call ‘Earnings 2’ and ‘Earnings 3.’ ‘Earnings 2’ backs out amortization of intangibles and some other things, like one-time items – true one-time items. And then ‘Earnings 3’ also backs out all that plus 123R, which the expensing of stock-based compensation.

“So I’m looking at different types of P/E ratios, I’m looking at different enterprise value to EBITDA, I’m looking at free cash flow.” But Sosnowski’s analysis doesn’t stop with the individual firm: supply and demand industry fundamentals, the competency of management and analyses from sell-side analysts weigh heavily in Sosnowski’s opinions of the companies he examines.

And Sosnowski isn’t one to abandon his roots: as his history background taught him, he never stops his research without finding a primary source. Secondary sources – in this case, sell-side analysts – are great, but there’s nothing like talking to the CEO or the CFO of the company he’s examining.Like most fund managers, Sosnowski is a numbers guy. He knows the financials of the companies he invests in inside and out.

But he’s not the stereotypical quant. “At the end of the day, these companies are run by people,” he says. “You’ve got to make judgments about the competency of the people running [the companies], their understanding of their business and their industry, whether they’re conservative or promotional, whether they’re trustworthy.”


“This business is very humbling,” Sosnowski admits. “Just when you think, ‘Oh, I’m smart, I’m doing really well,’ then here come the mistakes.”

According to Sosnowski, too many investors let what they could’ve, would’ve, should’ve done lead them to believe they’re wiser than they are. Rational discipline, not wishful thinking, bodes for success in the market, he says.

Sosnowski gives an example. “A stock’s down twenty percent, and there’s a fundamental reason,” he says. “Probably, the stock’s not been doing well because the fundamentals are eroding. Too many investors go, ‘I could’ve sold it three months ago for a higher price, so I’m going to hold on until it gets back up. Conversely, let’s say a stock is down twenty percent, and you’re angry. A lot of investors just puke it out.”

According to Sosnowski, both of these reactions are incredibly common but equally misguided. And no investor – even him – is completely immune, he says: “Even many highly educated people have trouble drawing that distinction.”

Sosnowski also sees many investors whose inflated perceptions of their investing abilities lead them to believe they know far more than they actually do. “How many times do you say, ‘Well, I knew that was going to happen’?” he asks. “Well, did you invest that way? ‘No, I didn’t.’ I can’t count how many times I hear that. “ Over time, Sosnowski says, investors who recognize their actual knowledge – and who aren’t falsely influenced by the investments they merely considered making – will come out on top.

Full disclosure, my father is an investor in Sosnowski’s fund. Sosnowski would not discuss his performance history with me, but I was able to see his annual results in the reports my father receives. In 2008, when the market was in a free-fall, Sosnowski’s fund beat the indices by more than fifty basis points – this coming after a year when his fund posted a return of forty-six percent. He followed his 2008 market-blistering year with a fifty-seven percent return in 2009.

When questioned on these results, Sosnowski demurs. Of all the traits that make Sosnowski an outstanding investor, perhaps humility is the one that best allows for his long-term success.

Sosnowski shakes his head. “Past performance is not indicative of future results.”