Raising Capital When Everyone Is Scared: Do Investors Really Buy Low?

EA: Glad to have you. So I wonder if you could take a few moments to introduce yourself and tell us a bit about your mandate at Tulane.
JM: Sure. I'm a managing director at Tulane University's Investment Management Office, where I'm responsible for overseeing the global equity marketable alternatives and fixed income portfolios of a $1.5 billion endowment. I joined the investment office back in 2014 prior to which I worked at a family office with somewhat of a similar mandate.
EA:Great, great. And you mentioned endowment, you're in an endowment, what is Tulane's approach to investing vis-a-vis the "Endowment Model"?
JM: Sure. So for the audience's benefit, I will start out by describing the Endowment Model also known as the Yale Model. It was developed by David Swensen who was the CIO of the Yale Endowment back in the 1990s. It advocates for a diversified portfolio and a relatively large allocation to higher returning assets, such as equity and alternative assets. Notably those that offer liquidity premium such as private equity and private real assets.

So Tulane's endowment largely follows the Endowment Model. It has a 30% allocation to private equity and private real assets and then another 27.5% on marketable alternatives, which consists of both hedge funds and some private credit investments. Our private equity investments have been very accretive to our overall returns. They have generated over 500 basis points of premium to public market returns during the last five years. And we expect that part of the endowment to grow over time.

Conversely, our allocation to fixed income and cash remains relatively small at only 10%. That part of the portfolio largely serves as a source of liquidity rather than for incremental returns, especially today when the 10-year treasury yields is only around 70 basis points.
EA:Yeah. 70 basis points is very different from the risk-free assumption of 4% that they teach in business school. So after living through a couple of full market cycles, I've noticed that even institutional investors run-for-the-hills in a sell off. Why is that? And how do you think about positioning when equity markets gap down, bond spreads widen and valuation soften?
JM:Sure. That's a great question. Let's start from the perspective on endowment. One of the key advantages of the Endowment Model is that we are investing in asset of the university which has an infinite time horizon. So the only liquidity provision is the annual payout to the university to help cover some part of its operating budget. Typical annual payout is around 5%.

A model that allows us to invest a perpetual asset should also allow us to take volatility and liquidity risk. To that end during periods of volatility, our team traditionally has endeavored to lean into risk and make marginal allocations to the most beaten down asset classes and sectors that also offer the best expected returns.

In fact, a recent study by our staff that was conducted internally has shown empirical support for those types of allocation decisions. But it's important to know that making allocation decisions during heightened market volatility with a near fully invested portfolio is not as simple as allocating from a pool of cash. For example, we need to take into consideration private capital calls, which actually increased during these periods without the offset of distributions as realization slow down.

We also get a payout that we have to make to our university on a quarterly basis and that's regardless of market conditions. So while I doubt most institutional investors are sellers of risk during a sell off, perhaps many of them like ourselves, can slow their pace of new allocations due to some of these other liquidity considerations.
EA:Okay. So really in the Endowment Model, you have the luxury of not panicking because you don't have investors calling for their money back, et cetera, the way you would in a hedge fund or some other investment models. So then I guess that sort of is a great segue and you've partially answered this question, but I still want to ask it is whether you see current market volatility and uncertainty as an opportunity to make investments or are you concerned about visibility down the line on the long-term global economic implications of the COVID pandemic?
JM:Sure. Great question. Since nearly all of our assets are externally managed, we actually rely on our managers to make the most of those market calls. That said, we do spend a significant amount of time speaking with them about their return projections, given both, current valuations and the economic uncertainty surrounding the COVID pandemic. All of our managers on both the public and private sides have done a good job identifying those investments, which are beneficiaries of both the COVID pandemic.

So for example, Think Tech for example, as well as those which are sensitive to the pandemic but whose market valuations significantly discount the prospects of returning to pre-pandemic levels within the next two to three years. So in short, both types of investments could have a place in the portfolio. The key for us is making sure we're invested at the right valuation.
EA:Okay. And valuation is a great segue to this question which is, what do you make of recent strength in the US equity market? A few months ago, I had the opportunity to deploy a significant cash and get some things on Neiman Marcus Last Call sale rack in the stock market. But what do you make of recent strength in the equity market in the US?
JM:Well, that was a great trading call. Actually, that's a really good question. And it requires further dissection. It's not as optically kind of easy to answer at first. So let's start with the key barometer for the US equity markets, which is the S&P 500. And while we think of the S&P 500 as the diversified index representing the top 500 US companies by market cap, it has become a lot less diversified over the last five years.

So today, six stocks which internally we've coined them as the FAANGM, it's Facebook, Apple, Amazon, Netflix, Google and Microsoft, actually represent nearly 24% of the index. That's up from 10% in 2015. And these six stocks have compounded nearly 30% per annum over the last five years and returned just in the last fiscal year, which for us ended June 30th, returned over 49% over that timeframe.

So that's compared to 7.5% for the broader index. So you can imagine if you actually took those stocks out, the broader index is likely to be flat, just slightly down. In comparison actually, if you look at the Russell 2000, which is a market cap weighted index representing mostly US small and mid-cap stocks, that index over the same fiscal year, which ended June 2020, actually lost 6.6% during this time period.

