Oregon Investment Council, which oversees $140 billion of investments including the $97 billion Oregon Public Employees Retirement Fund, OPERF, currently has 55 per cent of its assets in private markets, well above its target allocation of 40 per cent. The overweight to illiquid investments that can take years to sell is a growing source of consternation for chief investment officer, Rex Kim.

“We have much less liquidity in our portfolio now,” says Kim in an interview from the fund’s Tigard investment headquarters.

Oregon is not alone. According to analysis from CEM Benchmarking, average LP allocations across private equity, infrastructure, and real estate were at or above target allocations as of the beginning of the year. Meanwhile a lack of exits and rebounding valuations have driven net asset values (NAVs) higher. Analysis from McKinsey and global private markets firm StepStone Group suggests that an overallocation of just one percentage point can reduce planned commitments by as much as 10 to 12 percent per year for five years or more.

One way the Oregon team are approaching the problem is by reducing risk in the liquid portfolio. Comprising fixed income, public equity, and hedge funds, it is supposed to be split 55:45 between stocks and bonds respectively. Today it is tilted 40:60 in favour of bonds.

“We have decided that the mix of this piece of the portfolio needs to be less risky. We look at the risk level of the liquid portion of the portfolio relative to how much weight to illiquids we have, and we want this part of the portfolio to be less risky so it has lower drawdown potential and enables us to pull funding from it overtime.”

To illustrate the problem Kim turns to the real estate portfolio where Oregon has a 12.5 per cent strategic allocation which is currently overweight at 14 per cent. He says the market is struggling to find the right pricing thanks to a vicious circle of lacklustre transactions and little price discovery that means Oregon is struggling to value the assets it is sitting on.

Oregon accesses real estate via separate accounts so has a direct look into the assets. As well as meeting external managers more frequently, portfolio managers now visit the assets to try and get a sense of where the market is.

“We’d like to bring the allocation to real estate down and we will reduce it once there is more price discovery. My hunch is there is more downward pressure on prices to come,” Kim says.

“Many of our peers are facing an overweight in private markets,” he continues. “Our investment managers are aware of the problem, and everyone in the ecosystem is trying to appropriately manage it. From our perspective, it will take numerous years to reset, and that’s ok.”

Still, the large allocation to private markets is knocking on to other corners of the portfolio too. For example, the team, consultants, and board are keen to build out private credit but Kim is minded to wait, describing increasing the allocation to private credit when the fund is already pretty illiquid as a “balancing act.”

For now, the allocation to private credit sits in Oregon’s 0-5 per cent (currently 2.5 per cent) allocation to opportunities, that also serves as a store of dry powder. If the team find an investment that doesn’t fit into the strategic asset allocation, they can invest via the opportunity fund which is also used to incubate ideas – the  allocation to hedge funds, infrastructure, natural resources and bank loans all began life in the opportunities portfolio.

“Long term it’s likely we’ll have a strategic allocation to private credit, but I’d like to see how it behaves in a fuller market cycle and softer market environment. I’d like to see more stress, and see how managers handle that stress,” he says.

The over allocation to illiquids is also hindering his ability to explore new manager relationships. Over the years, Oregon has pared down its number of manager relationships in private equity to a roster of around 35 of the highest conviction names. Now Kim would like to expand the number of relationships. “We do generally think that our manager line up is on the smaller side,” he says. “We want to be somewhere in the 40s.”

In a recent Annual Review of private equity, the private markets team told the investment council that OPERF’s large program is skewed to allocating to larger funds – yet smaller private equity funds have significantly outperformed.

New manager relationships would reflect the evolution of private equity, he continues. The portfolio has steadily evolved since Oregon’s first foray into the asset class, a direct investment in a chain of local grocery stores.

“We still see these types of transactions, but they are not for us. We don’t do direct investments anymore and our portfolio is very tech and consumer heavy,” he says.

Kim says offloading private equity in the secondaries market is difficult. Oregon does transact private equity in the secondaries market, but the volume of transactions the investor requires can only really happen through exits. And he acknowledges this will take a long time.

“It all goes back to price discovery,” he concludes. “With higher interest rates, buyers are wondering at what level to buy assets. It does feel like the bid ask spread is wider than normal.”

Asset owners who assess their outsourced fund managers are facing mounting challenges that mean emerging tools, such as AI, are key to successful operational due diligence. Top1000funds.com takes a closer look at the responsibilities and skillsets of those conducting ODD and why it’s core to a successful investment function. We speak to ODD specialists at APG, Australian Retirement Trust and Local Pensions Partnership Investments in London.

