- Circle of Competence
- Competitive Advantages
- Is there a Superior Endowment Strategy?
Many institutional endowment portfolios look similar to the Yale Investments Office (”Yale”) portfolio. This is particularly the case for university endowments. Some of this is down to the Yale influence but some of it is a natural consequence of what an endowment aims to achieve. The heavy reliance on the capital to fund the organisation over the very long-term, combined with the great difficulty in predicting macroeconomic outcomes, means that the portfolio must be robust to a whole range of different possible economic scenarios. A globally diversified portfolio with assets that have different long-term drivers of returns can be a great starting point…but it is not necessarily so.
There are many potentially successful approaches but not all are suited to all organisations. The right approach depends on the characteristics and objectives of the organisation. Some of these factors include the organisation’s circle of competence, competitive advantages, passions, return objectives, risk tolerances, liquidity needs, and governance structures. Taking the time to understand and clearly articulate these foundations, before deciding on the strategy, is incredibly important. The right strategy is then an output of these foundations.
Circle of Competence
“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” — Warren Buffett
There are two critical aspects of one’s circle of competence. The first is understanding what it is and most importantly what it is not. This requires a high degree of self-reflection combined with a large dose of humility. The second is having the discipline to stay within the circle. It can be very tempting to stray from one’s circle of competence when subjected to the allure of a potentially juicy investment return. However, by definition, it is very difficult to properly underwrite any investment that sits outside one’s circle of competence.
The circle of competence need not be static. Indeed, nearly all great investment firms have strong learning cultures. In such cultures, the individuals and the collective team invest time to learn, to evolve, and to ultimately expand the organisation’s circle of competence. A great example here is Hillhouse in China. They invested 7 years of time and energy in learning how to invest in healthcare before making a single investment. They are now China’s pre-eminent healthcare investors.
Each team behind an endowment fund will have its own circle of competence, and these will sometimes look very different. It is natural then that they should seek different investment strategies. Swensen and the Yale Investments Office have built their competence in attracting and analysing investment managers and so their model of backing 3rd party investment managers is good for them. In contrast, a successful hedge fund manager has most likely built a strong competence in their field of investment and it therefore makes sense that they would consider investing their family’s endowment alongside their fund. Buffett has built his and Berkshire Hathaway’s competence in understanding and backing high-quality business models. It makes sense therefore for Berkshire Hathaway and Buffett’s family investment office to be one and the same.
Exactly what the circle of competence may be is less relevant than knowing what it is and staying within it. For team’s starting out, the circle of competence will very much depend on the individuals involved, both the investment team members and the stakeholders. As the organisation matures, the circle of competence becomes embedded as institutional “know how”.
“Warren and I have skills that could easily be taught to other people. One skill is knowing the edge of your own competency. It’s not a competency if you don’t know the edge of it. And Warren and I are better at tuning out the standard stupidities. We’ve left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error.” — Charlie Munger
Passion is important when considering the investment strategy as it is the fuel that sustains the team over the longer-term. Without passion, the work quickly becomes a job and the people involved will naturally place less attention, thought, and focus on the work. They become less innovative and think less critically. Again, the expression of investment passion will differ by organisation.
Most investment-related competitive advantages stem from one of the following:
Information Advantage: Very few investment managers have true and enduring informational advantages. It is not good enough to have unique information on one company — to be an enduring advantage, one would need unique information on many investments over many years. Over the years, the only areas we have witnessed enduring information advantages are (i) in quantitative “big data” strategies; and (ii) in strategies that focus on a highly complex niche areas that require very specialised knowledge. In the former, the firms typically invest heavily in proprietary data sources and algorithms.
Analytical Advantage: It is very hard for any investment manager to sustainably rely on an analytical edge. While it is true that many investors simply do not do the work, there remains a large number of smart, talented investors who do. Predicating investment success on continuously outsmarting the market is unwise. With the proliferation of great investment talent over the last few decades, great analytical work should be considered table-stakes.
Operational Advantage: Some investors create an advantage by bringing strong operational expertise and talent to companies that lack this. The key is whether these operational advantages are sustainable and repeatable over many investments and whether the potential for operational improvement is not already reflected in the price paid.
