The Art and Science of Investing
Successful investing is one part "art"…
The term "art" covers many aspects of life: images of beautiful art galleries, exquisite paintings, and even masterpieces by Shakespeare are quickly brought to mind with the mere mention of the word "art." The word "art" hardly brings forth images of Wall Street, investment risk, hedge funds…or any of the thousands of other words associated with the investment world. Just like in the painting of a splendid watercolor, though, the art of investing relies on creativity and judgment. This reliance on creativity and judgment is exemplified in UTIMCO's successful investing in hedge funds. Hedge funds are a classic application of the art in investments.
Hedge funds have historically outperformed most equity and fixed income indices on a risk-adjusted return basis, but the range of returns within the hedge fund industry is continually broadening. Therefore, an important element for the Marketable Alternatives group at UTIMCO is the selection of top quartile hedge fund managers that will outperform both market indices and hedge fund peers. In identifying and evaluating these top tier hedge fund managers, the Marketable Alternatives group relies most readily on qualitative and artistic factors.
Just as an artist is initially compelled to source an idea to paint or an object to sculpt, the first step for the Marketable Alternatives staff is to source top tier hedge fund managers to add to the UTIMCO hedge fund portfolio. Identifying these managers involves UTIMCO's broad network of hedge fund contacts, which can include other endowments or foundations, hedge fund managers, capital introduction groups at the large investment banks, and UTIMCO's consultant, Cambridge Associates. Once a potential manager has been identified, the UTIMCO staff begins the process of appraising the various factors of the hedge fund manager. Although the Marketable Alternatives staff does review historical performance statistics, more concentration is placed on qualitative factors such as the strength of the investment team, the effectiveness of the strategy, and the competitive edge of the investment manager. These essential factors are often not quantifiable, but are instead understood through numerous due diligence meetings with the managers over an extended time frame.
The allocation of capital among the hedge fund managers in the Marketable Alternatives portfolio is also a more subjective process. A capital allocation for a particular manager is based more on the conviction and confidence UTIMCO has in the manager rather than a complex optimization model. The Marketable Alternatives group looks to position the experienced and established hedge fund managers as core investments and the more specialty managers as satellite investments. The resulting portfolio is a culmination of successful and complementary hedge fund managers that take a similar approach to investing in securities as UTIMCO does in hedge fund managers.
A central component of UTIMCO's evaluation of a hedge fund manager is his ability in security selection, which in itself involves a high degree of artistry. An example position that demonstrates the art of investing by a hedge fund manager is YUM! Brands, which is a long position that has been successful for one of our current hedge fund managers. YUM is a company of quick service restaurants such as KFC, Taco Bell, Pizza Hut, Long John Silver's, and A&W. The hedge fund manager sourced YUM through an article in the Wall Street Journal that mentioned a significant price decline due to poor year-over-year financials reported by the KFC brand.
The manager had liked YUM since the time it was spun out of PepsiCo, but the valuation of YUM was too expensive to warrant an investment previously. However, the recent price decline offered a data point off which to conduct further research. As part of the initial research process, the hedge fund manager developed operating and cash flow models, all of which indicated that the recent price decline was unsubstantiated. Understanding the financials and operating model of YUM resulted in a small position of 2% in the portfolio during October 2002. However, in order for the investment manager to establish a meaningful position in the portfolio, he would have to conduct more qualitative research. The qualitative research on the part of the investment manager included elements similar to those included in UTIMCO's research process of hedge fund managers: evaluating the strength of the YUM management team, the effectiveness of the company's strategy, and the competitive edge of YUM. To properly understand these factors, the investment manager conducted field research, interviewing franchise owners at some of the larger KFC, Pizza Hut, Taco Bell, and Long John Silver businesses. The results from this qualitative research process further confirmed the positive investment thesis of YUM. The ending investment thesis included the following qualitative data points: 1) a positive relationship between company management and the franchise owners, 2) a strong management team and energetic company culture, 3) a co-branding effort (e.g. Taco Bell and Pizza Hut in the same restaurant) that should strengthen volume sales, 4) a significant percentage of franchises owned by YUM, which aligned the interests of the company with franchise owners, and 5) an international distribution system that was underappreciated by the market. In the end, the investment manager viewed YUM as an attractive position, as it was a great business model with a temporary dislocation in price. Therefore, the manager built into a larger 8% position based on the qualitative details behind the numbers. Subsequent to becoming a larger component of the manager's portfolio, the price of YUM! Brands corrected, experiencing an increase of over 75%.