Rigorous operational due diligence (ODD) is a cornerstone of managing relationships with asset managers, as well as being a critical tool in both maximising returns and minimising risk to investors’ capital. 

At the end of the day, an ODD team stands between a great investment idea and a potential operational disaster. And while asset managers can seek to dazzle investors all they like with smart investment theses and cherry-picked investment performance, they’ll quickly run into a brick wall of ODD practitioners who care little for egos, and even less for reputations. 

An ODD team stands between a great investment idea and a potential operational disaster

ODD specialists exhibit a healthy level of scepticism towards what they’re told by asset managers, and willingness to dig deep into a manager’s business to see for themselves how it’s structured and how it works. 

“I want to know how the business is run, not how they want to outwardly project themselves,” says Kevin Eastwood, head of operational due diligence at the £25 billion ($31.8 billion) Local Pensions Partnership Investments.  “I’m into practicalities. I’m an ops person – I want to know how it’s run.” 

A good ODD process generally won’t on its own improve returns, but LPPI chief investment officer Richard Tomlinson – to whom Eastwood reports directly – has observed that “deep and detailed ODD underpins a solid investment process and provides CIOs with an additional, critical risk control; return of capital is more important than return on capital”. 

ODD looks past investment returns and the performance claims of asset managers to take a cold, hard look at the quality of the governance, controls, processes, and systems underpinning the manager’s business and investment strategy. 

“Our role is to assess a manager, to do a risk-based assessment of a manager, on their operational controls and functional areas,” Eastwood says. “It’s literally from the moment the manager has an idea. From the point that he executes that idea we’re looking at the governance, we’re looking at the controls, we’re looking at the systems; and we will follow that transaction through the entire process: how it’s settled and how payments are made; how does it get communicated to the service providers; how is it reported; how the compliance people look at it; how the risk people look at it – all the way through to investor reporting.” 

When ODD works, it supports asset owners in selecting managers unlikely to come unstuck through some sort of business or process failure. When ODD doesn’t spot the red flags, it can lead to the loss of investor capital and incalculable reputational damage to the asset owner. 

Global head of operational due diligence for the €569 billion ($617.3 billion) APG, Michiel Vetkamp, says the fund’s portfolio managers focus on the asset manager’s investment proposition, whereas the ODD team focuses on “the operational profile of a firm you’re engaging with”.  

“That can be an external investment manager. In our case, it can also be what we call a direct private investment,” Vetkamp says. “That’s usually a corporate such as a wind farm, a hotel, or something else. Obviously, we want it to be a solidly organised firm.  

“Our perspective is more the operational perspective. The PM usually starts with the investor proposition; we are more looking at the downside, that the firm is really solidly organised.” 

Vetkamp says the APG team conducts ODD on managers in all asset classes where APG has externally managed money and conducts the process globally. 

For some asset owners, ODD is a major undertaking. Australian Retirement Trust senior operational due diligence specialist Andre Kopiec says the A$260 billion ($171 billion) fund has money invested with around 260 external managers across all asset classes, and every manager receives an attestation or a “small health check” from the ODD team at least every year. 

“We also do look at managers on a risk-based approach, where we will do what we call either a desktop deep-dive, or an onsite visit,” he says. “It means that over a four-year period, those managers will at least have had a deep dive.” 

New and emerging challenges 

Asset management is dynamic and complex, and the ODD specialist is constantly faced with new and emerging issues to grapple with. 

“Cybersecurity is top on the list,” Eastwood says. “It’s an ever-moving feast. In regulation, things are changing so quickly. The great thing at the moment is the SEC [Private Fund Adviser] reforms – that’s going to change [things] about transparency and valuations. We need to figure out how we do that. 

“We work with our RI team. Obviously, the investment team are asking about ESG; so are we. Are we asking the same thing? No. They’re asking about strategy; we’re asking about the manager. We want to know how they run the business.  

“We also ask about diversity and inclusion. That’s becoming a big-ticket item.” 

Vetkamp says the role of the due diligence expert is “is ever-evolving”. 

“What you see is that [on] some risks, our risk view is changing over time,” he says. “If you look at information security – that’s fraud, perhaps the most important one – every organisation is becoming more vulnerable to information security, cyber-crime, et cetera. That has become more and more an important focus.  

