Investing as an endowment works well with $43 billion of assets but the approach doesn’t scale efficiently, and will throw up some significant challenges as the endowment grows, the head of Stanford Management Corporation has told the Fiduciary Investors Symposium.
Size could be a challenge to the endowment-model style of investing, says Robert Wallace, chief executive of the Stanford Management Company, which manages the university’s $43 billion endowment.
Two of the tenets of the endowment model – an aggressive asset allocation heavily weighted towards private equity and venture capital; and partnerships with distinctive funds managers – are challenged by larger asset sizes.
“We implement the endowment model that was developed by my former boss and mentor and friend, David Swenson, and it works really, really well,” Wallace told delegates at the Fiduciary Investors Symposium at Stanford.
“It provides very attractive risk-adjusted returns over long periods. If you can execute well, if you can pick your partners well, I think it’s a really wonderful model in that way, but it doesn’t scale effortlessly or infinitely.
“And so, your ability to manage a portfolio like we do at Stanford [when it reaches] $500 billion is, I would argue, pretty much zero. I don’t think you can do it. Maybe you can do it at $100 billion. I hope I get a chance to find that out. But, you know, at some point it’s not possible.”
Stanford Management Company had just $1.7 billion in assets when was established as a formal entity to manage the university endowment, and Wallace said that even now, with assets of $43 billion, the team is refining its approach due the difficulty in maintaining desired allocations to some asset categories.
“That’s something I think a lot about,” he said.
Wallace said he thinks of asset allocation and manager selection as being “inseparably linked, two sides of the same coin”. He says this is particularly true for asset classes like venture capital, private equity, private real estate, absolute return and private natural resources where the dispersion from active management is very wide.
“If you’re in the median venture capital fund in the United States, you’re going to end up with results that are well below public markets,” he said.
“You have to feel sure that you can access the top quartile, better the top decile.
“You can’t be in the middle of the distribution in these expensive, fancy asset classes. You have to be towards the top of the distribution. And so, your ability to have an asset allocation like this is really dependent upon your ability to build the right partnerships, and so I always think they go together.”
As the fund gets larger its ability to access different partners is changing and Wallace is aware of the impact of size on manager selection.
“At $43 billion our ability to access the right type of partners in some of these categories, particularly early-stage venture, is a lot different than it was 10 years ago when we were $20 billion, and so if we’re every lucky enough to get to $80 billion it will be different again, because some of these categories don’t scale very well, particularly things like venture capital,” he said.
Broadly speaking the endowment is looking for managers which have a competitive advantage that will allow place them at the top of the distribution in their asset class. That means a robust process but also a strong alignment of interest.
“We care a lot about a strong economic alignment of interests, and we work hard to make sure that the economic terms of the partnership that we’re in with our partners are fair to Stanford, and that they reward our partner for superior performance,” Wallace said.
“This is probably the hardest part. We have to see a superior investment judgment, so a strong process that accurately surfaces and analyses all of the quantitative and qualitative risks that go into an investment thesis is essential.”
Wallace said the SMC team spends an enormous amount of time with partners and potential partners, and the due diligence process can sometimes take more than a year. An additional perquisite is an appropriate regard for human an environmental welfare.
“We’re long-term investors, and we care about working with people that have a long- term sensibility, that want to build powerful businesses in the public or private sector and be rewarded for that in the long run, and therefore do demonstrate an appropriate regard for human and environmental welfare,” he said.
The endowment is the biggest line item on Stanford’s $9 billion annual budget, contributing $2 billion a year, the equivalent of about 5 per cent of the endowment in payouts each year. It’s one of two objectives that influence the asset allocation: to provide capital to the university annually; and to impact future operating budgets.
“We need to have a pretty high return over long periods in order to satisfy both of those goals,” he said, noting that around 70 per cent of the portfolio is in equity risk.
“The reason we don’t have 100 per cent in equities is if you’re 23 per cent of the operating budget, and you’re up and down 15 or 20 per cent every year, that’s really hard for the operating budget to absorb, and we would argue that you don’t need to take that volatility in order to get 8, 9 or 10 per cent return from your portfolio.”
Making the most of Stanford’s Silicon Valley location, Wallace is working with the team to take advantage of the innovation and opportunities coming from the venture capital world in its backyard, and the insights of the university’s professors.
But he’s also embracing the opportunity he can afford students and the impact that young, intellectually curious minds can have on the culture of the investments office.
After graduating from Yale, Wallace himself went into the Yale investments office under David Swensen, and it’s ahe has been implementing since he started in the top job at Stanford nine years ago. HMC has hired one or two Stanford undergraduates from the business school as analysts each year, from but also hires from the computer science, philosophy, psychology and history departments.
“You get these incredibly bright, intellectually curious, energetic, high-integrity people that are 21 or 22 and after you’ve given them access to the type of endowment portfolio that Stanford has and the type of partners around the world that we have, after five years they’re phenomenal investors,” Wallace said.
“After 10 years they’re better than you are, almost certainly, and they’re still only 32, so it’s one of the things that we’ve done now for nine years.
“They are these incredible raw sources potential that have no bad habits. It’s been a great source of strength for our office, but also, I think, a source of a lot of fun to have these incredible young people around.”
