Last time, we discussed a different approach to fund management and examples of strategies that can be employed by the Heritage and Stabilisation Fund (HSF) in an effort to boost returns to the benefit of the people of T&T.
Dr David Swensen is the long-time manager of the Yale Investment Fund which has consistently outperformed all other university endowment funds in the United States.
The strategies employed were discussed but why exactly did they do what they did? What was the thinking behind employing a strategy so heavily dependent on investments in alternative assets in search of increased uncorrelated returns from the general stock market?
First, Swensen would define the efficient markets hypothesis, that the prices of publicly traded securities accurately reflect the underlying value of the asset, as accurate. This is evidenced by his unwillingness to be involved in the timing of market investments and his heavy investment in investment strategies which offer uncorrelated returns from the general market.
Investment in alternative assets offer uncorrelated returns and the Yale fund is heavily invested in private equity, hedge funds, real assets and foreign investments which may yield higher returns due to market inefficiencies.
Swensen believes that to achieve outsize performance his fund has to invest in these alternative assets because the general US investment markets are highly efficient and would offer very little return on investment.
Swensen does not believe in market timing in any of these categories. He believes that returns come from a disciplined fundamental approach that could be clearly articulated and differentiated from others. He is convinced that a disciplined fundamental based approach, when intelligently applied, could generate reliable and superior long-run performance.
Also, the illiquidity of private equity assets made market timing a very challenging prospect. Swensen would prefer the various funds he invested in managed by sector-specific industry experts with undergraduate degrees from prominent state universities (no graduate degrees) and with many personal contacts in the industry developed based on years of industry experience. He believed that success in private equity investing depended on strong relationships and networks. These relationships also allowed for a certain degree of due diligence and vetting of proposed projects and transactions.
In an effort to manage risk, Yale had set up facilities to manage operating transactions, capital projects, and endowment liquidity; the commercial paper facility, which was backed by fully committed bank lines of credit, provided Yale with access to US$2 billion of funds during the financial crisis.
This ready access to liquidity assisted Yale in weathering the storm of the financial crisis relatively unscathed.
Yale’s AAA credit rating meant that they could borrow funds at a relatively low rate and maximise the spreads between the borrowed rate and the returns on investments. This competitively priced leverage allowed the fund ready access to inexpensive liquidity and was also used to maximise returns.
During the financial crisis, while other funds tried to sell illiquid assets, Yale used its superior credit rating to purchase more assets for their fund.
Swensen not only structured compensation of fund managers based on performance but also that of his employees. His employees are also compensated with a modest base salary and bonuses based on the fund’s performance. This structure aligns management’s interests with those of the fund’s investors. This is a sensible structure which should bring comfort to the fund’s investors.
Yale’s fund has a staff of 25 people. That’s just 25 people to manage almost US$30billion. This is appropriate because Yale outsources the management of its capital.
If the fund were ten times its current size, there would not be a need for much additional staff because these resources would be outsourced to the same or additional fund managers.
Yale’s staff acts as oversight for the various outsourced investments. Similarly, if the funds were reduced, the size of the staff would not change much because the number of outsourced fund managers would also not change by much.
Swensen did differentiate between which type of venture capital (VC) fund he was willing to invest in and was also careful to understand why an investment may have underperformed. The main reason for the spread between upper and lower quartile VC funds is that some VCs invest in early-stage startups, which could provide huge upsides, while others come in later when the firms begin to be profitable but have less upside.
The differing levels of liquidity can severely affect the returns of a VC fund. Also, VC returns can be an uneven prospect and this volatility, sometimes due to the demise of the start-up, can severely impact returns.
Narrative fallacy also plays a role in investor under-performance. Our brains are wired to look for cause and effect and act upon it. When something unpleasant happens our minds immediately seek a cause, fabricating one if necessary. This narrative of cause and effect is the default for humans. Such stories are simple and compact, more easily remembered and communicated to others.
The problem with this way of thinking is one effect can be explained by multiple, logically-consistent narratives, each of which would suggest a different cause. Though seemingly rigid, Swensen also proved flexible in his approach to selecting fund managers with various investment strategies; the emphasis was on performance and the investor’s network within a chosen industry.
Take the case of Nancy Zimmerman. Nancy Zimmerman is an American hedge fund manager. She is the co-founder of Bracebridge Capital, a Boston-based hedge fund with over US$10 billion of assets under management.
This fund employs a mathematical strategy based on financial engineering. Swenson is opposed to this type of strategy. Keep in mind that of late, quantitative fund strategies have been outperforming traditional hedge funds. Financial engineering is the application of mathematical methods to the solution of problems in finance.
It is also known as financial mathematics, mathematical finance, and computational finance. Financial engineering draws on tools from applied mathematics, computer science, statistics, and economic theory. It can be used to combine various types of financial securities for differing effects.
Though Nancy Zimmerman makes effective use of financial engineering, which Swensen is opposed to, he is clearly enamoured by her fund’s performance and her powerful network. These are two of the main characteristics Swensen looks for in a fund manager. The point of all this is to say that we can do better when it comes to financial services in T&T.
This week at the Energy Chamber’s energy conference at the Hyatt Hotel in Port-of-Spain, several panellists bemoaned the lack of capacity and capability available in T&T for making us the energy financing capital of the world.
Even though we are world leaders in several aspects of the energy sector several local and international energy companies still have to look abroad for the financing of their operations. How ironic that all of this was being said in the shadow of the proposed location of the International Financial Centre.