“In the past, we always looked at IT. Then, we looked at IT governance, IT control environments. But nowadays, we spend much more time asking specific questions about do you have vulnerability software detection software, do you perform penetration testing on IT? Is that mandatory? Do you do it on an annual basis? Is it on a rotating basis with different providers? All that kind of stuff. Information security has become more and more important.”  

Kopiec says the starting point for most ODD processes is a questionnaire sent to an investment manager. But even the questionnaire – its structure, the issues it canvasses and how the data is collected from the managers – has evolved. 

“If I go back to when I started, information security, was quite minor,” he says. “Today, it is a core component of what we look at. For investment managers we are looking at the framework, the controls to make sure they’re robust, and they can meet the regulatory requirements as put out by the regulator.  

“It’s probably gone from two or three questions to a lot more, in terms of framework process control. So, in that respect, your questionnaire will change also,  

“The way that we’ve looked at how we invest with managers also impacts the question, affects the questionnaire. And the final one probably, is that internally, as a group, we’ve discussed whether or not the questionnaire is fit for purpose.”  

ODD in a time of automation and AI 

A certain amount of ODD work is automated or at least mechanised, such as collecting information from asset managers via questionnaires. However, the use of AI to streamline the process is only now beginning to emerge. 

Vetkamp says APG launched an in-house-developed ODD tool in late 2023. 

“It has brought more control. Efficiency is still a purpose, but if I’m really honest, so far it is primarily focused on additional control and having a uniform standardised methodology,” he says.  “It’s what we call an ODD workflow management tool, where it guides the PM or the ODD experts through the whole process of ODD, via an automated mechanism.” 

Vetkamp says that in the analysis and reporting phase of the ODD process the APG tool has an embedded risk control framework which “triggers you to think about what kinds of risks and controls are important for this type of assets class and this type of manager”.  

“The first step in ODD is a due diligence questionnaire. The tool also enables us to make that much more tailored. Basically, what we do when we start is that we define the asset class but also some specific manager characteristics – so how mature is the manager? Is it only in developed environments or is it also in less developed countries? 

“That enables us to make the ODD questionnaire much more tailored before we send it out.” 

To date, AI has played only a small role in how both APG and LPPI conduct ODD, but Vetkamp says APG is developing a screening tool based on AI that will scour the world’s news sources to bring to its attention anything it needs to know about the managers it has placed money with. 

“We have selected an external data provider, who is basically collecting all the news, and that’s huge, the universe of news is huge,” he says. 

APG is developing a screening tool based on AI that will scour the world’s news sources for news about the managers it has placed money with

Eastwood says technology is embedded in the process to some degree now, but he expects that it will make further inroads, particularly the application of AI to sorting through large volumes of information. 

“We’re testing some AI and how that can work,” he says. “Can it do what I need it to do now? No. Could it? I think so. We have to be careful how we ask AI the questions for it to go back and look for. 

“The application that I see at a local level, potentially, is could I point AI, with my questionnaire, to a certain set of documents and ask AI to go into those documents and answer those questions for me?” 

Vetkamp says a welcome AI-based development would be to help organise the provision of information about asset managers. 

“What I’ve seen in the market is there are some initiatives where firms basically collect all kinds of information from investment firms so that they can easily offer it,” he says.  “They have huge questionnaires with standard responses available, which are being updated all the time. I think it’s now really still at the early stages, but it may be quite nice evolvement actually, if that happens, that you could reach out to such an organisation for all the up-to-date information, basically, and that you would get it instantly.” 

Kopiec says that ODD is a data-intensive activity and while technology has played some role in making the process more streamlined there is further work to do. 

“It doesn’t matter who you talk to, there’s a questionnaire that needs to be sent out in need to obtain information back from a prospective investment manager,” he says.  “What’s changing is how information is gathered and collected, and that’s a journey, which is still evolving. To this day, whether it’s through a consultant or through industry, market participants, how you can obtain information in the most effective manner and be able to analyse it is what we’re still working towards.” 

Change keeps it interesting 

Kopiec describes ODD as the ability to look dispassionately at an investment manager “through an independent lens to ensure that it aligns with ART’s risk appetite”.  

“We’re independent of the investment team,” he says.  “We provide the independent colour to the investment team and the relevant committees, so they can factor that into their practices. We have an independent review or control framework…so it’s not influenced [by the investment team]. 