As demonstrated from the example above, UTIMCO's process for selecting hedge fund managers mirrors the process the hedge fund managers use in selecting securities. Both processes require additional insight into the qualitative aspects of a business, which involves more than the numbers - or science - of investing. Though there is a general misconception that hedge funds are inherently risky, the managers in which UTIMCO seeks to invest are all characterized by certain similar qualitative factors, such as experienced investment teams, conservative risk management approaches, and stable business models, that mitigate the business and investment risks of the hedge fund. Further quantitative analysis supports the claim that these qualitative elements do indeed contribute to reducing the risk of the individual manager as well as the UTIMCO portfolio as a whole.
and one part "science".
In the Art of Investing, we discussed the expertise of our Marketable Alternatives team. Figure D illustrates the team's ability to select quality hedge fund managers by comparing the UTIMCO portfolio's returns with the returns of four other major asset class indices.
If you had invested $1,000 a little over six years ago (the time when UTIMCO first invested in hedge funds), your original investment could have grown to $1,780 by the end of August, 2004. This represents a compounded annual rate of return of almost 10% as compared to 1.2% for the S&P 500 and 6.7% for the Lehman Brothers Aggregate Bond Index.
In addition to providing attractive returns, hedge funds play an important role in the endowment funds. By adding a portfolio of hedge funds to the asset allocation mix, risk is actually reduced in the overall portfolio. Wait, how can that be? You thought hedge funds were risky, didn't you? Hedge funds are able to do this for two reasons: 1) they have lower volatility (variability in returns or standard deviation) as compared to other asset classes; and 2) they have a low correlation with other asset classes. Correlation measures how returns from one asset class move in relation to other asset classes. Two asset classes are said to be correlated when movements in one asset class, "A", are mirrored by movements in another asset class, "B". The opposite is true if asset classes A and B are negatively correlated; when asset class A increases, asset class B decreases (or vice versa). If asset classes A and B have no correlation, B does not move consistently, up or down, with A. As a result of their low volatility and correlation, hedge funds serve to reduce risk in a portfolio. They neither go up or down as much as other asset classes, nor do they go up or down consistently with other asset classes.
To illustrate the impact of hedge funds on portfolio asset allocation, in Figure E we compared the UTIMCO Policy Portfolio for the endowment funds, which includes hedge funds, with two portfolios that exclude hedge funds.
In Portfolio X the hedge fund allocation is replaced by public equity and fixed income, split 2/3 and 1/3, respectively. In Portfolio Y, hedge funds are replaced entirely with fixed income. The assumptions used in this analysis are those which were developed earlier in the year by UTIMCO Staff and the UTIMCO Board for our annual Asset Allocation Review. As expected, the portfolio with hedge funds, the Policy Portfolio, has an equivalent return, but lower risk profile than Portfolio X. Although Portfolio Y has the lowest risk, due to the large fixed income allocation, it also has the lowest returns - returns so low that they will not cover future endowment distributions, expected inflation and expenses estimated at 8.1%.
So far in this discussion, we have focused on UTIMCO's hedge fund program performance and its impact on asset allocation, but how do hedge funds in general perform relative to other asset classes? In Figure F, we graphed individual hedge funds (fuchsia diamonds) against hypothetical portfolios consisting of 25 randomly selected publicly traded stocks (purple diamonds) in risk-return space.
We define risk here to mean standard deviation. The data used are monthly returns from January 1999 to December 2003 from 2,215 hedge funds and 4,852 stocks (creating 5,000 random portfolios of stocks.)
As you can see in Figure F, while the returns for the stock portfolios are slightly higher, the risk of investing in the stock portfolios is also significantly higher. The hedge funds' returns also appear to be much more concentrated, less dispersed than stock returns. Despite the seeming benefit of similar returns with lower risk, it is clear that it is not appropriate to replace stock portfolios entirely with hedge funds. As an asset class, Figure F shows that stock portfolios still have a potential for higher returns. The gold star in the upper center of the hedge fund group represents the performance of UTIMCO's hedge fund portfolio.
In this brief discussion, we have touched on the role of hedge funds in the endowments. A quality hedge fund portfolio, as that selected by our Marketable Alternatives team, serves to both enhance returns while at the same time, reduce risk.
Like many other decisions in investing, the case for hedge funds in the endowment portfolios relies on both art and science. The hard-edged statistics supporting hedge fund investments would be insufficient without the intuition and judgment needed to select the right funds. Likewise, qualitative considerations alone would clearly not be sufficient in our hedge fund due diligence. Art and science are the complementary left and right "brain" elements of our investment process that, together, produce better decisions and higher returns.