August 27, 2024 • 17 mins
Unlock capital allocator hacks and discover the secrets to optimizing long-term oriented pools of capital with our special guest - Sami Mesrour, CFA - partner at Jasper Ridge and Board President of CFA Society San Francisco. In this episode, Sami shares key tips and innovative strategies that promise to revolutionize how we approach long-term capital allocation. He delves into several critical areas of portfolio management, including strategic factor allocation, using derivatives prudently, and the integration of illiquid assets.
Sami shares tactical strategies for maintaining equity exposure, ensuring your portfolio remains robust and aligned with your benchmarks. The episode also dives deep into the complexities of managing hedge funds, private equity, and real estate. Sami highlights the importance of measuring illiquidity exposure accurately, considering factors like unfunded commitments and spending needs.
Whether you're managing an endowment, foundation, or family office, this episode is packed with valuable tips from a seasoned expert on optimizing your investments for long-term success.
If you'd like to learn more about the show, have a topic or speaker to suggest, or would like to leave us a comment, email podcast@cfa-sf.org.
This podcast is produced by CFA Society San Francisco, a not-for-profit professional association, providing professional learning and career resources to over 13,000 investment industry professionals worldwide. To learn more about CFA Society San Francisco, visit our website or connect with us on LinkedIn.
The information contained in this podcast does not constitute financial or investment advice. Please consult your own financial advisor for information concerning your specific situation.
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Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Lindsey Helman (00:05):
Hello and welcome to the Season 5 premiere
of Financial Perspectives, aCFA Society San Francisco
podcast, where we interview anddiscuss trends with leaders from
across the investment andfinance industry.
This month, our host, TanyaSuba-Tang, membership Director
with CFA Society San Francisco,had the pleasure of speaking
(00:25):
with Sami Mesrour, CFA - partnerat Jasper Ridge and CFA Society
San Francisco Board President.
Listen in as they discussseveral capital allocator tips
to increase portfolioperformance and optimize
long-term capital.
Tanya Suba-Tang (00:45):
Sami, great to have you at Financial
Perspective Podcast.
How are you today?
Sami Mesrour, CFA (00:49):
Doing very well.
Thank you, Tanya, great to seeyou and thanks for having me.
Tanya Suba-Tang (00:58):
Absolutely! So.
For our listeners, Sami is avery special guest because he is
our current president for CFASociety of San Francisco board
of directors and he's also apartner at Jasper Ridge in Menlo
Park, and today on our showhe's going to share some capital
hacks.
So, jumping right in, Sami.
These hacks a tips andsuggestions on how to manage
long-term oriented pools ofcapital, such as foundation
(01:19):
endowments, family office, soforth.
So, to kick off, what issues doyou see with these asset
allocation in this space?
Sami Mesrour, CFA (01:26):
Yes.
So the first hack I like totalk about is to stop thinking
about strategic asset allocationand start thinking about
strategic factor alloca tion.
So one of the things that'sreally interesting is when you
open up most endowment annualreports or investment policies
for foundations, you'll see alist of asset classes and
(01:48):
they'll have an associatedpercentage target range and what
these targets imply for riskand return.
So typically you know X percentallocated to small caps and Y
percent allocated to mid caps,this much to international
stocks, maybe this much toprivate equity or venture.
Now the problem with thesepercentages is that you end up
(02:09):
allocating to stand-ins for thereal sources of risk and return
that you want to build into yourportfolio.
T hese asset classes, they're alittle bit like shadows on the
wall of Plato's caves.
They're these categories whichare just kind of poor
reflections of the actualdrivers of portfolio outcomes.
They sort of pose as these kindof grand characters in
(02:32):
investment portfolios butthey're actually mostly just
stand-ins for the real actors inthe play.
What really drives portfolio interms of outcomes is how
exposed it is to defined rewardsfor taking on certain risks,
for making certain sacrificeswith your capital.
So what do I mean by that?
(02:53):
Well, there are very fewopportunities to make money in
today's market without taking onsome sort of risk or providing
some sort of service.