Kopiec says a big part of the challenge of ODD, and the pleasure of doing it, comes from the fact that “it is a constantly changing landscape”.  

“If I think about what it looked like when I first started [compared] to today, the reason why I like to do it is because it continues to evolve,” he says. “Whether it’s through ART’s growth, to the investment managers, to the regulatory landscape, each has a challenge. That’s what continues to drive people in ODD, because it doesn’t matter whether you look at a manager today, compared to three years ago it’s not the same lens, it will have changed.” 

Typically, an asset owner’s ODD process kicks in after its investment team has already determined that it needs to hire an external asset manager, and often the investment team will conduct some investigations and can weed out managers that are obvious non-starters before handing over the task for a deep dive by the ODD specialists. 

“We then will work with the team to understand whether or not that manager is going to proceed; only at the point where that manager is going to proceed would we then start the due diligence process,” Kopiec says. 

“The way that I would look at it is if you use the funnel approach, where you have a large number of investment thoughts, distil that down to where you get to the [point] we’re going to move forward; and we then get engaged with the relevant asset classes to start that process.” 

Vetkamp says APG’s portfolio managers have long been involved in ODD, but in 2017 it made ODD a centralised and specialised activity. 

“And to be honest, since that time we have continuously been working on what we call the ODD framework,” he says. 

It’s a two-way street 

LPPI’s Eastwood notes that ODD creates a virtuous circle. It gives an asset owner confidence in the business models and structures of the asset managers it hires, but it can also deliver valuable feedback to asset managers to help them improve systems and processes, which is good for asset owners. 

“Part of the discussion that we have with the manager is we say to them, we’re not here to play gotcha. That’s not our job. We’re not consultants. We’re not being paid by the amount of red flags that we find. We’re not there to discount them, we’re there to see if we can invest with them in a safe and secure environment.” 

Eastwood says feedback commonly takes the form of comparing a manager’s processes and structures with what LPPI sees across the market, and what it considers to be best practice. 

Feedback commonly takes the form of comparing a manager’s processes and structures with what LPPI sees across the market

“We sit in front of 30 managers a year; these managers don’t,” Eastwood says.  “Our knowledge and our information is valuable. We give that back and the managers appreciate it. 

He says there is rarely a single flaw or shortcoming in an asset manager’s business operations that turns out to be a complete showstopper, because such managers are not likely to get past the investment team to start with. But there are some common red flags that prompt closer attention or discussions with a manager. 

Typical warning signs may include “inadequate controls; and risk-management systems where I can’t see how they control the business, how they’re monitoring risks, how they’re doing any risk-assessment of the business”, he says. 

“And lack of transparency around fees, valuations, controls, or where they say, ‘oh no, we don’t share that’. Why? OK, talk to me.” 

Kopiec says ART has always “taken a collaborative approach with all investment managers, whether we proceed with them or not.”  

He says the fund has a core set of expectations of any manager it considers working with, around organisational structure and people, internal controls and assurances, and operations and IT. It makes these expectations clear at the outset of any engagement and is prepared to work with a manager, within reason, to remediate any issues it may find before committing capital. 

“If a manager was below what we would consider to be a minimum threshold, then that is where we would escalate those issues through internal review, and from that determine whether or not they could be remediated prior to appointment,” he says. 

“We would have discussions with the investment team, and with the investment manager, to determine whether or not they were willing to take on board ART’s feedback, and maybe implement what we’ve said. 

“We will not just tell the manager ‘no’ per se. I’m quite happy to say that in the last five years, there’s only been one manager we’ve said no to, and that was simply because the manager was going to take a lot longer to remediate the issues in the timeframe that we were prepared to accept.” 

Being taken more seriously 

APG’s Vetkamp says asset owners’ focus on ODD has become more significant in the past few years and that “over time, it’s being taken more seriously” by investment teams and senior management ranks. 

“I think originally, the Netherlands, Canada and Australia were the main countries that devoted a lot of attention to ODD, but what I see now happening is that many more institutional investors from other jurisdictions are also starting to have ODD professionals, dedicated teams, et cetera, to look at it,” he says. 

Vetkamp says that while it may be true that the volume of funds placed by some asset owners with external asset managers has increased – placing more capital at risk of events such as fraud – one other driver is “also the regulators, who are also asking more questions about ODD when they do their regulatory investigations”. 

