Last autumn, Clare College Cambridge made the headlines by borrowing £15 million at an inflation-linked rate of 1.09% for 40 years and investing the money in global equity index funds.
The college has a reputation for making astute market judgements—it successfully negotiated the 2000 crash by cutting its equity holdings ahead of time, for example.
This latest investment view caught investors’ attention for a number of reasons. First, the college was acting rather like a hedge fund (without the fees!), using leverage; second, its innovation in the use of college funds reminded many of the often-admired Yale endowment, run by David Swensen; third, the taking out of an inflation-linked loan at such a long maturity was the first of its kind for any British or US college.
How does this work? The college is taking a view that over its 40-year life, the cost of the inflation-linked loan will be covered by the return on equities. To protect against runaway inflation, the college has bought an inflation cap as well, which kicks in at a 7% annual rate.
The college used the advice of former alumni, notably Andrew Smithers of Smithers and Co., and Norman Cumming of hedge fund CR Global, who both sit on Clare’s investment committee.
The study that the investment committee reviewed before putting on this trade highlighted that the minimum real (i.e., after-inflation) return from an equity portfolio for any 40-year period beginning in 1900 was 2.5%. Therefore, they felt, borrowing at inflation plus 1.09%, compounded over 40 years, should, barring catastrophe, be paid for easily by the inflation-plus returns from equities, whether from dividends or capital gain.
How does the decision look nearly six months later?
The cost of funding for the college will have been based on the real yield on UK government index-linked gilts (government bonds), to which a margin will have been added. The real yield on the gilt closest in maturity to Clare’s loan repayment date hit all-time lows of just above 0.3% in early August 2008, just before the college took out its loan, suggesting that Clare did reasonably well in its timing. See the chart below for the real yield on the Treasury 0.75% index-linked 2047 since its issue in late 2007.
One of the reasons for the very low level of real yields on inflation-linked bonds is that there’s a steady demand for them from UK pension funds and insurance companies that want to match long-term liabilities. Clare is taking the other side of the trade (and meeting the institutions’ demand) by borrowing.
I don’t know what global equity index the college has used for its tracker portfolio, but the iShares MSCI World ETF is down just over 10% since the end of October 2008. The ETF is priced in US dollars, however, and sterling is down by almost double figures against the dollar over the same period, suggesting that the college is probably about flat on its equity purchase in sterling terms.
Adding the two legs together, Clare probably has a slight profit to show as at today, mainly from the rise in the cost of inflation-linked borrowing since last October. The college is planning to keep the position for 40 years, so if I’m still around and writing for Index Universe then, we can run through the final sums. I may revisit the Clare gambit from time to time before then, however.
What’s the relevance of this for the average ETF investor? Long-term asset allocation exercises, comparing the attractiveness of different asset classes, are precisely the type of investment thinking anyone with a pension plan and, say, more than 20 years to retirement should be undertaking on a regular basis.
It’s impossible to replicate the Clare trade without using leverage. Those who have the flexibility to do this could reproduce the college’s portfolio, more or less, by shorting the iShares £ Index-linked gilt ETF and buying a broad equity index tracker like the MSCI World ETF. But, even for those who don’t have the ability to short-sell, Clare’s portfolio view gives us an intriguing insight into what some investment experts think of the relative attractiveness of equities and government-guaranteed inflation-protected debt.