Brand and Access Advantage: Some firms have built strong brands and reputations. This may afford them preferential access to deals, particularly in the private markets. This is perhaps most prominent in the venture capital world. Entrepreneurs seek out the top tier venture firms as having them on the cap table creates a strong signalling effect to other investors and to employees. This is also evident for both the Yale and MIT endowments. Both are sought after partners for emerging investment managers and both carry a strong signalling effect to other endowment funds.
Cultural Advantage: Great investment cultures are incredibly hard to build, even when starting from scratch. It is even harder to change and adapt a pre-existing, often deeply embedded culture. As such, a great investment culture can be a durable competitive advantage. We discuss learning organisation cultures (just one aspect of culture) here.
Behavioural Advantage: A lot of firms fail because they lack the right behavioural traits and irrational decision-making creeps in. They might have the wrong client base, a bad culture, a poor decision-making process, the wrong incentivisation structure, an unrealistic return objective, a lack of philosophical discipline, or perhaps a bad philosophy to begin with. This can lead to value destructive behaviours such as focusing on multiple expansion and short-term performance, selling at the wrong time, excessive trading or risk-taking, investing in businesses that do not match the strategy, and market-timing.
Endowment funds have a really interesting advantage in this respect — their ultra-long-term capital base. True long-term capital is rare and the behavioural edge that it affords is repeatable and enduring. Raising capital is incredibly difficult and time consuming. Not having to focus on this allows the investment team to stay focused on the investment process. Retaining capital can be fickle. The surety of the capital allows the focus to remain on long-term performance, to worry less about short-term price volatility, and to take advantage of strategies that require long holding periods.
The advantage of long-term endowment capital can be all too easily forfeited without the right culture, disciplined investment process, and governance structures. A clearly articulated investment philosophy combined with a disciplined investment process serves as a north star during the tough times. It helps manage the emotions and to help maintain the long-term focus. This must be backed up with a culture that puts process at the forefront. One that recognises that investment mistakes will be made and treats them as learning opportunities. Portfolio managers and chief investment officers need to evaluate their teams over the long-term, the same way they themselves ask to be evaluated over the long-term by their stakeholders.
For endowment funds that fully outsource the investing to 3rd party managers, this behavioural advantage can be lost if the managers they are investing in do not share similar long-term capital advantages. This is a key consideration when considering whether to outsource or invest directly (the subject of a future post).
Very often endowment funds are faced with a principal-agent issue — that is, the investment teams are not the owners of the capital. The governance structure in this case is even more critical. Short-term incentive structures are a sure way to forfeit the long-term advantages of the capital. Equally, stakeholders must look beyond returns and benchmark comparisons when evaluating their investment teams — these are just outputs. At the same time, stakeholders cannot wait 10 years to evaluate long-term performance. To evaluate the teams on an ongoing basis they must look to assess and monitor the inputs that lead to long-term investment excellence — investment philosophy, investment process, people, and culture.
The return objectives, risk tolerances, and liquidity needs make up the final foundation. Others have written extensively on this area so we won’t aim to cover everything. In short, these relate to the ambitions for the capital and how dependent those ambitions are on the investment returns. Some endowments have fairly fixed dollar spending needs while others simply pay out a percentage of the endowment value whatever it happens to be. Some endowments have other sources of income while others rely entirely on the investment returns. As a general rule and all else being equal, endowment funds with a more fixed dollar spending requirement, a higher percentage pay out, and that have no or fewer sources of income other than investment returns are more limited in their long-term capital advantage. That is, they are more dependent on producing returns over shorter periods (say 3-5 years) and have a lower ability to withstand mark-to-market volatility. Sometimes a smoothing formula is applied to dampen the impact of market volatility on the operating budget but this only helps so much. It is important to recognise these limitations and adjust the investment strategy accordingly. Such endowment funds may target a lower overall percentage of risk assets and/or may seek a higher market-neutral allocation. In contrast, those with a variable pay-out (i.e. one that is free to vary with the asset value), that represents a very low percentage of the assets, have a marked long-term advantage and are more free to assume higher equity risk with the benefit of higher long-term returns (as long as they have the right governance structures).
Is there a Superior Endowment Strategy?
This is the topic of the next post, see here.