Very few opportunities toemploy arbitrage and make money
totally risk-free.
Most returns are compensationfor something.
If you're an owner of capitaland you decide to postpone your
(03:17):
consumption today and push itout to tomorrow, you're allowing
someone else to borrow andconsume today and you should
expect to get paid for that.
So if you're delayingguaranteed consumption in real
terms for one day, you've justcharged that borrower, the
market, for overnight realyields.
If you're willing to consumelater and allow your delayed
(03:40):
consumption to be guaranteedonly in nominal terms, you've
earned overnight T-bills whichhave inflation risk.
If you're willing to lend foran extended period of time and
you've charged for that periodof time, you're generally
earning a term premium.
If you charge folks forpotentially not paying you back
and defaulting, you've charged acredit risk premium, so on and
(04:01):
so forth.
If you, instead of getting paidback at the front of the queue,
you you want to earn a residualclaim on the assets or earnings
of a company, you've earned theequity risk premium, so on and
so forth.
So the point is that if thesepremiums exist out there and
you're charging for them.
They are the real drivers ofrisk and return in your, in your
(04:23):
portfolio, and so it.
So it feels a little bit strangeto be defining your portfolio
in terms of some other or moreclassic asset class definitions,
that sort of mix and match, andrepeat these factors, these
premiums that actually reallymatter.
So instead of allocatingseparately, to say, listed
equities and private equities astwo separate asset classes, it
(04:46):
probably makes more sense toallocate to the equity risk
premium as distinct and separatefrom the illiquidity risk
premium instead.
Or thinking about your realestate allocation in your
portfolio as both bringing in anequity risk premium as well as
buying back or reducing yourinflation exposure.
Your mid caps and your smallcaps both contribute to an
(05:10):
exposure to illiquidity or size,or whatever you want to call it
.
So that's the primary hack thatI have in mind when thinking
about the shortcomings oftraditional asset class
compositions.
Now you might still want toexpress your strategic asset
(05:37):
allocation as a traditionalasset allocation, both for
intelligibility purposes andimplementability purposes.
And the world is stillpopulated by specialists who
know the nuances of theirparticular areas of expertise,
but reinterpreting the strategicasset allocation, translating
it into the actual bets thatyou're taking whether it's in
(05:59):
absolute terms or relative tothe risks in a benchmark is
likely a better way toilluminate the true forces at
work shaping your portfoliooutcomes.
Tanya Suba-Tang (06:09):
So I know that from your time running a hedge
fund at BlackRock, you'refamiliar with the use of
derivatives.
Any thoughts on that topic?
Sami Mesrour, CFA (06:16):
Yes, yes, so many boards, committees, cios
that oversee long-term pools ofcapital.
They rely on this touchstone ofreceived wisdom, which is that
prudent, value-orientedinvestors don't use derivatives,
and their views you know.
Derivatives are, and this isthings like futures options,
(06:37):
swaps.
Those sort of things areprudent, these risky tools of
mass financial destruction.
They're responsible for allsorts of predictable blowups and
skewed returns, and so you getthese sort of thoughtful,
experienced investors who'vebeen around the block, but
they're often viewing the use ofleverage with a lot of
suspicion, and this isn'ttotally unwarranted.
(06:58):
Derivatives are very complex.
They're hard to trade, they'relikely to be abused.
The leverage that they comewith is hard to manage.
But here's the thing they canalso be one of the best, maybe
the only ways to reduce risk inan allocated portfolio while
still hitting your returntargets.
So let's talk through anexample here to illustrate.
(07:19):
So imagine you are running a$100 foundation which, based on
its risk tolerance and itsobjectives in terms of payouts,
has a policy portfolio, orbenchmark, that allocates 70% of
its portfolio to stocks and 30%to bonds.
So day one, the foundation youknow simplyates $70 to a global
(07:44):
stock ETF, $30 to a global bondETF.
It runs a portfolio, with zerotracking error, to that
benchmark.
