Last month David Swensen, Chief Investment Officer at Yale University, participated in a keynote conversation at the Stephen C. Freidheim Symposium on Global economics. During the session Swensen presented his thinking on a range of investment topics that are timelessly important as well as pertinent to the environment we are faced with today as investors. I thought it would be worthwhile sharing these insights with you – our clients, and friends, of Montaka.
Who is David Swensen?…and why do you care?
In the world of professional investing, David Swensen needs no introduction – but let’s give him one anyway. As Robert Rubin, the mediator of the discussion and former US Secretary of the Treasury said, “David is the iconic head of the Yale Endowment”.
Since 1985 Swensen has run Yale University’s Endowment, which is the second largest university endowment in the world and was valued at US$27.4 billion in June 2017. During Swensen’s 32-year tenure at the helm the Endowment has generated compounded average annual returns above 13%, significantly outperforming US equities which averaged annual returns of around 8.7% over the same period, and added around $27 billion of relative value.
Even more impressive than the fabulous performance itself (an incredibly high bar I admit!) is the strategy that Swensen devised and employed to generate it. Over the past three decades the Endowment dramatically reduced its dependence on domestic equities by reallocating assets towards absolute return strategies – including long/short equities funds like Montaka. Today, the Endowment has almost a third of its funds invested in low correlation asset classes, such as absolute return funds and also cash and bonds. This strategic repositioning resulted in higher returns and lower volatility. In fact, this approach has been so successful that it has been dubbed the “Swensen Approach”.
Owing not just to his track record, but also to Swensen’s study and application of investment philosophy over such a long horizon, it is always worth hearing his comments on the subject. So let’s do just that.
“You have to think about what’s going on in the tails of the distribution. I think that’s incredibly important. We spend too much time in finance class, in business schools or in colleges, thinking about normal distributions. And we know—we know the distribution isn’t normal. If securities returns were normally distributed, the crash in 1987 wouldn’t have happened. It was a 25-standard-deviation event. That’s an impossibility”
We often explain to clients that we do not view business results or stock price performance as deterministic. Rather, we view the world as inherently uncertain and unpredictable, and that means that outcomes for earnings and share prices result from a probability distribution. We try to estimate that distribution and take positions where the downside potential is low and upside is high. Swensen takes a similar approach and extends this model of the world by explaining that the possibility for very good and very bad outcomes are actually much higher than people typically think.
We would agree. And we try to capture this by buying high quality business in Montaka’s long portfolio – which have a high chance of good things happening to them – and at the same time short selling deteriorating businesses in Montaka’s short portfolio – which are continually up against it and have a high chance of bad outcomes occurring.
On correlation and protection
“One of the most important metrics that we look at is the percentage of the portfolio that’s in what we call uncorrelated assets. And that’s a combination of absolute return, cash, and short-term bonds. And those are the assets that would protect the endowment”
Swensen acknowledged that a large part of his success over the decades has also come from asset classes and funds that do not move with the market – they are uncorrelated. In times when markets have been buoyant the Endowment has been cautiously positioned. For example, Swensen goes on to explain that “prior to the downturn in 2008 we were probably about 30% in uncorrelated assets”. This positioning also provided dry powder when assets subsequently became cheap, and Swensen subsequently used half of these uncorrelated assets as funding sources to deploy into markets in 2009 and 2010.
As an absolute return fund Montaka is benchmark unaware and therefore has a structurally lower net exposure to the broad equity market – around 40% currently. Montaka is also very lowly correlated with market movements. Indeed, Montaka has only been around 30% correlated with global equity markets since inception. While we believe we have found exceptional investment opportunities both long and short, we are currently running relatively low to the ground as valuations grind higher. When prices pull back we will have the ability and willingness to invest greater sums in even better opportunities.
On fund size and returns
“…you can still make a great living, but instead of managing $20 billion, you probably manage $2 billion. And the other day we met with a manager, and they said their goal was to be in the IRR hall of fame. And I love that”
There are many large global equity managers around the world and in our own backyard that run many tens of billions of dollars. They charge many hundreds of millions (or billions) of dollars each year just from switching on the lights each morning as part of their management fee. As Swensen said “they make a lot of money for themselves” but they are restricted by virtue of their size and incentive structure from finding the best investment opportunities for their clients.
Our internal analysis suggests that around half of the holdings in Montaka’s long portfolio would not be possible if assets under management in our global strategies reached, say, US$40 billion. Consequently, we will limit the size of our global funds to ensure that we give our clients the best opportunity to generate outsized returns for many years to come – selfishly each member of the Montaka team is also an investor in, and therefore client of, our own funds and we want to compound at high rates too! We have determined that while the global funds could handle up to US$8 billion today, we will soft close the funds earlier, at around US$5 billion. That should give plenty of room for our early supporters to reap the benefits as we shoot for the performance hall of fame (rather than asset accumulation hall of fame).
Hear more for yourself
Swensen’s discussion with Rubin lasted more than an hour and touched on a several other important concepts and insightful counsel for investors. For interested readers here is the link to the full video recording of the conversation. I hope you enjoy it as much as we did.