How Does The Endowment Model (Of Investing) Work?

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During his recent interview with Tobias, Mark Yusko of Morgan Creek Capital Management discusses how the endowment model (of investing) works. Here’s an excerpt from the interview:

Tobias Carlisle: Just before you go on, what is the endowment model, that’s the … what is the insight, the key insight, to the endowment model? Is it getting as many different assets, uncorrelated assets, as you possibly can? Is that the endowment model, or what is it?

Mark Yusko: Well again, really important it goes a little bit back to Chicago and Markowitz investment theory. And look Markowitz was right, I have a shirt that says that, a friend of mine bought it for me. Because here Markowitz won the Nobel Prize for this construct that when you take uncorrelated assets … risky, when you put them together the portfolio is less risky. And it makes no sense when you think about it, how could I take bonds, which seem to be low risk, and add stocks which are risky, and the risk goes down? Add hedge funds, risk goes down. Add venture capital, risk goes down. And so that was the first takeaway, that one Markowitz was right, that diversification works.

Mark Yusko: But to your point, or to your question which again is a really insightful question, it’s not just maximizing the number of diversifying and uncorrelated assets, it’s really about how you move between and among those assets in a disciplined fashion. And so one basic example of that is you have to have a strategic investment policy. A policy that drives your long-term asset allocation. Now people talk about market timing all the time and they say, “Oh it’s evil and you should never do it.” No, not true at all. If you have edge, if you have information edge, or analytical edge, or process edge, and you have a better set of information and facts than someone else, you should definitely bet away from your strategic policy and you should bet with the trend.

Mark Yusko: And you should try to capture a bigger portion of those gains to be had as something goes from undervalued back to fairly valued or fairly valued to over valued. Because that pendulum is going to swing over time. And so part of the endowment model is having this willing to say look market timing in and of itself isn’t bad, that’s just a movement away from your strategic target, it has to be intentional. And I always say as a good Catholic boy, sins of omission are bad, sins of commission are forgivable. If you don’t know you’re doing something wrong, that’s bad. But if you decide and it turns out bad, that’s okay because you made a decision. And so rebalancing back to your strategic policy is moving back toward that target.

Mark Yusko: And so both are a form of market timing, people think rebalancing is good, but think market timing is bad, well that’s just silly. You’re taking profits from one and you’re allocating to cheap assets in another. If you think about if you got a super cheap asset and you want to overweight that asset, well that’s market timing, but why is that bad? That’s what we should do, we should buy things when they’re cheap. And if we have a really overvalued asset, and we want to rebalance away from it, that’s market timing, but why is that bad? Just makes no sense to me.

Mark Yusko: So those are the two elements of the endowment model. So one is yes a broad base of uncorrelated assets is superior. Two is having a strategic policy and a discipline. But the third and then there’s four points, the third is a value bias. And a value bias you talked about it on the podcast with lots of guests, Seth Clarman says it, it is a little bit genetic, you either have it or you don’t. And it’s not always a good thing, there are plenty of times where it can hurt you because you can’t participate in a crazy upside move of some crazy growth stock that you can’t understand the value. So it’s not always a good thing. But there is a value bias into the endowment model.

Mark Yusko: And then the fourth piece of it is a huge biased to the illiquidity premium. So having an over weight to private equity, private real estate, private energy, private debt, venture capital growth equity. Things that take advantage of the third risk. I always say there are only four risks that you can take in the whole world, if you take no risk you stay in cash, you get the risk free rate, hence the name. You can take credit risk, can buy a bond. You can take equity risk, you can buy a stock. You can take illiquidity risk, you can buy a private asset instead of a public asset. And you can use structure, fancy term for leverage. Those are the only four risks that exist in the world.

Mark Yusko: Now you can combine them in lots of different ways to make lots of different investment choices, but those are the only four risks. And you have to take risk in order to make return, and that’s how it works.

Tobias Carlisle: Endowments are uniquely or rarely positioned because they have such a long timeframe, so the illiquidity is something that you can factor that into what you’re doing and take advantage of that risk.

Mark Yusko: Well you know what’s great about that and what’s really kind of funny, many many people have that similar advantage because if you’re in your 20’s or your 30’s and you’re saving for retirement, investing for retirement, you’re not going to touch that money for decades, 40, 50, 60, 70, 80 years in some cases. So you should think like an endowment. In fact I always say, I get in trouble with this, but I say it should be against the law. Literally there should be a law that makes it against the law … if you’re under 60 years of age. Because you can’t touch the money, and it makes no sense because every day you’re in cash or bonds you’re losing to inflation. So you should be forced to take advantage of illiquidity premium when you’re young, and that’s when you should be taking the risk. But most young people, because they don’t think about this, they don’t study it, it’s not their primary thing that makes them their money, it’s not their career, they underinvest in those years where everything’s working in your favor in terms of compounding.

Tobias Carlisle: So 93 to 98 you’re at Notre Dame, you develop this endowment model and then this is after you’ve had the call to go to your Alma Mater, and I can see you’ve got the fighting Irish poster just over your shoulder there.

Mark Yusko: Yeah, behind me. Yeah.

Tobias Carlisle: Then University of North Carolina Chapel Hill calls and what do they say?

Mark Yusko: Well it’s actually funny. So I was the number two guy at Notre Dame, I was always going to be the number two guy, Scott’s a year older than me, we lived in the same dorm, had the same major. He’s never going to leave, but I was happy being number two. I was at the Alma Mater. But the wife was a little less happy, turns out North Carolina is a little nicer place than South Bend. So North Carolina calls and says, “Hey we’re interested in you being the CIO.”

Mark Yusko: And I said, “Hey hun, there’s a job in North Carolina.” She says, “Take it.” I said, “Don’t you want to know what it is?” She said, “No, I just want to live in North Carolina.” She was right, so 21 years ago we came down here and we’ve loved it. I mean it’s just amazing. And the best part about it actually was UNC was so broken when I got here that it was just easy to look good. Like if you’re going to go some place it’s better to go some place that’s not perfect, because then you can look really smart. I use the basketball analogy-

Tobias Carlisle: That’s the deep value guy in you.

Mark Yusko: Exactly again deep value. My first year everything we did we looked Tomahawk slam dunk, second year free throws, third year … I mean second year layups, third year free throws, fourth year had to take a jump shot. It wasn’t even until year five we had to do anything hard and take a three pointer. And again, it was because they didn’t have a discipline, they didn’t have an investment policy, they were run by a part-time board, they didn’t have staff. They didn’t think strategically, they didn’t have a value bias, they didn’t take advantage of the liquidity premium. So all the things that I had inculcated from my time at Notre Dame and working with Cambridge, and being fortunate enough to have Jack Meyer as a mentor from Harvard. I’ve been very lucky.

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