Now you, as the investmentmanager, likely have better
ideas on what investments shouldoutperform this benchmark, and
so you might believe that ahedge fund to which you have
access has a great chance ofgenerating, let's say, 10
(08:08):
percent in terms of returnsannually, with no exposure to
market factors like equities orthe term premium.
So 10 percent per year of alpha, unrelated to the markets.
Two and a half percent perquarter, since there's no
exposure to the market.
If the equity market goes down,you know, hopefully you should
(08:28):
continue to earn that two and ahalf percent per quarter from
the hedge fund and it shouldn'tbe impacted, at least not
systematically or in any biasedsort of way.
So this hedge fund, you know,you look at it and you say it's
probably a good idea, goodaddition in the portfolio.
So let's say you decide to put10% of the foundation's capital
into this hedge fund.
So what you're going to do, outof that $100 that's invested in
(08:50):
the ETFs, you're going to sell$7 worth of the stock ETF, $3
worth of the bond ETF.
You're going to collect this$10 together and you're going to
wire it to the fund.
So all good.
So now you've got $63 in stocks, $27 in bonds, $10 in this sort
of diversifying profitable inexpectations for the hedge fund.
Importantly, all of your assetsare invested.
(09:11):
You're fully capital deployed.
So what happens if the stockmarket rallies by 20% over the
course of that coming quarter?
So the benchmark is going toappreciate.
It's got $70 in equities timesthat 20% in gains.
So it appreciates by $14.
However, your portfolio onlyappreciates by $12.6, since the
(09:34):
foundation only has $63 in thestock market, not 70 like the
benchmark.
The hedge fund is going to makeup for some of that.
So it's going to do.
It's two and a half percent perquarter, so that's going to
give you another 25 cents or so.
But despite the hedge fund doingexactly what you want it to do,
just to give you this sort ofdiversifying, unrelated return,
you've underperformed thebenchmark because you simply
(09:56):
have less equity beta than thatbenchmark.
So unless you've actively had anegative view on the equity
markets and it didn't happen topan out actively, had a negative
view on the equity markets andit didn't happen to pan out.
You're probably running anunintended bet relative to where
you want it to be.
So the obvious solution in thissituation is to keep the target
amount of equity exposure inthe portfolio to be the same as
(10:19):
what you have in the benchmark,assuming that you have no views.
But how do you do this whilealso investing in the hedge fund
and respecting the fact thatyou only have $100 of capital
total that you can deploy?
The answer I'm suggesting islevered exposure through
derivatives, prudently,judiciously used.
Leverage for the purposes ofreducing tracking error risk
(10:43):
makes sense.
It is derivatives, and so thereare.
You know you want to becautious about, and have
expertise with respect to, howthat portion of the portfolio is
implemented.
But you end up generally in abetter place, and in this
example that we just walkedthrough, you might buy equity
futures to plug the exposure gap, or you might sell puts and buy
calls, you might enter into anindex swap, and this principle
(11:06):
applies not just to equity andduration gaps, but also to
smoothing out other deficiencieslike sectors or geographic
factors or other types of active, unintentional portfolio tilts.
So the next time you're talkingto a CIO who's managing a
benchmark portfolio of assetsand it's got some allocation to
(11:29):
hedge funds or absolute returnor uncorrelated investments, ask
them how they're ensuring thatthey're plugging the gap that
those uncorrelated assets arecreating in the book.
It's a good example of why anendowment or foundation or
intergenerational family wealthmight actually need derivatives
to meet their goals, despite thenegative press on that type of
(11:51):
asset.
Tanya Suba-Tang (11:51):
Wow, thank you for that very thorough
explanation.
Any other suggestions onmanaging these types of
portfolios?
Sami Mesrour, CFA (11:57):
Yeah, so I wanted to talk a little bit
about illiquid assets.
So, as we just talked about,most excess returns are the
result of taking on some sort ofexcess risk providing some sort
of service to the market thatthe market is then going to
price for you, and usually thatprice that the market gives you
should cover you for a bit morethan the true cost of the risk
(12:21):
that you're absorbing, and sohopefully you end up earning a
premium above that true cost ofthat risk.