“If you outsource something you are still somehow responsible, so you have to demonstrate that you’re outsourcing to a solid party, and you also need to be able to demonstrate this to the regulator,” he says. 

LPPI has three full-time ODD specialists and has an outsourcing arrangement to a specialised external consultancy to handle overflow and “they can, under [our] permission, go and perform an operational due diligence on our behalf. 

“We also have with one of these consultants a 20-days secondment environment, where if need to I can pull somebody in from this business and drop them into my business for 20 days,” he says. 

To date the LPPI team has been focused on assessing new managers to add to its line-up, and Eastwood says it is preparing a program to systematically review incumbent managers. 

APG has eight ODD specialists: seven in Amsterdam and one in New York, with a ninth soon to be added in Hong Kong. 

“The APG ODD team functions as a global team, with a global pipeline and globally uniform processes and systems,” he says. 

“And to be honest, we have more business, more flow, than that the person in Hong Kong can absorb, so in that sense the team in The Netherlands will still help. And basically, the same goes for US.” 

Vetkamp says APG’s ODD team is “positioned in the first line of defence, we are residing as part of the chief investment officer”. 

“We also have some ODD professionals in the second line, in risk management, who basically look at our work…and also form their own opinion as part of risk cycle for the investment committee, if new investment proposals are being prepared,” he says. 

LPPI’s Eastwood says some asset owners locate ODD specialists in their risk operations, but he says they function better when treated as part of the investment team. 

“The reason why it works better is Richard [Tomlinson] was at Albourne Partners and understands what ODD is. And he believes that this is part of the investment team, because we’re part of the investment decision process. I hadn’t thought about it like that before; I would have thought it’s a risk-based approach. It is, but this way works so well because you’re embedded into the decision process. In my opinion, it’s the best place for them.” 

ART head of investment operations Antony Gold says the fund’s ODD team is part of a 70-person investment operations team that ultimately reports to the fund’s chief financial officer, unlike the ODD teams in LPPI and APG, who report to the CIO. 

“There’s very much are two schools of thought out there, and we’ve obviously gone for the segregated model,” Gold says. 

“Our workload is more aligned to the CIO than to the CFO, but from a segregation of duties perspective it’s not only ops due diligence we do, we do performance and data reporting, which the investment team is remunerated off. We…govern the investment data to make sure that…there’s independence from people who might benefit from that.” 

“We’re not aligned to the investment team, we’re there to make sure we’re aligned to the fund as a whole, and we’re making the right decisions, and we’re not part of a team that is driven towards making an investment.” 

 

Research into Top1000funds.com readers’ preferences and habits reveals that the publication is rated as the most useful to them in the performance of their jobs, and is read by some of the most senior investment professionals inside asset-owner organisations around the world.  

New independent research reveals that Top1000funds.com readers consider the publication the most useful of its type for delivering news, insights and analysis that help them in their jobs.  

The publication, launched in 2008 with the aim of promoting best practice in asset ownership and management in the global community of international pension funds, sovereign wealth funds and other institutional investors, is rated by almost three-quarters (73 per cent) of its readers as the most useful publication to them. 

It ranks well ahead of Bloomberg (68 per cent) and FT.com (65 per cent), while less than half consider Institutionalinvestor.com (48 per cent) and Pionline.com (28 per cent) to be most useful to them. 

Overall, 96 per cent of Top1000funds.com’s readers find the publication useful, including 62 per cent who say they get information from it that they simply cannot get anywhere else.  

Top1000funds.com’s focus on investment strategy and implementation issues and commitment to original news stories, case studies and research means that almost a third (31 per cent) of its readers say it is an essential business resource for them, and around four in 10 (39 per cent) regularly share articles published in Top1000finds.com with colleagues and friends. 

The publication’s differentiating factors – including being for and about asset owners, and the mission to lead the global investment industry to continuous improvement – have positioned it well among readers. The publication continues to push the industry to question whether status quo processes and behaviours to tackle risks and opportunities will be sufficient in the future, and actively campaigns for diversity, sustainability, transparency, innovation and better alignment of fees in the investment industry. 

The research, conducted independently by US-based market research firm Signet Research, shows that more than half (52 per cent) of Top1000funds.com’s readers are employed by asset owners, including public and corporate pension funds, sovereign wealth funds, foundations, and non-profit institutions. 

