The Importance of Continuity in Portfolio Management

The Ivy League endowment funds are some of the most closely watched institutional funds in the world. Whether they’re equipped or not, nearly every other institutional quality fund is trying to replicate what the best and brightest Ivies are doing in their portfolios. With this spotlight comes praise, but also scrutiny.

This week, Chief Investment Officer offered up a cautionary tale about what can go wrong with these more complicated investment approaches. They looked at what’s transpired over the past decade at the endowment office for Stanford, one of the most prestigious universities in the country (while not technically an Ivy League school, they’re about as close as you can get). They detailed the story of Jason Zhang, a rising star at Stanford Management Company until things fell apart in the mid-2000s:

Zhang had no way of predicting the event that would kick off a decade of turmoil at SMC (Stanford Management Company): On January 9, 2006, the fund’s leadership quit en masse.

CEO Mike McCaffery, CIO Mike Ross, and private equity chief Dave Burke were leaving Stanford to launch Makena Capital—an outsourced-CIO (OCIO) shop—across from SMC on Sand Hill Road, the artery at the heart of Silicon Valley. The announcement threw SMC into crisis.

One of the problems was that high level investment officers could earn higher paychecks in the private sector by starting their own firm. But there were plenty of other organizational issues beyond that.  Over the next few years, they continued to see key employees leave. Plans for an office in China were tabled. Then came the financial crisis where their problems became amplified.

Tail risk hedges that were implemented by the previous staff had to be unwound. The endowment was forced to lay off staff (as so many charitable foundations had to do during the crisis). The spending payout to the university was slashed. They even had to issue new bonds to stave off a liquidity crisis because of the illiquid nature of the portfolio. Many of their private investments had to be put up for auction on the secondary market for far less than their fair value (they ended up pulling the sale because the bids were so low).

While this makes for a very interesting story, the truth is, for a place like Stanford this probably doesn’t matter all that much. What’s a few hundred million dollars in lost returns during the transition years when you have a near unlimited supply of Silicon Valley alumni donations coming in every year to add to your $22 billion endowment?

Stanford and their peers can probably afford to make these types of mistakes. Just look at how these funds judge themselves:

“When you’re the CIO of Hewlett-Packard and sharing results with your board—and we had always done very well—no one ever asks, ‘How did the IBM retirement plan do?’” he added. “In the big endowment context, when you tell your board how the fund had done, they want to know how the other leading endowments did in the same time period.” Pressure to beat the Ivies went beyond board meetings. It dictated staff paychecks: One-third of SMC’s senior investment team’s bonuses were (and likely still are) tied to performance relative to peers on a rolling three-year basis.

These funds often care more about how they’re doing in relation to their peers than their own goals. It’s madness, but again, these schools with huge endowments can get away with it because they’re basically show ponies.

Look how big our endowment is!

No we have a bigger endowment!

But there are some lessons here for smaller institutional funds and individual investors. My biggest takeaway is the importance of continuity in an investment plan. This type of situation could have completely shut down a smaller foundation or endowment.  For smaller institutional funds these types of missteps can severely constrain future spending and potentially alter the entire future prospects for the organization.

On a smaller scale, constantly changing your portfolio strategy can completely ruin an individual’s retirement account as well. Consistency of approach over time is critical for any organization or individual because not everyone has unlimited funds to come back from an overly complicated transitional period.

The average tenure for a chief investment officer of a state run pension fund is just 3 years. The average tenure for a board member is 5 years. There’s no one right or wrong way to invest a portfolio. But one of the biggest keys to long-term success is the consistency of a plan over time. It’s amazing how great the results can be if you’re able to look past the constant temptation of making unnecessary changes to the overall strategy every few years. The revolving door of consultants and investment strategies is one of the reasons so many institutional funds underperform a simple 60/40 portfolio over time (shameless plus — see a handful of studies in my book for more on this).

Running a very complex, unique style of portfolio management might impress the boosters, but it’s terrible from a continuity standpoint. You give yourself the potential to hit a home run, but the risk of striking out is magnified.

The more complex you make a portfolio in terms of different investment structures and strategies, the harder it becomes to maintain a consistent approach over time. It’s an operationally inefficient way to invest and requires serious manpower, time and resources to pull it off. Very few organizations can thread the needle in this way. And even if you have all of those things in place there’s no guarantee, except for the fact that you’ll be paying much higher fees. Increasing the number of fund types you implement only increases the operational risk, due diligence costs and monitoring problems.

All that aside, it becomes nearly impossible to implement a consistent investment plan over time when you increase the complexity of your portfolio. Multi-billion dollar funds can afford the luxury of experimenting with how they run their investment offices. For everyone else, the simpler and more consistent the approach, the better.

Source:
The Stanford Endowment Experiment (CIO)

Further Reading:
Advice Doesn’t Have to be Complicated to be Good

Here’s the stuff I’ve been reading this week:

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  1. Jason 588 commented on Oct 16

    What surprises me is that taxable entities will compare their 10 year returns to NACUBO #s without even thinking about the impact of taxes or how the private equity returns are translated into time weighted.