And so there are a lot ofsophisticated long-term pools of
capital that have gravitated toearning a return premium in
exchange for investing in assetsthat are illiquid, so not
readily marketable.
(12:41):
Think of things like privateequity and venture capital funds
, real estate, infrastructure,private credit, that sort of
thing.
When allocators are thinkingabout how much to allocate to
this source of risk and return,they often talk about targeting
some percentage of the portfolioin this or that illiquid asset
class.
(13:01):
And beyond what we alreadydiscussed in terms of asset
classes versus factors, what wesee is that the quantum, the
amount of illiquidity, isusually discussed as a target in
and of itself.
We want this percentage of theportfolio in illiquids because
it would be imprudent to havemore or having less would leave
(13:23):
money on the table, butirrespective, it tends to be
expressed as a target percentageof the portfolio.
Now the problem is that this isa pretty imprecise way of
sizing exposure to illiquidity.
Imagine you've got two identicalendowments.
They're the same size, they'vegot the same spending needs,
they've got the same level ofrisk aversion, but one of them
(13:46):
invested in the illiquidityfactor via commitments to
venture capital funds, while theother invested in illiquidity
by investing directly intoinvestments, say company cap
tables, on a fully funded basis.
So cash out the door on day one.
The first endowment would havelarge amounts of unfunded
(14:06):
commitments that come along withthose fund investments and they
act as liabilities for theportfolio.
So those liabilities start tolook very similar to other
liabilities, like its spendingneeds, for example, and the
higher these unfundedliabilities, the more of the
endowment's capital or net assetvalue has to be kept liquid to
(14:27):
meet those potential liabilities.
In contrast, the endowment withdirect investments could, in
theory could run 100% investedin illiquid assets, for example,
if they had no spending needsin that particular case, and so
its liability profile isdramatically different and
therefore the percentageallocation that it has to
(14:47):
illiquid assets is substantiallydifferent.
So, in other words, the amountof illiquidity that you might
want to take in an allocatedportfolio doesn't depend so much
on the appropriate level ofinvestment risk or some
quote-unquote reasonablepercentage allocation.
It depends more on the specificstructure of a specific pool's
(15:10):
liabilities.
Where those liabilities arethings like unfunded commitments
we talked about the spendingpolicy margin requirements Maybe
there's some small amount oftaxes or something along those
lines.
Many times, endowments want toinvest in illiquids in a smooth
fashion as well, so they mightwant to have dry powder for
re-ups or reinvestments withexisting fund managers.
(15:32):
So they need reserves, andpacing their commitments is
important too.
So there's a variety ofdifferent liability influences
that make a portfolio veryspecific to its own conditions.
There are models out there thatcan guide you in sizing this
illiquidity exposure andfiguring out how you pace
investments to get to the rightplace.
(15:53):
But the right place is not astandard one size fits all
percentage of capital, eventhough there are ways of
expressing it that way.
The right place to land isfiguring out how much
illiquidity a portfolio cantolerate in the context of its
own specific liabilities, aswell as the comfort level that
the managers have with respectto any risks for not covering
(16:15):
those liabilities in variousscenarios.
And there are models out thereequilibrium ones, scenario-based
, romano-carlos and so forththat do a good job of helping
managers and CIOs and so fortharrive at the right exposure to
the illiquidity factor, and soit does make sense to use them.
But the hack is really to thinkabout the liabilities of a
(16:35):
specific plan, not what othersare doing in terms of the
illiquidity allocation.
Tanya Suba-Tang (16:41):
Wow, Sami, what a wealth of information you
just shared.
Thank you so much for being onour show today.
Sami Mesrour, CFA (16:47):
You're welcome.
Pleasure to be here.
Thanks for having me.
Lindsey Helman (16:55):
Thank you to this month's guest, Sami Mesrour
, for your thought-provokinginsights.
I'm sure the many tips you'veshared will have a lasting
impact on not only mine but ourlisteners' perspective on
allocations.
