Learning From Endowment Funds

This article was first published in Money Management magazine, 8 October 2020

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Why do some sports teams remain perennial title favourites, while others seem to consistently languish for decades? If you’re one of the poor souls who finds themselves rooting for the frequent losers, you’ll know the answer isn’t simply ‘our players aren’t up to scratch’. On the other end of the spectrum, the best teams always seem to have an ability to combine mediocre players into a high-performance unit. They seem to be one step ahead of the competition, playing a long game that presciently fills the gaps in their rosters, drafts the best rookies before others spot them, and adapts their capabilities to the evolution of the sport. This is where the behind-the-scenes manoeuvres of the front office management team lead to long-term dominance. These imperceptible strategic decisions go beyond the coach and players, they are macro decisions that create long-term franchises. In investment parlance, asset allocation is exactly those front office decisions you need to make correctly to ensure long-term success. In this publication, we’ll take a deep dive into how two of the world’s best are manoeuvring their portfolio for the future.

Australia’s Future Fund – anticipate, don’t emulate

A few weeks ago, Future Fund reported their asset allocation on 30 June 2020. Interestingly, they have been cashing in their investments across the board. Their allocation to global equities remains the dominant piece at 27%, but almost all asset classes have decreased across the board. The last time the Future Fund held this level of cash was in September 2017.

Source: Future Fund, Lumenary Analysis

Yes, this does have a little to do with the pandemic, but notice many of the changes were in relation to unlisted assets which take some time to turn over – in other words, many of these liquidations were premeditated and only just came to fruition last quarter. This was far from a spur-of-the-moment reaction to the pandemic.

But just because your cross-town rival makes a change to their team doesn’t mean you should too. Future Fund’s circumstances are far removed from a nimbler private investor and their investment objectives are vastly different. The best sporting teams never emulate the success of others, they create their own success based on independent evaluation. As I delved deeper, the question emerging in my mind was “What can I learn from the intentions of a $161 billion fund, so I can anticipate the next flow of capital, not copy it?”

The bigger they are, the slower they move – but that’s your edge

Delving deeper to uncover the rationale, I found the Future Fund’s CEO had spoken publicly about the portfolio, citing long-term falling interest rates as the cause of asset prices being bid up, which has subsequently led to their cautious view of the world. He went on to explain why he expected headwinds going forward, summarising the year with:

“This year we undertook a material rebalance of the Private Equity portfolio, reducing some of our exposure to international growth and buyout managers following a period of very strong performance. We also completed the sale of other unlisted assets including Gatwick Airport. We deployed some of that capital into new infrastructure themes including fibre and data centres, in Australia and offshore.”

Readers who only skimmed the negative headline would be tempted to cash in the chips and stash money under the pillows. Tempting as it is, I would caution against that. Near-zero rates are fine to accept over the short-term, but a 1% return on cash will destroy wealth over the long-term.

Delve deeper. Future Fund’s high levels of cash are a result of a recent sell down of private equity and partial re-allocation to new infrastructure themes. Enterprising investors can expect this capital to be recycled at some stage, especially as cash returns continue to drag. Expect Future Fund to redeploy this capital, but it will take time. As they’ve already alluded, their capital will continue to flow into non private equity opportunities over the coming quarters. The opportunity now is for investors to move ahead of the pack, to anticipate where this money will land; if June 2020 is anything to go by, increasingly it will likely be in the form of exposures to telecommunications and associated technology infrastructure. If we move up the value chain, we can expect companies in programmable communications and internet infrastructure to create significant value over the long-term, especially when the adoption of 5G and IoT products become mainstream with improved reliability.

As the game evolves, the best management teams recruit the players that will take them to the next level. They have an innate ability to anticipate the direction of others and make decisions ahead of time. Knowing global equities is Future Fund’s largest allocation piqued a broader question in my mind – who else, globally, has a formidable strategic long game?

Learning from best-of-breed endowments

I found particular US Ivy League endowments have done quite well over a long period of time. In particular, Yale and Harvard are the standouts, returning 13.7% p.a. and 11.8% p.a. over the past 20 years. They have greater discretion, tend to be more flexible with their risk/return requirements and don’t have the bureaucratic approach typically seen in sovereign funds (they aren’t accountable to the entire population, after all) – Ivy League endowments run a leaner, more agile operation.

