Thursday, August 19, 2010

Baschab and Piot, Outperform

John Baschab and Jon Piot have added to the growing literature on endowment fund investing in Outperform: Inside the Investment Strategy of Billion Dollar Endowments (Wiley, 2010). The bulk of the book is taken up with interviews, first with fund managers from both public and private universities (Ohio State, University of Oklahoma, University of Texas, Cornell, Case Western Reserve, Emory, George Washington, Rice, Texas Christian, and Tulane) and then with advisors and managers.

Although the authors, most likely at the behest of the publisher, try to find lessons from endowment fund investing strategies for the individual investor, the book struggles a bit on this front. The managers whom they interview are clearly more comfortable talking about what they do than about how individual investors might be able to profit from imitating them. Indeed, the authors themselves admit that “the number and magnitude of differences between the situations of an individual and an endowment make it difficult to mimic endowments closely.” (pp. 281-82) Among the main differences they identified are: access, expertise, bandwidth, taxes, time horizon, liquidity requirements, fees, and vintage year diversification.

The upshot is that this is a book for those who want to know how endowment fund managers think. And here it succeeds admirably. For instance, the CIO and director of risk management at Case Western Reserve suggest that some endowment fund managers might be wise to shift their emphasis from performance-based thinking to liability-driven investing, somewhat similar to pension funds. “We believe that the future of asset management will be outcome-driven investments, which will give people a specific outcome at a future point in time for a certain amount of risk. The approach relies on defining exactly what you need your investments to deliver at certain points in time and then using derivatives and other products to ensure that those marks are met.” (pp. 109-110)

The managers and advisors talk about the trends they are looking at, thematic investing, tail risk hedging, selecting managers, and asset allocation. And, of course, the inevitable “Performance Derby.”

Having said that takeaways for individual investors are limited, let me nonetheless mention two. First, advice from a manager that I may not agree with wholeheartedly but is probably as close as one comes to a potential SNL skit in an investment book. An individual should have three investment buckets: the liquidity bucket (10-15%), the stay rich bucket (70-89%), and the get rich bucket (10-15%). The liquidity bucket should cover your spending for two years, the stay rich bucket should be with an advisor who puts you in a diversified portfolio that you don’t have to think about, and the get rich bucket is “that bucket that everybody shouldn’t have, but everybody wants to have so they can do that stock tip, so they can do that friend’s condo deal, and that brother-in-law’s venture deal. … It’s cocktail party conversation money. The get rich bucket probably allows the individual to satisfy that need to feel like they’re doing something.” The real money, however, is being generated in the second bucket where the investor heeds the saying, “Don’t just do something. Sit there.” As Michael Mauboussin showed, “people who look at their portfolio every day underperform those that look once a year by something like 7 percent.” (pp. 239-240)

Second, although we normally think of the endowment fund model in terms of asset class diversification, we should look at diversification more broadly. It is important to diversify sources of return, sources of alpha, and risk as well as to reduce volatility in normal environments. (p. 100) This is sound advice not only for endowment fund managers but for individual investors.

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