Beyond Becalmed Swensen: The Next Generation Model

The Portfolio Whiteboard Project takes its name from a question that project members put to asset managers, “how would you allocate your portfolio if you could start from just a blank whiteboard?”

The answers they got when they gathered with a roomful of experts in May 2013 turned out to depend upon the meaning the interlocutors gave to the word “how.” There were three kinds of answers: fund governance; asset allocation; and execution.

The “Endowment Model” associated with David Swensen and Yale University was much on everybody’s mind at that gathering. For Swensen had done much the same thing thirty years before. He had asked his colleagues to work out a new model on tabula rasa, and the Endowment Model was the result.

Next Generation

By way of both homage and contrast, the PWP thinks of the consequences of its own efforts as the “next generation model.”

The investing world was very enthusiastic about Swensen’s model in, say, 2006. It seemed to have sailed with a favorable wind. But the financial crisis becalmed it, and a withering critique by the Tellus Institute in 2010 charged that endowments following the model had “played a role in magnifying certain systemic risks in the capital markets.”

Yet in the three years since Tellus opinion on the endowment model has mellowed a bit, and the participants in the PWP sponsored meeting seem to have regarded Swensen in a collegial spirit as well as a critical one.

They also seem to have ended up with three different whiteboards. Let us say a little about each.

Governance

As to governance, PWP’s experts said that the necessities for a successful investment institution include a mission-driven culture, principled execution, a set of clearly defined roles, and a long-term mindset.

“Long term” in this context doesn’t mean “buy and hold.” It means learning to think in terms of themes that will still make sense in another 20 years, themes such as the Japan syndrome; low interest rates, deflation, an aging population, emerging markets [young populations, geopolitical upheaval, a rising middle class with political demands. Or market structures;central banking, visible hands, investment crowding.

Long term thinking also means learning to think beyond the day to day vicissitudes of valuations. The report quotes one participant who said, “The only true loss is the permanent loss of capital; mark-to-market loss … is not a loss.”

Allocation

As to asset allocation itself, the results of the desired roles, cultures, processes, etc.: the experts said that it has to be driven by objectives-based choices, a risk framework, broadly defined asset classes, and that it should be “vehicle agnostic.”

Vehicle agnosticism means that a manager shouldn’t commit to allocating a certain percentage of its portfolio to, say, hedge funds. Or PE funds. Those are the vehicles, they should be regarded as a means to the end. Certainly portfolio managers have to concern themselves with, say, the liquidity of their portfolio, and both PE and hedge funds present liquidity issues, especially in those moments of crisis when the hedgers’ gates come down. But the real concerns are only very incompletely correlated with the vehicles, and focus on the latter distracts one’s attention from the former.

Even more specifically, a long/short hedge fund and a private equity fund might well be treated as parts of the same basket, as ways of gaining exposure to equities.

Execution

In terms of execution, the experts called for more complex organizations and process, but acknowledged that allocation by asset class is going to remain – portfolio managers can’t do without it.

Asset classes have to be tied in to themes, though. For example, the theme of social change in the EM world might suggest opportunities in desalination, waste management, or Shariah law. Those opportunities in turn suggest asset classes: infrastructure, venture capital, commodities.

The experts also stressed risk managing and monitoring under the heading of execution. When done properly, this entails the establishment of draw down tolerances, the institution of stress tests, and the study of correlations. This will require “bigger investment in systems and technology and more carefully defined processes, probably adding more personnel.” There is no such thing as a free monitor.