Join us next time for anotherFinancial Perspectives episode
airing on the last Tuesday ofthe month, and make sure to send
in a message to the show usingthe link at the top of each
(17:15):
episode description or byemailing podcast@ cfa-sf.
org.
We'd love to hear what youthink of this episode or any
suggestions on future topicsyou'd like us to cover.
Thank you for being a dedicatedlistener.
This podcast is produced by CFASociety San Francisco, a
(17:38):
not-for-profit professionalassociation providing
professional learning and careerresources to over 13,000
investment industryprofessionals worldwide.
To learn more about CFA SocietySan Francisco, visit our
website at cfa-sf.
org or connect with us onLinkedIn.
Hello and welcome to the Season 5 premiere
of Financial Perspectives, aCFA Society San Francisco
podcast, where we interview anddiscuss trends with leaders from
across the investment andfinance industry.
This month, our host, TanyaSuba-Tang, membership Director
with CFA Society San Francisco,had the pleasure of speaking
(00:25):
with Sami Mesrour, CFA - partnerat Jasper Ridge and CFA Society
San Francisco Board President.
Listen in as they discussseveral capital allocator tips
to increase portfolioperformance and optimize
long-term capital.
Tanya Suba-Tang (00:45):
Sami, great to have you at Financial
Perspective Podcast.
How are you today?
Sami Mesrour, CFA (00:49):
Doing very well.
Thank you, Tanya, great to seeyou and thanks for having me.
Tanya Suba-Tang (00:58):
Absolutely! So.
For our listeners, Sami is avery special guest because he is
our current president for CFASociety of San Francisco board
of directors and he's also apartner at Jasper Ridge in Menlo
Park, and today on our showhe's going to share some capital
hacks.
So, jumping right in, Sami.
These hacks a tips andsuggestions on how to manage
long-term oriented pools ofcapital, such as foundation
(01:19):
endowments, family office, soforth.
So, to kick off, what issues doyou see with these asset
allocation in this space?
Sami Mesrour, CFA (01:26):
Yes.
So the first hack I like totalk about is to stop thinking
about strategic asset allocationand start thinking about
strategic factor alloca tion.
So one of the things that'sreally interesting is when you
open up most endowment annualreports or investment policies
for foundations, you'll see alist of asset classes and
(01:48):
they'll have an associatedpercentage target range and what
these targets imply for riskand return.
So typically you know X percentallocated to small caps and Y
percent allocated to mid caps,this much to international
stocks, maybe this much toprivate equity or venture.
Now the problem with thesepercentages is that you end up
(02:09):
allocating to stand-ins for thereal sources of risk and return
that you want to build into yourportfolio.
T hese asset classes, they're alittle bit like shadows on the
wall of Plato's caves.
They're these categories whichare just kind of poor
reflections of the actualdrivers of portfolio outcomes.
They sort of pose as these kindof grand characters in
(02:32):
investment portfolios butthey're actually mostly just
stand-ins for the real actors inthe play.
What really drives portfolio interms of outcomes is how
exposed it is to defined rewardsfor taking on certain risks,
for making certain sacrificeswith your capital.
So what do I mean by that?
(02:53):
Well, there are very fewopportunities to make money in
today's market without taking onsome sort of risk or providing
some sort of service.
Very few opportunities toemploy arbitrage and make money
totally risk-free.
Most returns are compensationfor something.
If you're an owner of capitaland you decide to postpone your
(03:17):
consumption today and push itout to tomorrow, you're allowing
someone else to borrow andconsume today and you should
expect to get paid for that.
So if you're delayingguaranteed consumption in real
terms for one day, you've justcharged that borrower, the
market, for overnight realyields.
If you're willing to consumelater and allow your delayed
(03:40):
consumption to be guaranteedonly in nominal terms, you've
earned overnight T-bills whichhave inflation risk.
If you're willing to lend foran extended period of time and
you've charged for that periodof time, you're generally
earning a term premium.