96 per cent of Top1000funds.com’s readers find the publication useful for their jobs

It shows that Top1000funds.com reaches the key decisionmakers inside asset-owner organisations. More than half of its readers hold senior roles within their respective organisations, including 18 per cent who are chairs, chief executives, presidents or partners; and more than a quarter (26 per cent) who are chief investment officers, portfolio managers or heads of asset classes. 

In addition, almost half (47 per cent) of readers are involved in investment policy committees, pension boards, boards of directors or executive committees, or other committees and boards.  

Around 45 per cent of readers are personally involved in selecting external asset management firms – and for around half of the 55 per cent that are not, it’s only because their organisations do not employ external firms. 

Overall, about 85 per cent of readers are directly or indirectly involved in or influence asset manager selection. 

Almost a quarter of Top1000funds.com’s readers work for organisations that manage $100 billion or more. The average asset size of a Top1000funds.com reader is $148 billion. 

Top1000funds.com enjoys a truly international reach and a geographically diverse readership, with 44 per cent located in North America, 28 per cent in Europe and 19 per cent in Oceania.  

And its readers are loyal, with one in seven (14 per cent) having read the publication for 10 years or more, and another four in 10 (38 per cent) having read it for between five and 10 years. But it also continues to attract new readers, with around one in 12 (8 per cent) having read the publication for a year or less. 

Three of Top1000funds.com’s regular featured editorial and research projects and Fiduciary Investor Symposium (FIS) events are well understood and supported by its readers, with 66 per cent, 63 per cent and 57 per cent of readers aware of the Asset Owner Directory, CIO Sentiment Survey and Global Pension Transparency Benchmark, respectively. 

More than a third (35 per cent) of readers have already attended a FIS event and will attend again in future, with another 24 per cent saying they plan to attend their first FIS event in future. 

Around eight in 10 (79 per cent) of Top1000funds.com readers are male and two in 10 (20 per cent) are female, with an average age across the board of 54 years. Almost six in 10 (58 per cent) hold a master’s degree or higher, including 12 per cent who are PhD qualified. 

Every morning at around 7.30am the investment team at the Stanford Management Company, SMC, managers of Stanford University’s $40 billion endowment, receive a flash estimate of the value of the portfolio. If market movements have taken assets in the portfolio away from their policy weights impacting its risk return and liquidity characteristics, the team will sell what has gone up and buy what has gone down to bring assets back to target.

Rebalancing can happen daily in times of volatility and is a central tenet to success of the endowment that supports research at the university in the heart of Silicon Valley.

Speaking at Norges Bank Investment Management’s 2024 investment conference, SMC’s CEO Robert Wallace outlined three essential pillars to successful investment: strategy, execution – under which rebalancing falls – and governance.

Wallace joined SMC in 2015, and his prior experience included a five-year stint in the early 2000s at Yale Investment Office where he started as an intern and rose to a senior associate role under celebrated investor David Swensen. He attributed SMC’s robust long-term returns to these central tenets.

“If you had taken $100 in 1991, when SMC was established, and invested in the endowment portfolio you would have made 32 times your money by mid-last year. That’s double the amount you’d have achieved in a typical endowment, and four times the result if you’d taken the same $100 and invested it in a 70:30 portfolio divided between equity and bonds. If you form the right strategy, have the ability to execute, and good governance that protects you from outside interference, you can get attractive long-term results.”

Execution at SMC also involves rotating capital inside the asset classes. When SMC’s carefully picked cohort of external managers flag that the opportunity set has evolved, Stanford’s investment team act.

“If the opportunity set gets more attractive, we give them more money and if it gets less attractive, we take money back” he said. “Rebalancing between asset classes and rotating capital within an asset class can take up to 30-50 per cent of the value of the endowment in a single year. We are very active in managing the portfolio.”

Manager selection is also essential to successful execution. Witness the dispersion among leverage buyout firms in the US between 2001 and 2020. Investors in the top 5 per cent of this universe outperformed the medium by 20 points a year while the bottom 5 per cent underperformed the medium by 20 points.

“If you have a complex strategy like Stanford, you have to be in the top distribution in this asset class, and it’s the same for private real estate and venture. You need to execute well.”

Accessing and selecting specialist, niche investment firms rests on key principles, he continued, warning the audience they “probably wouldn’t know the names of most of them.” SMC selects managers according to their grasp of the difference between investment and speculation, and only works with managers that have a strong and repeatable process that the team can see and touch. Next, managers must be able to apply superior investment judgment to data so the SMC team can understand how they assess the risk and return and what kind of weights to attach.