Delving deeper into Yale’s approach, I found one quote which succinctly summarises their mindset:

“Over the past three decades, Yale dramatically reduced the Endowment’s dependence on domestic marketable securities by reallocating assets to non-traditional asset classes. In 1989, 65% of the Endowment was targeted to U.S. stocks and bonds. Today, target allocations call for 9.75% in domestic marketable securities and cash, while the diversifying assets of foreign equity, absolute return, real estate, natural resources, leveraged buyouts and venture capital dominate the Endowment, representing 90.25% of the target portfolio. The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today’s actual and target portfolios have significantly higher expected returns than the 1989 portfolio with similar volatility. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management.”

From their latest annual report, their asset allocation looks like this:

Source: Yale annual report

This allocation is notably different to the Future Fund’s and Temasek’s of the world, and I would not suggest replicating this structure in entirety; Yale has a significant allocation to venture capital (‘VC’). They have pioneered this space in the endowment world, and off the back of the tech boom have returned about 20% p.a. just from VC investments. They have been able to achieve this by good alumni connections and have preferential deal access that most won’t have.

It’s not the strongest, but the most adaptive

Instead of replicating Yale, investors can borrow some of the underlying principles to improve their existing framework. Notice how the top three allocations are foreign equity, venture capital and absolute return? Most investors have limited access to these asset classes. Coincidentally, or rather not so, they happen to overlap with Yale’s connections with industry. Even though Yale can source the world’s best next-generation investments from around the world, it doesn’t mean other investors can’t also win. Just because other teams have a greater salary cap or more talent scouts, doesn’t mean they will assemble a franchise team. Investing is a game with more than one winner; it rewards resourcefulness and adaptability. If the pundits are right, we’ll be heading into a low-return environment but if you borrow from Yale, investors can mitigate this by focusing on companies with a high growth trajectory – not the old-world companies, but the ones creating new markets never-before-seen in the world, even in a low-growth world, products that add value to our lives never go out of fashion. Investors should be looking globally for the best, not just sorting through our own backyard. The best-of-breed have decades of growth runway ahead, so even if you miss the VC opportunity, plenty of opportunity still remains post-IPO.

In closing

Adapting to change is how the best front offices build franchise teams. They combine the right mix of the tried-and-tested players but continue to inject new blood with rookies that fill the gaps for the future. Much is the same in investing; building a portfolio of the best companies now is equally important as paying heed to future growth areas.

It’s not the biggest budgets and the highest paid teams that win, it’s often the ones that have strategic foresight that don’t emulate others, they build their own strategy. Based on actions taken by Future Fund so far, investors have the chance to move ahead of the pack, particularly in global technology-related infrastructure companies. As the pace of reliability and adoption increases, capital will continue to flow heavily into companies that create new markets and products useful to our changing lives. In other words, build a team with solid performing players, but keep your eye on rookies and anticipate where capital will next flow.

Happy compounding.

 

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

 

Searching for the source of alpha

This article was first published in Money Management magazine, 16 July 2020

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We are all baking cakes. The wealth cake. We search for the highest quality ingredients, we put those ingredients into a mixer, then the oven, and voila – here’s one we prepared earlier. With the right recipe, some will end up with a creation that is magnificent, fluffy and moist, far superior to others. But those that get it wrong can end up with a sad puddle of mess. This is high stakes baking where the best result depends not only on having the best flour, freshest eggs, and best elements, but applying them in the right quantities, timing and method. If stock selection is akin to picking the ingredients, then we are only part way there in our quest for alpha. How we allocate also has a big contribution to the result. In this publication I will outline how our fund captures alpha through stock selection, weighting and allocation.

Outperformance originates from unconventional means

You do not win a race by driving in the same lane. Remember, the source of alpha is, by definition, unconventional. It is common for stock analysts to focus on specific sectors or geographies but these attributes are not advantages unique to any one company or investor. 

One of the largest and most successful active managers in the USA, Capital Group, failed several times to launch their Best Ideas fund which took the best single idea from each of their sector specialists. The Best Ideas fund was appealing in theory, but it underperformed because selecting the best companies from each sector is vastly different to simply selecting the best companies full stop. What they thought would be a source of alpha turned out to be a limitation in their stock selection.

How to catch alpha through stock selection

In order to find the freshest ingredients, immerse in catchments where they are most likely found. The first source of alpha comes from either company-specific or investor-specific attributes. Company-specific examples may include board or management characteristics, spin-offs, capital raisings and other corporate actions where unique opportunities flash by for those paying attention. Investor-specific examples include long-term ownership mindset, high concentration, or lower trading frequency. 

