Introduction
David Swensen’s Handwritten Note
Star Magnolia Capital was founded in October 2012. Over the past 10+ years, I have made conscious efforts to explain the endowment approach. This task was not easy in Asia, as many people had never heard of university endowments and their investment approaches. Some had heard of the Yale Model, perhaps because their daughter or son graduated from the school, but they interpreted it simply as an aggressive allocation to venture capital, which undeniably outperformed other asset classes after the 2008 financial crisis.
The endowment approach is an philosophical and commonsensical approach pioneered by late David Swensen. In 1985, at the age of 31, he became CIO of Yale's fragile endowment, which had suffered from the Great Inflation of the 1970s that eroded much of its buying power. The endowment, heavily invested in fixed income, found little relief in its real estate investments. After taking the helm, the young CIO initiated an overhaul of the endowment's management to achieve its perpetual goal of supporting academia, making an irreversible impact on the world of allocators.
This 'Finding Experts' series is a collection of essays focusing on how allocators can find their investment managers. It is based on our observations of Yale and other endowments and foundations, as well as our own experiences in the industry over the last twenty years. This series should not be used as a manual, as we are still on a long journey of learning, but we hope it will be useful for comparison in how you identify your experts.
The Framework
The first step in Finding Experts is establishing the Framework. Without this Framework, it's like traveling in a red ocean without a map and compass. Our Framework is rooted in our belief in the endowment approach. The simplest way to understand our endowment approach is shown in the chart below. Generally, there are three steps to managing an investment program: Asset Allocation, Manager Selection, and Security Selection. In the conventional approach, a family office's internal team is responsible for all three steps. However, in the endowment approach, the internal team only conducts Asset Allocation and Manager Selection, while outsourcing Security Selection. Many believe Security Selection is the most critical risk-taking operation and are skeptical about outsourcing it. This requires a 'leap of faith' that many family offices are not accustomed to: trusting others
The difference between the conventional and endowment approaches may seem subtle, but the outcomes are significant. The Endowment Approach begins with trusting external managers for security selection. By outsourcing this process, our internal team can dedicate 100% of our time to Asset Allocation and Manager Selection. Security Selection requires significant resources and a large team to cover global markets for diversification, which many family offices, regardless of size, lack. By trusting external investment managers, we gain the support of an extensive group of professional investors.
For us, Asset Allocations and Manager Selection work as two wheels to enable us generating successful long-term returns, however, many people tend to weigh more on the asset allocations and the manager selection. The asset allocation is a very helpful tool from the governance perspective as it can provide a clear guidance that the investment team can follow and execute the investment process. It is also more exciting to talk about big geopolitical and macro changes of the world. The problem, however, is that predicting the macroeconomics and global market trends are extremely difficult, especially in a short time span, and we tend to have more group thinking to predict the trend. Private banks understand this preference quite well, so they often organize “Next Year’s Tactical and Strategic Asset Allocation” events at the end or beginning of a year. We believe this short-term asset allocation has more harm than benefit. It is important to understand the big macroeconomic conditions and trends in order to identify (1) the irrational exuberance and (2) the market inefficiency caused by uneconomical sentiments, but we shouldn’t believe that we know something markets don’t know.
In contrast, there is limited narrative and analysis on how college endowments like Yale have generated excess returns through the manager selection process. One such rare commentary is a column titled 'The Death of Alpha?' in Yale's 2013 Endowment Report. Yale's argument here is particularly important:
Yale has never viewed the mean return for alternative assets as particularly compelling. The attraction of alternatives lies in the ability to generate top quartile or top decile returns. As long as individual managers exhibit substantial dispersion of returns and high-quality investment funds dramatically outperform their less skilled peers, Yale enjoys the opportunity to produce attractive returns for the Endowment and to demonstrate that manager alpha (excess return) is alive and well.
Over the two decades preceding June 30, 2013, 57% of Yale’s outperformance relative to the median Cambridge Associates endowment was attributable to the value added by Yale’s active managers.
