Yale Endowment CIO David Swensen doesn’t make too many public appearances so I was excited to run across a back and forth he had with Robert Rubin this past week at the Stephen C. Freidheim Symposium on Global Economics.
Swensen touched on a number of subjects investors should be interested in from expected future returns, market crashes, the current low volatility regime, asset allocation, alternative assets, and his current worries among other topics.
While I can appreciate a good discussion on the current market environment, that’s not the stuff I’m interested in hearing from someone like Swensen. I’m always more interested in his thoughts on organizational issues (my book Organizational Alpha was inspired by the investment program Swensen built at Yale).
Money manager due diligence is one of the trickier aspects of the institutional asset management business. Picking stocks and other securities is hard but picking the stock pickers is probably an order of magnitude harder.
The rise of quantitative investing adds another wrinkle to this equation but many in the institutional world rely more on black box quant funds than the transparent quant approaches that are taking over the ETF and mutual fund world. Here’s Swensen’s take on the problem of dealing with black box quant funds as an investor:
You know, I have never been a big fan of quantitative approaches to investment. And the fundamental reason is that I can’t understand what’s in the black box. And if I don’t know what’s in the black box, and there’s underperformance, I don’t know if the black box is broken or if it’s out of favor. And if it’s broken, you want to stop. And if it’s out of favor, you want to increase your exposure.
And so I’m an old-fashioned guy that wants to sit across the table from somebody who’s done the analysis and understand why they own the position. And then if it goes against them, I can have another conversation and try and figure out whether the thesis was wrong and we should exit, or whether the thesis is intact and we should increase the position. And I don’t understand any other way to invest.
The 4 P’s of due diligence are process, performance, portfolio, and people. Swensen rightly points out that people is the most important of the 4. Unfortunately, most investors only care about performance.
Rubin also asked Swensen how his views on investing have shifted from 10, 15, or 20 years ago. I love how he brings it back to the basics with a focus on principles, philosophy, and again, people:
You know, I think if you asked me that question 25 years ago, I would have had a reasonably long list of things that I thought were important in an investment management firm. Today, I would say that number one is the character and quality of the investment principles. Number two is the character and quality of the investment principles. Number three—(laughter)—you get the idea. And you have to go further down the list before you get to some of the nuts and bolts. And I’m absolutely convinced that there is nothing more important than being partners with great people.
This gets to my idea that people are constantly looking for tactics (the nuts and bolts) when what they really need is systems (principles).
In my book I discuss the problem with peer pressure in the institutional world with a little help from Robert Cialdini:
Psychologist Robert Cialdini has shown that one of the main filters we use to make decisions is by looking at the decisions of others. Social proof is the idea that it feels more comfortable to go along with the crowd when making tough decisions on our own because we look at what others are doing in times of uncertainty. Investors with lots of money at stake tend to feel that they have to use “sophisticated” investment strategies that cost a lot of money in order to keep up with their peers.
Swensen discussed why this is such a problematic way to manage money for institutions when asked how other investment committees should be thinking about their allocations:
You know, it’s a great question, because this world of comparing returns to peers is all-pervasive. And I think it’s incredibly dysfunctional when it comes to making really good investment decisions. People are concerned about underperforming, and that causes them to want to put together portfolio allocations that look like other similar institutions.
And if you express concerns about market valuations by increasing your exposure to non-correlated alternatives, in a bull market you’re going to suffer poor relative performance. And there aren’t very many institutions that can maintain a position where, year after year after year, the numbers don’t look as good as those that are more invested in risk assets.
And so the advice that I would give would be to try and put together a portfolio that really works for your institution, and try and pay less attention to the returns that others with riskier portfolios might be generating, knowing that ultimately, if you’re making well-grounded decisions, that the numbers will come.
There’s a fine line between “best practices” and the herd mentality when it comes to managing large pools of institutional assets. I’ve always been shocked by how pervasive social proof can be in this segment of the money management business.
The funny thing about the pervasiveness of peer comparisons is that Swensen was the biggest reason for it in the first place. The Yale Model was so successful throughout the 80s, 90s, and 00s that the majority of the institutional investment world decided to mimic what they were doing.
But these funds were mostly trying to copycat the nuts and bolts while missing out on the importance of the principles. Trying to “put together a portfolio that really works for your institution” as Swensen puts it is good advice for these funds (and all investors).
Unfortunate Realities of the Institutional Asset Management Business