Qatari Businessmen’s Association Investment Fund Conference 2007“Harvard vs Yale: Internal vs External Investment Management Styles” November 26, 2007
1) The Contrast of Styles • What do you want to build? • Internally managed operation: Harvard has 120 investment professionals managing 65% of their capital • Externally managed operation: Yale has 20 investment professional who have allocated 100% of their capital to external funds • Do you want to pursue the quest for alpha? • Active management – try to beat the indices • Passive management – index and asset allocation • The sources of returns: • Asset Allocation • Manager Selection • Leverage • FX • Sector Allocation • Security Selection • A key success factor: do things differently • Both Harvard and Yale embrace alternative investments well before it was customary to do so and had much larger allocation to those asset classes
2) Effectiveness • Completely different skill sets: • Harvard: picking securities • Yale: picking people • Key issues to consider in the Internal vs External approaches • Minimum Efficient Scale • Agency Cost • Optionality of Capacity • The Problem of the One-Way Ratchet • Reputational Issues • Seeding Risk • Costs • Track records (1985-2007) • Both endowments outperformed the average endowment by ~500bp per annum over a 20 year period.
3) Key Questions for any Investment Model • What is your investment objective? • Asset allocation: what is the right mix of asset classes? • Risk vs Volatility • Diversification • Market/sector movements account for 70%+ of returns of most funds. • Differential results by asset class: In some asset classes, the spread in returns between the Top Quartile and the Bottom Quartile • is vast (REITs, Private Equity), • in others it’s inconsequential (bonds)
3) Key Questions for any Investment Model (cont) • Investment managers: how do you identify skill? • Intellectual flexibility • You need to find managers who can make money through a series of market conditions. • The Lake Wobegone Problem • The greatest challenge is knowing what risks were taken to produce the results. The best performer last year is not necessarily who you want to back. • Luck vs Skill: You need to understand the processes that produced those results. How did they sourced the idea and do the research? Is their process/strategy scalable? • Consistency: second quartile performance every year = top decile over time.
4) Capacity • The Groucho Marx Problem: The challenge is identifying those managers early and being able to get sufficient capital into those funds. • Balance between analytical resources and being nimble • There is a lot of capital chasing a small number of highly skilled investors.
5) Internal Asset Management • To a greater degree, there is more flexibility in asset allocation decisions. • However, there are a lot more questions and a lot more headaches. • You don’t have as much of a capacity issue, but you have to build a high performance organization.
6) The Barriers to Success • Stable investment/leadership team: It is near impossible to build a performance organization without stability in the core leadership team • Deep analytical training: This is an apprenticeship business; processes and mental models need to be learned early • Prudent risk-taking needs to be encouraged • Failure needs to be accepted (and encouraged) • Batting average vs slugging average • Bar bell theory • Scale to do all the work that is necessary • Nimble enough to exploit it • Flexibility of mandate: To go where opportunity is most bountiful and sit on cash if the well runs dry. • Stable capital base
7) Our Advice to QBA • Invest in building these relationships now. • It takes years to find the right partners that you can trust. It may take engaging dozens of managers to find the one or two that will make sense for you. • David Swensen (Yale) ensured superior ongoing results by being early in his funding of several world class funds. He now has a permanent advantage over other endowments; he can still get capacity into skilled firms that others cannot. • Use stable capital as an advantage. • Capital is plentiful but it can be differentiated • The right capital, ie long-term focused capital that allows the investment managers the opportunity to exploit their skills, is very valuable. • Study the models to find one that fits you