Yale 2013 Endowment Update
https://investments.yale.edu/s/Yale_Endowment_13.pdf
We conducted further analysis on Yale’s attributions to better understand the importance of the excess returns generated through superior manager selection. The table below was created using numerous 'educated guesses,' as Yale does not make this data public.
In our next article, 'Three-Step Execution,' we will discuss how to execute the investment program based on the Framework.
Future Articles of Finding Experts Series:
Finding Experts 02: Three-Step Execution
Finding Experts 03: Trust but Verify Process
Finding Experts 04: Sourcing Experts
Finding Experts 05: Interviewing Experts
Finding Experts 06: Good People
Finding Experts 07: Good Investing
Finding Experts 08: Good Business
Finding Experts 09: Good Operations
Finding Experts 10: Decision-Making Process
Finding Experts 11: Monitoring
Finding Experts 12: Art of Quitting
The World of Allocators (”WOA”)
World of Allocators (WOA), also known as Capital Allocators China (CAC) is operated by Shanghai Ziben Consulting Management Limited, and is the official licensee of the podcast program “Capital Allocators” by Ted Seides and his company. CAC was established in 2020 with the goal of promoting the long termism and endowment approach of investment in the asset management industry in China. We created an investor community that is eager to share and learn, and we serve as a bridge between domestic and overseas practitioners. At the community grows, we believe World of Allocators reflects better our ambition to unite more like-minded professionals on our platform, regardless where they are based.
WOA Family Office Study Group
WOA is launching Family Office Study Group (the “Study Group”, or “FOSG”). In recent years, we recognize more and more family offices became interested in implementing the endowment approach for their own family’s asset management, but they also face challenges – where is the resource family office can learn? This is exactly the reason why we brought Capital Allocators, which accumulated rich educational contents and resources on the endowment approach, to China. We are establishing the Study Group to share the important and useful resources with fellow family office members and practitioners.
Benefit
There will be three communication groups: Wechat, WhatsApp and Slack. You can join both or only one, but it is important for you to be part of the community so that you will not mise the exclusive opportunity we offer to the family office community.
You will be invited to some exclusive events for family offices organized by Academic Partners
You will receive useful information and resources for the development of your family offices
You will have opportunities to interact with other family offices in China, Singapore and other regions
You can access the exclusive resource library for a family office and endowment approach
You will be invited to apply for exclusive educational activities by WOA and its Academic Partners (additional fees may apply)
Eligibility
Must be an Individual or Institutional Member of WOA
Must be a family member or a professional at a single-family office or a professional at a multi-family office
Must have passion to learn and share with other members in the community
Application Process
Application will be open from Dec 15, 2023 and ongoing basis; and applicants will be notified if they are accepted within 15 days
Contact: Fan Fan (fan.fan@starmagnoliacapital.com)
Application will be reviewed and approved by the Operating Committee
Applicant must submit the application form and provide necessary information to verify his/her eligibility (on a confidential basis)
Applicant must sign a confidentiality and no-solicitation agreement
Family Office Learning & Sharing Program
The Learning & Sharing Program offers a discussion-style learning, using Harkness Table approach. This requires all participants to actively engage in the sessions. This unique approach of learning is proven to be highly effective to develop creativity and decision-making skills, but not for knowledge-building.
What is the Harkness Table?
The Harkness table, or Harkness method, is a teaching and learning method involving students seated in a large, oval configuration to discuss ideas in an encouraging, open-minded environment with only occasional or minimal teacher intervention. It is in use at many American boarding schools and colleges. Developed at Philipps Exeter Academy, one of the most prominent boarding schools in the United States, the method’s name comes from the oil magnate and philanthropist Edward Harkness, who presented the school with a gift. He is also a major benefactor to Yale University, Harvard University, Columbia University as well as the Metropolitan Museum of Art.
Main Module
Discussion based, mutual learning session by participants, about a specific topic with a pre-assigned learning material
Designed for senior members of an investment team
Meet once a quarter in person
Foundation Module
Hybrid style of lecture and discussion
Designed for a new family office principles with no or some financial knowledge who are interested in the endowment approach
6 sessions
Meet every month in person