“When we make a mistake about a partner, it’s mostly because we get their investment judgement wrong,” he reflected.

Wallace added that he doesn’t like managers sitting on too much capital either. When this happens, they should return capital to investors so “size doesn’t become the enemy of performance in our portfolio.”

Execution also rests with Stanford’s own team, working on an open floor plan to engender collaboration, minimize hierarchy, and make it fun. Wallace described an investment team characterised by intellectual curiosity; an ability to accept personal accountability for investment decisions and with a strong sense of mission.

“We try to grow our own talent; hire out of Stanford and train our own,” he said.

SMC’s renown strategy (the first pillar of investment success) has a 70 per cent exposure to equity in a reflection of the endowment’s high compound real return target of 7.1 per cent. SMC must ensure 5 per cent of the endowment goes to support the academic life of the students present and future annually, and that returns also take into account the rising price of education year on year. “Higher education price inflation runs higher than CPI,” said Wallace.

The equity bias in the portfolio brings worrying volatility, and price volatility, he warned, erodes long term compound returns. SMC counters this by diversification across every flavour of equity from public to private, international and asset-backed. Although domestic public equity  (8 per cent) international public equity (16 per cent) private equity (38 per cent) real assets (10 per cent) are correlated, these allocations do react differently to macro events.

SMC then adds fixed income/cash (9 per cent) and hedge funds (19 per cent), designed to give high expected returns but with reasonable levels of volatility.

Wallace said governance is the final pillar and crucial in supporting the disciplined execution of the right strategy. Governance comes into play when a particular asset class is outperforming everything else. Bad governance would encourage chasing the sector. Alternatively it would allow panic selling risky assets to raise cash in a falling market, when the right thing to do is rebalance to the desired risk return.

“Governance shelters the management team from external influences,” he concluded.

Factor rebalancing a portfolio is a better way to manage liquidity and leverage implications of illiquid assets compared to traditional rebalancing to a static asset allocation, according to new research presented at the Fiduciary Investors Symposium in Singapore.

A research paper, (Re)Balancing Act: The interplay of private and public assets in dialing the asset allocation, published in the Journal of Portfolio Management in April, proposes a new way to rebalance portfolios that more deliberately considers a more stable risk and leverage profile of a portfolio.

Co-author Redouane Elkamhi (pictured), Professor of Finance at the Rotman School at the University of Toronto, who presented the research in Singapore, said this approach allows investors to rebalance to the same underlying exposures – such as growth, inflation, and real rates – without being forced to rebalance to the fixed allocations.

“Generally, we think if you have come back to the SAA and rebalance, that is an active decision at each point in time that that is the best portfolio you can hold,” he said. “Coming back to that starting point is a big call. We need to be more dynamic in the face of uncertainty and the framework we have worked under for a long time.”

The factor rebalancing approach focuses on addressing a number of problems when it comes to rebalancing illiquid assets. For example, during market downturns, private assets can become significantly overweight due to stale valuations and the depreciation of public assets.

And standard rebalancing strategies can unintentionally introduce leverage due to the illiquid nature and potential stale valuation and lead to a deterioration of the fund’s liquidity position.

“You can’t easily rebalance illiquid assets, but the way people deal with that is by leverage, which means an unintended active decision that has implications on value-add,” Elkamhi said.

“This is a plumbing issue – a serious issue in asset management. As the privates get bigger it creates liquidity and leverage problems.”

Liquidity and leverage

The paper demonstrates how liquidity and leverage changes with a traditional rebalancing approach and using factor rebalancing which is designed to help the portfolio achieve more stable profiles in terms of leverage, risk, and liquidity.

This is done by considering public assets as complements to the illiquid private assets and making adjustments to the allocations of public assets to maintain the desired factor allocation for the overall portfolio.

Elkamhi said the approach gives investors a framework that allows a portfolio to be tilted without unintended active decisions.

Elkamhi said the paper was not a view on the optimal allocation to private versus public assets but a tool to rebalance to desired allocations without the unintended impacts on leverage among other things.

“If you have constraints to come back to the fixed allocations this is giving you a degree of freedom to give you a better liquidity coverage ratio and to better deal with privates in the portfolio,” Elkamhi said.

“We are not advocating for more privates but if that is the aim our methodology allows you to have more private without effecting the liquidity coverage ratio (LCR) level the same way traditional rebalancing will do, with a huge magnitude.