Lumenary are experts in founder-led investing – our companies possess a source of outperformance tracing back to an aligned governance and decision-making structure at the core. We find this a profitable universe to play in – founder-led companies have achieved a 7% outperformance over other companies since 2006. The narrower the focus on the source, the better. As you would expect, the source of alpha is not wide. This is a scenario where you would rather delve deep than go wide. Become a specialist rather than a generalist. For example, I have written previously about some niche opportunities I am seeing in technology.

Once you have found your source of outperformance, the allocation plan can be built around that foundation by fine-tuning the focus even further.

How to fine-tune an advantage

For instance, founder-led companies tend to outperform over the long-term. But this is not the end of the story, this is just the first tier of advantage. Investigate further to find secondary tiers, tilt the allocation towards these additional pockets of opportunity, and press the advantage further. 

By way of example, contrary to popular belief, the saying “the first generation makes it, the second spends it, and the third blows it” is simply not correct. The data shows a different story altogether. The often (unfairly) maligned second generation is in fact the cohort that delivers the greatest source of performance for founder-led companies. The building of businesses takes time, becoming a dominant player takes years, and it is often the new ideas of the second generation that changes the game, as the foundations paved by the first generation are expanded and taken to new heights by the second. 

As a second tier advantage, we find first and second generation founder-led companies particularly appealing. 

Contrary to popular belief, the second generation adds the most value

If the source of your advantage comes from other origins, find the additional tiers that have the potential to generate the most alpha. Specialists in capital raisings might investigate further to determine whether rights issues, hybrids, or debt opportunities generate the greatest outperformance, for example.

Identifying more advantages

Identifying more secondary tiers will enhance the ability to allocate with a greater degree of conviction. Taking you back to our example, we have established one source of deeper advantage – first and second generation founder-led companies. 

Again we will turn to research to inform our investigation into other secondary tier advantages, guiding our approach to allocation. Long-term research found smaller companies (under USD $3 billion market capitalisation) have greater propensity to compound. “Small” in a global context, are founder-led companies under USD $3 billion in size. Skewing a founder-led portfolio towards these up-and-comers boosts exposure to challengers who have the motivation to topple market leaders, and have the runway to execute.  

‘Smaller’ founder-led companies outperform larger brethren

To illustrate further, a specialist in capital raisings may sniff out certain uses of funding to have foretelling properties as to whether likely future success is imminent. The impact of the coronavirus has forced many companies to raise equity at dilutive prices; the use of these funds will determine the long-term success of these companies. Find the attribute and allocate heavily towards it.

How to allocate using a tiered approach

Sensible investors will acknowledge that basing allocations on research which can be high-level, will provide general guidance, but is limited in its practical considerations which still need addressing when putting actual money to work. In the search for outperformance, how do we allocate with a balanced approach to risk management and concentration?

Simply because a company is run by the daughter of a founder and under $3 billion in size does not automatically guarantee it will outperform. As long-term investors will appreciate, the purpose of portfolio allocation is just as much to protect downside as it is to seek upside. A balanced diet approach is healthiest – everything in moderation. Skew towards the source of outperformance by all means – first and second generation founder-led companies and companies under USD $3 billion, but be mindful to hold cash according to the market climate, and in our case, we balance out the volatility with a blend of larger, more stable founder-led companies. 

The all-weather founder-led portfolio is one dominated by first and second generation companies, companies under USD $3 billion in size, rounded out with a small proportion of larger, steady-state companies which act to temper volatility. Of course the level of cash is important and will depend on prevailing market conditions. In this current climate, there will be more attractive opportunities to come, especially with the possibility of a second wave of coronavirus. As I have written previously, Lumenary has adopted a mindset of opportunism in this environment.

To summarise, the allocation strategy should go past the first level of alpha, but seek to identify secondary tiers, tilting even further within that set, which should be the predominant weighting of the portfolio. An appropriate level of cash and mixing in some companies less susceptible to large price fluctuations will balance the portfolio’s volatility.

Investigate beyond the first tier of outperformance

Closing remarks

How you select from the universe of investment opportunities around the world and how you weight these investments has significant bearing on your returns over the long run. 

The search for outperformance requires a bold conviction to do things differently to others, a high level of specialisation in overlooked areas of opportunity, and improvement on traditional approaches. Outperformance can be found in a wide variety of areas so remain vigilant for company-specific traits where you can cast your net. 

Once you find the source of your advantage, keep the stock selection confined within that zone, examine closely and leverage tier 2 benefits by apportioning heavily into those areas. This is the process of progressively tipping the scales in your favour by concentrating your exposure in high potential areas.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com