If you charge folks forpotentially not paying you back
and defaulting, you've charged acredit risk premium, so on and
(04:01):
so forth.
If you, instead of getting paidback at the front of the queue,
you you want to earn a residualclaim on the assets or earnings
of a company, you've earned theequity risk premium, so on and
so forth.
So the point is that if thesepremiums exist out there and
you're charging for them.
They are the real drivers ofrisk and return in your, in your
(04:23):
portfolio, and so it.
So it feels a little bit strangeto be defining your portfolio
in terms of some other or moreclassic asset class definitions,
that sort of mix and match, andrepeat these factors, these
premiums that actually reallymatter.
So instead of allocatingseparately, to say, listed
equities and private equities astwo separate asset classes, it
(04:46):
probably makes more sense toallocate to the equity risk
premium as distinct and separatefrom the illiquidity risk
premium instead.
Or thinking about your realestate allocation in your
portfolio as both bringing in anequity risk premium as well as
buying back or reducing yourinflation exposure.
Your mid caps and your smallcaps both contribute to an
(05:10):
exposure to illiquidity or size,or whatever you want to call it
.
So that's the primary hack thatI have in mind when thinking
about the shortcomings oftraditional asset class
compositions.
Now you might still want toexpress your strategic asset
(05:37):
allocation as a traditionalasset allocation, both for
intelligibility purposes andimplementability purposes.
And the world is stillpopulated by specialists who
know the nuances of theirparticular areas of expertise,
but reinterpreting the strategicasset allocation, translating
it into the actual bets thatyou're taking whether it's in
(05:59):
absolute terms or relative tothe risks in a benchmark is
likely a better way toilluminate the true forces at
work shaping your portfoliooutcomes.
Tanya Suba-Tang (06:09):
So I know that from your time running a hedge
fund at BlackRock, you'refamiliar with the use of
derivatives.
Any thoughts on that topic?
Sami Mesrour, CFA (06:16):
Yes, yes, so many boards, committees, cios
that oversee long-term pools ofcapital.
They rely on this touchstone ofreceived wisdom, which is that
prudent, value-orientedinvestors don't use derivatives,
and their views you know.
Derivatives are, and this isthings like futures options,
(06:37):
swaps.
Those sort of things areprudent, these risky tools of
mass financial destruction.
They're responsible for allsorts of predictable blowups and
skewed returns, and so you getthese sort of thoughtful,
experienced investors who'vebeen around the block, but
they're often viewing the use ofleverage with a lot of
suspicion, and this isn'ttotally unwarranted.
(06:58):
Derivatives are very complex.
They're hard to trade, they'relikely to be abused.
The leverage that they comewith is hard to manage.
But here's the thing they canalso be one of the best, maybe
the only ways to reduce risk inan allocated portfolio while
still hitting your returntargets.
So let's talk through anexample here to illustrate.
(07:19):
So imagine you are running a$100 foundation which, based on
its risk tolerance and itsobjectives in terms of payouts,
has a policy portfolio, orbenchmark, that allocates 70% of
its portfolio to stocks and 30%to bonds.
So day one, the foundation youknow simplyates $70 to a global
(07:44):
stock ETF, $30 to a global bondETF.
It runs a portfolio, with zerotracking error, to that
benchmark.
Now you, as the investmentmanager, likely have better
ideas on what investments shouldoutperform this benchmark, and
so you might believe that ahedge fund to which you have
access has a great chance ofgenerating, let's say, 10
(08:08):
percent in terms of returnsannually, with no exposure to
market factors like equities orthe term premium.
So 10 percent per year of alpha, unrelated to the markets.
Two and a half percent perquarter, since there's no
exposure to the market.
If the equity market goes down,you know, hopefully you should
(08:28):
continue to earn that two and ahalf percent per quarter from
the hedge fund and it shouldn'tbe impacted, at least not
systematically or in any biasedsort of way.
So this hedge fund, you know,you look at it and you say it's
probably a good idea, goodaddition in the portfolio.
