The State of Investing
The equation above is very familiar as Einstein's Theory of Relativity. As it relates to UTIMCO's efforts in Public Markets investing, we'd like to propose a new description - a simple representation that best outlines our efforts to try to attain industry-wide best practices on behalf of the endowment funds. Call it our Theory of Profitability.
Excellence equates to our ability to deliver returns that meet or exceed our prescribed market benchmarks.
Mass relates to the size of the assets under our purview to deploy.
Conviction runs two ways. It is both UTIMCO's conviction in the manager and also the manager's conviction in their own capabilities.
So, let's begin with Mass. Mass relates to size, and in investing, size does matter. It not only gets you a seat at the table, but in UTIMCO's case, it often gets you a seat at the head of the table. Of course, that is only worth something, if one chooses to take advantage of it. UTIMCO's public markets investment team takes advantage of size in the following ways:
1. Nearly all active managers are under performance-based fee arrangements, predominantly unique to UTIMCO in their construction, and serve to compensate managers only when they outperform a significant longer term return hurdle over their benchmark. For example, the Russell 2000 Small Cap Index plus 200 basis points per annum over a three year period. We currently have one manager that receives no fee over that three year period, unless they are able to accomplish that task. Typically, UTIMCO seeks to pay the manager no more than the passive alternative (Russell 2000 Exchange Traded Funds) unless they reach total return objectives. Those managers able to meet our lofty return objectives will rank as a top quartile manager, at which time they should earn a healthy percentage share of the profits above this return objective to reward such exceptional performance.
2. UTIMCO has taken advantage of the size of the endowment funds to negotiate royalty-like arrangements with some managers. The endowment funds receive compensation as new clients for providing a "seal of approval" for a new offering by a manager. If Michael Jordan gets a royalty for endorsing Nike, isn't UTIMCO in effect endorsing the active manager? For calendar year 2005, the endowment funds are projected to earn nearly $1 million in such royalties. In addition, such arrangements are already in place in some cases until 2011. That's using size to our advantage.
3. Terms. In the end, all active managers are in a negotiated relationship with UTIMCO. Given that size has its advantages - and that we can manage assets internally if we can't find a worthwhile external manager match - we always seek to structure creative and beneficial terms with all outside vendors. In this way, we are better able to protect and preserve the endowment assets and their 'status' versus most managers' other clients.
Additionally, it doesn't hurt matters that the proliferation of managers makes the marketplace somewhat commoditized. Given that fact, and in contrast to the Hedge Fund world where capacity for the best managers is often constrained, the bargaining power of UTIMCO can be put to its most creative and effective use in the Public Markets asset areas.
In sum, Mass (or size) gets UTIMCO a seat at the head of the table and it is our philosophy that it can and must be used constructively, or it is a wasted asset just as is an underperforming investment.
Next is Conviction. What do we mean by conviction?
We believe success is determined in large part by both how much we believe in the manager as well as how much the manager believes in themselves. Conviction is crucial. And an accurate assessment of mutual conviction is key to longer term success. Conviction helps define legal and policy terms, the allocation to the manager within the portfolio, and really sets the tenor of the dialogue and the potential value-added profile of the relationship.
What does conviction on UTIMCO's part mean? A better ability to both position and weight the manager within the portfolio. The best way to determine which manager receives a $25 million allocation versus one that receives $250 million is through conviction. Conviction is the art that marries to the science of Mass to produce Excellence. Conviction on the part of the staff is the qualitative weight we place on the manager's ability to execute and produce within their particular investment strategy.
What does conviction on the Manager's part mean? A manager with great conviction can evidence this characteristic in a variety of ways:
Greater portfolio concentration. A manager holding 20-30 stocks has greater conviction in their stock picking ability than one holding 75 (which is more typical of the average manager).
Performance-based fees. A manager with high conviction will be more willing to accept pay based on their successful outperformance of a longer-term benchmark hurdle.
Activism. These are managers who actively seek to bolster the returns of their investments by working with company managements to improve shareholder value directly. These managers, who are some of our favorites in terms of their resources and insight deployed in this pursuit, are another prime example of having conviction in one's capabilities. UTIMCO appreciates manager efforts to 'make something happen', rather than 'waiting for it to happen'.
Creativity. It's a lot easier to invest in widely-held Samsung and call yourself an Emerging Markets manager, than to go to Oman and Mauritius and actually do the legwork to find that undiscovered nugget yourself. Again, the managers with the most conviction often are entrepreneurial enough to set out on their own path to find a better, more profitable way to conduct their investment business.
In sum, for this high mutual conviction level to be manifested constructively, there usually needs to be a healthy level of communication both between and among managers and UTIMCO staff.
We understand what they're doing, they understand what we need, and most importantly, we're communicating internally to make sure that we do our part to invest in talent that results in greater benefits for current and future generations of the endowment funds' beneficiaries.
We believe investment success is built on a platform of mutual communication and respect, sufficient time to allow for successful implementation of a manager's capabilities, clear guidelines for implementation (including investment latitude where prudent, earned and consistent with a manager's mandate and UTIMCO's policies), and a compensation structure that recognizes that UTIMCO has passive alternatives, and that the manager should be well compensated only when they are top quartile peer competitive.
While our intent is noble, our efforts are prudent, and our process rational, we realize that all theories must stand the test of time to be proven authentic and ultimately valuable. Rest assured that we will be watching with vigilance, learning from our successes and mistakes, and evolving this philosophy to make the endowment funds the standard by which others can be measured.