Smart Money: Diversify with caution

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William C. Fisher
William C. Fisher
Harvard's endowment has been famous for investing to generate enormous gains. From 1990 to 2005, the investment returns averaged 15% per year, growing the assets from almost $5 billion to almost $23 billion.

But when the 2008 financial crisis hit, the endowment dropped by $11 billion by June of 2009 and weaknesses in the investment process showed through. So even some of the best and brightest can be exposed at times. Here are some brief thoughts for CFOs about alternative investments.

So what happened? Lots of things went wrong: An attempt to lock in low interest rates backfired and losses on interest rate swaps cost millions. Holdings in publicly traded stocks dropped. Attempts to sell private equity investments were unsuccessful, locking in losses. The need for liquidity caused debt to be issued and stocks to be sold, at the wrong times. Real estate holdings could not be liquidated and the underlying values declined.

What can today's CFO do differently to learn from Harvard's investments? For one, the use of alternative investments should not be seen as a risk-free form of diversification.

Alternative investments such as private equity, real estate and hedge funds do not always cushion the losses during bear markets. Keep leverage at a minimum or totally out of the investment portfolio.

Remember: Illiquid investments have an inherently higher volatility. You earn the potentially higher returns by giving up liquidity.

Should today's CFO include alternatives as a central part of the long-term portfolio? The danger in this thinking is that private equity, real estate and hedge funds will replicate the strong performance of the past.

Work with your investment advisor to apply these lessons: Pay attention to near-term cash needs. Diversification helps but does not prevent losses. The combination of leverage and illiquidity is toxic.

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