So let's say you decide to put10% of the foundation's capital
into this hedge fund.
So what you're going to do, outof that $100 that's invested in
(08:50):
the ETFs, you're going to sell$7 worth of the stock ETF, $3
worth of the bond ETF.
You're going to collect this$10 together and you're going to
wire it to the fund.
So all good.
So now you've got $63 in stocks, $27 in bonds, $10 in this sort
of diversifying profitable inexpectations for the hedge fund.
Importantly, all of your assetsare invested.
(09:11):
You're fully capital deployed.
So what happens if the stockmarket rallies by 20% over the
course of that coming quarter?
So the benchmark is going toappreciate.
It's got $70 in equities timesthat 20% in gains.
So it appreciates by $14.
However, your portfolio onlyappreciates by $12.6, since the
(09:34):
foundation only has $63 in thestock market, not 70 like the
benchmark.
The hedge fund is going to makeup for some of that.
So it's going to do.
It's two and a half percent perquarter, so that's going to
give you another 25 cents or so.
But despite the hedge fund doingexactly what you want it to do,
just to give you this sort ofdiversifying, unrelated return,
you've underperformed thebenchmark because you simply
(09:56):
have less equity beta than thatbenchmark.
So unless you've actively had anegative view on the equity
markets and it didn't happen topan out actively, had a negative
view on the equity markets andit didn't happen to pan out.
You're probably running anunintended bet relative to where
you want it to be.
So the obvious solution in thissituation is to keep the target
amount of equity exposure inthe portfolio to be the same as
(10:19):
what you have in the benchmark,assuming that you have no views.
But how do you do this whilealso investing in the hedge fund
and respecting the fact thatyou only have $100 of capital
total that you can deploy?
The answer I'm suggesting islevered exposure through
derivatives, prudently,judiciously used.
Leverage for the purposes ofreducing tracking error risk
(10:43):
makes sense.
It is derivatives, and so thereare.
You know you want to becautious about, and have
expertise with respect to, howthat portion of the portfolio is
implemented.
But you end up generally in abetter place, and in this
example that we just walkedthrough, you might buy equity
futures to plug the exposure gap, or you might sell puts and buy
calls, you might enter into anindex swap, and this principle
(11:06):
applies not just to equity andduration gaps, but also to
smoothing out other deficiencieslike sectors or geographic
factors or other types of active, unintentional portfolio tilts.
So the next time you're talkingto a CIO who's managing a
benchmark portfolio of assetsand it's got some allocation to
(11:29):
hedge funds or absolute returnor uncorrelated investments, ask
them how they're ensuring thatthey're plugging the gap that
those uncorrelated assets arecreating in the book.
It's a good example of why anendowment or foundation or
intergenerational family wealthmight actually need derivatives
to meet their goals, despite thenegative press on that type of
(11:51):
asset.
Tanya Suba-Tang (11:51):
Wow, thank you for that very thorough
explanation.
Any other suggestions onmanaging these types of
portfolios?
Sami Mesrour, CFA (11:57):
Yeah, so I wanted to talk a little bit
about illiquid assets.
So, as we just talked about,most excess returns are the
result of taking on some sort ofexcess risk providing some sort
of service to the market thatthe market is then going to
price for you, and usually thatprice that the market gives you
should cover you for a bit morethan the true cost of the risk
(12:21):
that you're absorbing, and sohopefully you end up earning a
premium above that true cost ofthat risk.
And so there are a lot ofsophisticated long-term pools of
capital that have gravitated toearning a return premium in
exchange for investing in assetsthat are illiquid, so not
readily marketable.
(12:41):
Think of things like privateequity and venture capital funds
, real estate, infrastructure,private credit, that sort of
thing.
When allocators are thinkingabout how much to allocate to
this source of risk and return,they often talk about targeting
some percentage of the portfolioin this or that illiquid asset
class.
(13:01):
And beyond what we alreadydiscussed in terms of asset
classes versus factors, what wesee is that the quantum, the
amount of illiquidity, isusually discussed as a target in
and of itself.