So while it's optically kind of easy to say, "Well, the US equity markets just have strengthened." It's really just a number of bellwether tech stocks that have really been moving the markets. Now, whether these companies can justify their current valuations is another question that one could debate. There's no doubt there are quality companies.

But investors are definitely paying for the quality and for the fact that these companies are all COVID beneficiaries. The other thing I wanted to note is because you mentioned US equity markets, it's also important to note that US public markets have a greater tech representation than international markets. International markets tend to have more exposure to industrials, commodities and financials, and that also explains some of the large divergence in performance and valuation between both the US and international markets.
EA:So essentially, it's just driven by a handful of tech stocks and they happen to be listed in the US or the American companies primarily and that's really what's driving the impression of strengthen the US equity market.
JM:That's right.
EA:Right. So given that, what asset classes and management styles do you favor right now? Are we going to see a rotation back to active management? Because certainly over the market cycle, as we've seen a run up in the last decade or more, since the bottom in 2009, all of these passive strategies have come into favor and lots of institutional investors were allocating to passive strategies. And I would expect in a more volatile market environment, you'd see a rotation back to active management. I'm just curious as an allocator, what your thoughts are.
JM: Yeah. Well, as I mentioned earlier, we continue to be most constructive on private equity, especially venture capital and lower middle-market buyout. On the public side, we also continue to like emerging markets and other developed markets that trade at more favorable valuations. The key for us is to maintain a ballast of quality, growth and value globally.

And while value is definitely underperformed over the last decade, it's become incredibly cheap relative to growth. And we would be remiss to ignore that valuation gap. Regarding passive versus active, there's no doubt that passive was the place to have been invested over the last decade. However, as I described earlier, indices have become ever more concentrated and valuations within those indices have become ever more stretched.

We actually believe that there's reasons active management should outperform going forward.

The other thing I should mention is that Tulane's portfolio is nearly entirely expressed through active management, we don't have any passive exposure. And happy to say that we've generated nearly 2% of our performance annually with a beta of one and similar volatility to the markets for 20 years over our benchmarks, despite those challenges. So we're still believers in active management.
EA: I'm sure all the managers out there listening will be happy to hear that. So, how do you pick managers? How are you conducting manager diligence in the virtual environment? Are you prepared to pull the trigger on managers with whom you've not previously invested and you've never met in person?
JM: Yeah. No, that's the question de jure. Well, like many and other investors, we've been conducting all of our diligence virtually these days, primarily over Zoom. We have actually recently allocated two managers with whom we've met in the past, but where the bulk of the diligence has been conducted remotely.

We have yet to invest with a manager with whom we've never met in person previously. That will definitely be the litmus test for long-term investing in a virtual environment. I should also point out that the pandemic has shown how adaptable our offices with the full team working remotely. And in fact, quite productively. So we'll continue to have to adapt to the current environment as we don't have the luxury to wait for another year plus for a vaccine to get back to normal course of business.
EA:Right. So do you think in this environment that institutions need to adjust their return expectations for the coming market cycle or can they generally meet their stated goals through adjusting asset allocation? I mean, it sounds like Tulane's done incredibly well and perhaps Tulane's not in this position, but from what you know in the industry, do you think that expectations generally speaking, are realistic or not?
JM: So I have a really simple answer to your question. Yes and yes. So, let me elaborate what I mean by that. So most capital market assumptions ascribe very modest five-year projected returns to public equity, credit and fixed income assets. That's just a given. Just given where spreads are today, where the nominal and real yields are today and also where valuations are.

So, as I mentioned earlier, our payout or typical payout is 5% hence our benchmark is CPI plus five. 5% plus inflation to the extent that we can beat that hurdle or exceed that hurdle, then we'll grow the endowment of retirement. Thankfully we have indeed done that. But given those capital market assumptions, a CPI plus five return hurdle is very difficult to achieve with market beta returns, even when you consider alternative risk assets under the current asset allocation model.

So either it will require that we shift into more illiquid assets, as I mentioned earlier, or conversely, we'll have to lower our return expectations. Now, we can't do both.

EA: Right. And in the current environment, I mean, I'm curious to know, for universities in general, including Tulane, does the potential loss of tuition revenue related to COVID put pressure on the investment office for greater returns? Do you anticipate that maybe the administration will come back and say, "We did more than 5%."
JM: Yeah. Great question. And something we were concerned about earlier in the year. Fortunately today, where we stand, the loss of tuition revenue does not appear to be a cause for concern at this time. And given Tulane's standing as a first grade academic and research university. That said, we would be remiss not to notice evolving trends.

COVID obviously has been the pressure point this year, but it's also accelerated the move to virtual or remote learning. And the model for college education may look drastically different a decade or two from now than it does today. So whether colleges can sustain the same level of tuition if lectures are delivered virtually is a challenge we'll need to be ready to face.
EA:Right. Well, there's nothing like sharing a beer with your classmates though. So I'm sure people will be eager to get back to that.
JM: Oh, I'm sure they will be.
EA: Yeah. Well, Julia, thank you so much for sharing your valuaEAe insights. It's been a great education for me. It's great to sort of share these ideas with you. And to our listeners, thank you for joining us for the Engaging Alternatives Spotlight part of the EisnerAmper podcast series. For more information on this and a host of other topics, visit eisneramper.com/FS.