Wisdom of Good Allocators
Updated: Dec 22, 2019
Each quarter, we receive hundreds of letters written by managers. Some of them are excellent, most of them are not, but we still read them because it is one of the greatest ways to understand managers’ investment philosophy and thinking process. We care less about their returns and actual investment ideas.
We think it is a great way to understand managers’ philosophy and mindset. On the other hand, there aren’t many good letters or reading materials to understand allocators’ mindset. So, today, we want to share with you some good ones.
Good Allocator No. 1: Yale University’s David Swensen
We will start with Yale University’s David Swensen. As you know, he is the pioneer of the endowment approach, which now became a standard way to allocate capital for endowments and foundations. The best way to learn his thought is his two books: Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (1st Edition, May 2000, David Swnsen) and Unconventional Success: A Fundamental Approach to Personal Investment (David Swensen, 9 Aug 2005). If you are a Simplified Chinese reader, we found Chinese translation.
We also recommend the Interview with David Swensen by Yale School of Management’s Dean Jeffrey Garten and a record of Swensen’s lecture at Yale University’s Econ 252 (Financial Markets) in Spring 2011.
Good Allocator No. 2: Global Endowment Management’s Hugh Wrigley, et al
Secondly, we want to introduce Global Endowment Management (GEM). GEM was founded in 2007 and manages $7 billion for clients including endowments, foundations and other institutional investors (as of 2015). Hugh Wrigley is a co-founder of GEM. Previously, he served as Head of the Private Investment Group at DUMAC (Duke’s endowment). There are two great articles based on the interviews with Global Endowment Management’s Hugh Wrigley and his team.
GEM’s manager selection approach echoes with ours (admittingly, they are better than us) and the following corresponding in the Manual of Ideas shares deep insights of how to find good managers.
MOI: What is the typical process you go through with an investment manager prior to entrusting the manager with your capital?
James Ferguson: In an ideal world, we would be able to spend several years building a relationship with a prospective manager, to underwrite both their process and their temperament. In our humble opinion, the former is much easier than the latter. We would like to see an investor work through a variety of market environments, and in particular how they react to adversity. If you look at challenging market environments throughout history, going back to the early 1920s, it’s amazing how many “great” investors did not have the emotional fortitude to withstand severe market drawdowns.
While we have spent years getting to know some of our managers before investing with them, it is often impractical to do so. Consequently, our ability to speak with people who have known the individual for a long time and have seen them in a variety of situations is a key part of our process. Besides personal vetting, we spend a significant amount of time going through individual portfolio companies to understand how the manager developed their thesis and identified areas of concern. The more in-depth the discussion we can have around the manager’s thinking about a company’s competitive dynamics, industry characteristics, and overall moat, the easier it is to underwrite the substance and sustainability of his or her process. The second step of our approach is that we think it’s important for a prospective manager to know how we will behave in challenging environments. Given the inherent fragility of an investment partnership, a manger’s confidence in their investor base could help reinforce their ability to withstand a significant drawdown. We encourage prospective managers to speak with our current managers in order to get a sense of how we respond. It’s a common bromide in our business to say you’re a long term investor. Reality is that career risk and human psychology often intervene in the short term to derail that long term focus. We think we are good long term partners, and that we do what we say we’re going to do. We want prospective managers to get a sense of that. Time and talking with others can go a long way in building that trust. Once we have conviction in a manager as an investor, we then conduct a thorough operational review in order to get comfortable with the controls and protections that are in place.
MOI: What characteristics make an emerging investment manager appealing to you as a long-term partner?
Campbell Wilson: What we’re ultimately looking for is a skilled investment analyst with the discipline and temperament to succeed in different environments. Importantly, they must be able to transition from analyst to portfolio manager—we have seen many who cannot. Creativity, persistence and humility are key traits— people who are confident in their abilities but clear-headed and forthright about their weaknesses. Seth Klarmann described it well when he said “You need to balance arrogance and humility”. And maybe more than anything else, we’re looking for fanatics who are extremely passionate about the pursuit of investing. Given the monetary benefits of working in the financial industry, it is often difficult to discern “passion for investing” from “passion for making money”, but understanding a manager’s motivation is a key requirement for us. MOI: What are some common mistakes managers make early on that make it more difficult for you to partner with them down the road? Campbell Wilson: At a high level we often see young managers compromise their investment ideals or approach in order to raise assets. They might, for example, agree to hold more positions than they would prefer. At the end of the day, we want our managers to manage our funds like it was their own money and they didn’t have a client base to worry about. Decisions made for the sake of the business or client base are often detrimental to long term returns in our opinion, and it’s very difficult for small, young managers to say no to someone who wants to give them money. Our advice is to give yourself as long of a runway as possible to stick to your guns.
Good Allocator No. 3: MIT’s Seth Alexander
The last good allocator is MIT’s Seth Alexander, one of many protégés of Swensen, who is leading Massachusetts Institute of Technology Investment Management Company (MITIMCo).
President Alexander spent the first ten years at Yale’s Investment Office and just completed his second ten years at MIT. As a milestone, he published a letter called 10 Year Alumni Letter, in which he shared his wisdoms of how to choose right managers for the endowment.
New Capital Allocation Philosophy – Over the past decade, we introduced a new framework by which we allocate capital. Ten years ago, our process started with a top-down assessment of asset class risk and return characteristics and the establishment of asset class target allocations. Over time, however, this process became increasingly less satisfying. While this approach had proven to be very successful for many investors, it did not seem to be a good fit for us. We realized that our ability to select specific investment managers with excellent risk-return prospects far exceeded our ability to forecast whole asset class characteristics. Why, then, should our process revolve around asset classes? In 2011, we formalized our shift in thinking and adopted a new manager-centric capital allocation framework. In our new framework, our primary goal is to identify exceptional investment managers who we believe will be excellent long-term fiduciaries for investor capital. To that end, we spend an enormous amount of effort underwriting the managers with whom we partner. We are particularly focused on identifying those traits that allow investment managers to thrive over long time horizons in a variety of market conditions: an absolute return orientation, prudence, humility, patience, high ethical standards, a focus on high quality assets or assets priced at a significant discount to fair value, a good selection of limited partners, and superb investment judgment.
After reading these four articles, you will find that their approaches are very different from other allocators. They care more about people (not pedigree), investment philosophy (not strategy) and alignment of interests. We want to read more of these letters and listen to these interviews, but unfortunately they don’t hit our mailbox very often.