We want this percentage of theportfolio in illiquids because
it would be imprudent to havemore or having less would leave
(13:23):
money on the table, butirrespective, it tends to be
expressed as a target percentageof the portfolio.
Now the problem is that this isa pretty imprecise way of
sizing exposure to illiquidity.
Imagine you've got two identicalendowments.
They're the same size, they'vegot the same spending needs,
they've got the same level ofrisk aversion, but one of them
(13:46):
invested in the illiquidityfactor via commitments to
venture capital funds, while theother invested in illiquidity
by investing directly intoinvestments, say company cap
tables, on a fully funded basis.
So cash out the door on day one.
The first endowment would havelarge amounts of unfunded
(14:06):
commitments that come along withthose fund investments and they
act as liabilities for theportfolio.
So those liabilities start tolook very similar to other
liabilities, like its spendingneeds, for example, and the
higher these unfundedliabilities, the more of the
endowment's capital or net assetvalue has to be kept liquid to
(14:27):
meet those potential liabilities.
In contrast, the endowment withdirect investments could, in
theory could run 100% investedin illiquid assets, for example,
if they had no spending needsin that particular case, and so
its liability profile isdramatically different and
therefore the percentageallocation that it has to
(14:47):
illiquid assets is substantiallydifferent.
So, in other words, the amountof illiquidity that you might
want to take in an allocatedportfolio doesn't depend so much
on the appropriate level ofinvestment risk or some
quote-unquote reasonablepercentage allocation.
It depends more on the specificstructure of a specific pool's
(15:10):
liabilities.
Where those liabilities arethings like unfunded commitments
we talked about the spendingpolicy margin requirements Maybe
there's some small amount oftaxes or something along those
lines.
Many times, endowments want toinvest in illiquids in a smooth
fashion as well, so they mightwant to have dry powder for
re-ups or reinvestments withexisting fund managers.
(15:32):
So they need reserves, andpacing their commitments is
important too.
So there's a variety ofdifferent liability influences
that make a portfolio veryspecific to its own conditions.
There are models out there thatcan guide you in sizing this
illiquidity exposure andfiguring out how you pace
investments to get to the rightplace.
(15:53):
But the right place is not astandard one size fits all
percentage of capital, eventhough there are ways of
expressing it that way.
The right place to land isfiguring out how much
illiquidity a portfolio cantolerate in the context of its
own specific liabilities, aswell as the comfort level that
the managers have with respectto any risks for not covering
(16:15):
those liabilities in variousscenarios.
And there are models out thereequilibrium ones, scenario-based
, romano-carlos and so forththat do a good job of helping
managers and CIOs and so fortharrive at the right exposure to
the illiquidity factor, and soit does make sense to use them.
But the hack is really to thinkabout the liabilities of a
(16:35):
specific plan, not what othersare doing in terms of the
illiquidity allocation.
Tanya Suba-Tang (16:41):
Wow, Sami, what a wealth of information you
just shared.
Thank you so much for being onour show today.
Sami Mesrour, CFA (16:47):
You're welcome.
Pleasure to be here.
Thanks for having me.
Lindsey Helman (16:55):
Thank you to this month's guest, Sami Mesrour
, for your thought-provokinginsights.
I'm sure the many tips you'veshared will have a lasting
impact on not only mine but ourlisteners' perspective on
allocations.
Join us next time for anotherFinancial Perspectives episode
airing on the last Tuesday ofthe month, and make sure to send
in a message to the show usingthe link at the top of each
(17:15):
episode description or byemailing podcast@ cfa-sf.
org.
We'd love to hear what youthink of this episode or any
suggestions on future topicsyou'd like us to cover.
Thank you for being a dedicatedlistener.
This podcast is produced by CFASociety San Francisco, a
(17:38):
not-for-profit professionalassociation providing
professional learning and careerresources to over 13,000
investment industryprofessionals worldwide.
To learn more about CFA SocietySan Francisco, visit our
website at cfa-sf.
org or connect with us onLinkedIn.
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