August 12, 2016
Interviewed by: Privcap
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The Secret to ‘Endowment Model’ Investing

Endowments are known for the long time horizon for their investments. But they aren’t the only investors seeking to use the longer time horizon to their advantage, says Daniel Feder of Washington University Investment Office. Feder also makes the case for uncertainty in investing, and discusses including the unknowable in an endowment’s investment portfolio.

Endowments are known for the long time horizon for their investments. But they aren’t the only investors seeking to use the longer time horizon to their advantage, says Daniel Feder of Washington University Investment Office. Feder also makes the case for uncertainty in investing, and discusses including the unknowable in an endowment’s investment portfolio.

Finding the Advantages to Long-Horizon Investing
With Daniel Feder of Washington University Investment Management Company

Tom Franco, Clayton, Dubilier & Rice: We’re here with Dan Feder from the Washington University Investment Office. [Let’s] begin by defining the problem. What is long-horizoned investing exactly and why do some institutions adopt this approach?

Daniel Feder, Washington University Investment Investment Company: The longest horizon investing there could be is perpetual, or forever, and at an endowment, that’s essentially the definition we’re taking. We hope the university will be around for a period of about forever, so therefore the endowment ought to be around about the same length of time.

In general, what endowments try to do is support a spending rate for the university, which—in most universities and colleges—stands at about 4% to 5% of the value of an endowment. [They] keep up with inflation, maintaining purchasing power. While long-horizoned investing implies that volatility holds less importance in how we go about investing, there is a requirement that we invest and have distributions in a way that allows generations of students to be treated in fair or equitable way—meaning that one generation of students isn’t sacrificed with respect to spending because market cycles would allow, or not allow, for greater or less amounts of spending across those generations.

Franco: But, if I understand it correctly, it doesn’t have to be restricted to an endowment context.

Feder: Some of that—I guess cynically—is that there are endowments that have performed particularly well, especially in an era that we think we’re going into, which is, by many accounts, a lowerreturn environment. I think what’s being sought is higher returns with less volatility, which is a bit of the best of worlds.

Groups—whether they’re family offices, sovereign funds, pensions or other endowments and foundations—seek to use a longer-time horizon to their advantage. That is one of the great advantages you can have in investing, meaning you don’t have to buy or sell things when the market goes up or down.

Franco: I always thought that uncertainty was very scary and something you should run away from. What is the case for taking on uncertainty?

Feder: Uncertainty is really defined as the area where things are not known and not knowable. If, as an investor, you can traffic in that region in a way that is effective, based on information that’s not knowable by other market participants, then you can make profits—true economic profits—in a sustainable way. Everything else is phenomenon or ways of participating in the market that can be replicated by someone at some point, and therefore is transitory.

Franco: I get the theory of the case of playing in the realm of uncertainty, but how do you execute that? How do you build the investment machine to go about and capture the opportunity from that?

Feder: The first step is finding people with whom to invest that are capable around the idea of investing with uncertainty. So, if we take a venture capitalist and an earlystage venture capitalist, that earlystage venture capitalist will seek to invest as a partner with an entrepreneur or a scientist who discovers something new. And, if you are investing behind that, you know something about the world that nobody else does. So, if you can do that consistently and pick the right people with whom to invest and execute well in helping build companies—that is an aspect of investing around or within the arena of uncertainty.

Franco: You identify the opportunities. Now, how do you go to the investment committee and say, “We have a wonderful investment opportunity in this unknowable—“

Feder: Right. This is where things are uncomfortable. You go to an investment committee and say, “We’re going to give some money to a group and they’re going to go out into the world for the next three to five years and just figure some things out.”

Franco: In your construct, I understand the competitive advantage that an endowment has. Let’s just switch to portfolio construction. Would it be fair to say, given this theme of the unknowable, that you would be over-indexed in your portfolio to venture capital, for example?

Feder: One of the binding constraints around venture capital for any program is getting access in a big enough dose to the things that you want to invest in. It’s been fairly well documented that venture returns are dominated by a very small number of firms and that the capital it wants to invest with those firms way outweighs the available allocations. So, most investors, including endowments, really never get to the question of how much is too much because they can’t quite get enough without lowering their quality hurdle.

Endowments are particularly well-suited because, if they’re able to traffic in investment ideas where uncertainty prevails, they have some advantages around access to the very best groups

Franco: Talk about measuring success. How do you do that in a long-horizoned context?

Feder: I believe there’s a high qualitative element to this because, by the time you figure out whether a decision you made three or four years ago was a good one, you’ve already started making ones that will be judged three, four, five, six, seven or eight years from there. What we look to is trying to determine whether we made high-quality decisions and whether the outcomes were reasonable, given those decisions. So, making good decisions with bad outcomes is okay.

At some point, you look at returns. If we are able to create a private markets portfolio that consistently ranks in the upper third of the benchmark, we should be fine in terms of generating returns that are about 300 basis points over a public index, or about 1.25 times a cash flow-matched public alternative.

Franco: So, if a manager comes into your conference room and touts exceptional risk-adjusted returns, how do you think about that?

Feder: That’s often code for low returns but low volatility. As an endowment and an investor that has a very long-time horizon, we ought not be too concerned about near-term volatility. We ought to be concerned about real upside and being compensated for taking on illiquidity. So, if it’s code for lower returns, lower volatility, that really doesn’t match well with what we are trying to do with an endowment.

Franco: Would the long-horizoned investment approach have more receptivity to new managers rather than legacy, established organizations?

Feder: It’s the oneandahalf or twoandtwenty model with a three to five-year investment period and 10 to 12-year fund life. It just doesn’t seem possible to me that that could be the exact right structure for every strategy or for every manager in an industry that prides itself on doing things that are idiosyncratic.

One of the things we’ve been spending a lot of time on is creating investment structures. I say structures, not structure, because there are a variety of them that we’ve looked at and considered that allow for the investment partner to drop or relax the constraint of holding period. It’s not to say that we want all of our investment partners to hold their investments for 15, 20 or 25 years.

Franco: What you’re really advocating or arguing for is what George Orwell once said is breaking the Geneva Conventions of the mind as applied to investing.

Feder: I don’t know if we’re doing anything that grand. We’re just trying to be effective investors in a corner of the market that people aren’t supposed to pay attention to.

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