Redouane Elkamhi is part of the faculty of the University of Toronto and will speak at the Fiduciary Investors Symposium on campus from May 29-31. For information click here.

In September 2022, the University of Exeter convened an international meeting titled ‘Tipping Points: from climate crisis to positive transformation’.  Part of the conclusion, and the subject of subsequent work (See USS outlines new climate scenarios for improved decision making), is the idea that ‘positive social tipping points’ are probably the fastest and most powerful way of addressing the climate crisis. That is the origin of this thought piece – how might we tip a social system?

Let’s start by creating a model to represent a generic social system. The model will be in the form of a network that has nodes and connections. The nodes will be entities that are capable of making decisions – so individuals and business (but with scope to go more abstract into algorithms, smart contracts and generative AI). The connections between nodes are flows. As we are considering social systems, these flows can include virtues like friendship, help and love, as well as more typical flows like information, money, goods and services.

Complexity science often refers to systems performing computation (they work out the best allocation of resources – the ‘invisible hand’), so let’s use computers as an analogy. A computer has an operating system and the real world equivalent is the ‘rules of the game’. The ‘rules of the game’ is shorthand for a very large set of layered ‘commands’ which govern the behaviour of individuals and corporations. They include international, national and local laws, as well as unwritten values and norms that govern ‘how we do things in this part of the network’[1]. They therefore encode the prevailing ideology (eg capitalism is the best way to organise an economy), amongst other things.

Similarly, the ‘software’ describes how the node processes incoming information and makes decisions. Some of the node’s decision-making algorithm may be standard across most local nodes, but some of the lines of code are likely to be bespoke and dependent on individual context. For example, the majority of nodes at the present time are likely to have a component in their algorithm which encodes the following sentiment: “the products of fossil fuel companies are currently required for internal combustion engines; AND immediately cutting off the supply of those products would be more harmful than beneficial”. We can imagine that the algorithm of a climate activist encodes a conflicting, or opposite, sentiment.

Using this mental model, we now have a line of sight to the answer to our question – how might we tip a social system? We can change the information flowing through the network; we can change the individual decision-making algorithms; or we can change the rules of the game that apply to all nodes.

In essence, our desire to tip a social system implies a number of things:

  • The behaviour of the social system is currently suboptimal (against some objective; this is likely to be a value judgement)
  • The behaviour of the components of the system might be suboptimal (against the larger, system objective)
  • We have identified a mechanism by which we can easily change the behaviour of at least some of the components (a tipping point implies we are looking for small changes that can have a large effect)
  • The change in behaviour of those components will propagate through the system, causing other components to change their own behaviour
  • The aggregate result of the changed components, will be significant change at the system level.

Our mental model shows how we might attempt to intervene within the system to bring about the change we desire. Most powerful, but most difficult, is to change the ideology (operating system). For example, we could seek to replace “growth is good” with “growth that damages the ecology or the environment is bad”.

We can also lobby for changes to the law. Many countries have already signed into law net-zero emissions commitments, opening the door for further laws to aid its achievement. This would change the societal incentive structure (the rewards and punishments attaching to behaviours). For example, a law that changes the price structure will trigger multiple behaviour changes.

Next, we can try to change the software. Because we are dealing with social systems, this will include a consideration of values and ethics, not just beliefs about how the world works. For example, does a human life in the global south have the same value as a human life in the global north?

I would argue that our current algorithms imply it has a lower value. If that is an uncomfortable, or even abhorrent, thought, then you are free to adjust your own algorithm accordingly – but the change might not produce as much financial return. To push a social system over a tipping point, we are effectively looking for the equivalent of a computer virus – a change in code that spreads through the network, altering the algorithm of each node it ‘infects’. This is what climate activists believe they are trying to do.

Finally, we can seek to change the information flowing though the network (the inputs to the algorithms). In a sense, this is what climate science has been trying to do.

In this thought piece I have only been able to sketch the initial idea. However, it seems to me that the conversation over social tipping points would be greatly enhanced if it included the change mechanism it was seeking to employ, in order to trigger the system change it would like to see.

Tim Hodgson is co-founder and head of research of the Thinking Ahead Institute at WTW.

[1] In the framing offered by Donella Meadows in Leverage Points: Places to Intervene in a System, our rules of the game relate to her three most significant (and hardest) intervention points – the mindset out of which the system arises; the goals of the system; and the rules of the system (such as incentives, punishments, constraints)