The Endowment Playbook for Long-Term Investing ft. Paul Chai

[00:00:01] Paul

Finding a team of people who think very differently from you and making it inclusive where everybody has the audacity and the courage to speak up when they don’t see things the way you do, these are things I look for when we are trying to make an investment decision. When I make a mistake, I don’t try to sugarcoat it. I try to be honest and try to explain what we can do going forward based on the lessons learned.

[00:00:28] Intro

Welcome to Top Traders Unplugged. In markets, success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

[00:01:01] Alan

Welcome back to Top Traders Unplugged. My name is Alan Dunne and this week I’m joined by Paul Chai. Paul is the Chief Investment Officer at Kansas State University Foundation, a US$1.2 billion endowment. He was previously a portfolio manager at a fund of hedge funds. He has a background in engineering, having previously studied at MIT.

Paul, great to have you with us here. How are you doing?

[00:01:29] Paul

I’m doing great. Thank you so much, Alan, for having me.

[00:01:32] Alan

Great to have you on. Looking forward to it. Well, we always like to start off by getting a sense of people’s backgrounds, how they got interested in markets, what was their journey to becoming an investor? I mentioned that you studied engineering at MIT. What made you ultimately make the leap into investing?

[00:01:49] Paul

So, my path into institutional investing was not exactly a straight line. I am a first generation immigrant from Taiwan, came to the States when I was 14 years old, and was raised by a single mother. Eventually I went to MIT, as you mentioned, and I was an engineer by training.

I started as an aerospace engineer, actually a structural engineer with a company called Pratt and Whitney that makes jet propulsion engines for airplanes as my first job. While I was an engineer, I realized that early on engineering was probably not my life’s passion. So, I ended up going to business school at Carnegie Mellon, got an MBA degree, left my job at Pratt and Whitney, and moved back to Taiwan.

I had an interest in becoming a management consultant, so, after some searches, I ended up at a company called TSMC which makes semiconductor chips. I was an internal management… somewhat of a management consultant within TSMC where I led multi-division projects and looking at business processes and trying to identify ways to improve efficiency within TSMC in terms of how they run certain workflows and business processes. I was recruited by my former roommate from college to join his family office in Los Angeles in 2006.

And, initially, I was brought in as a jack of all trades to really help run the operations within the family office. I was managing investor reporting. I was also managing internal operating systems, looking into IT as well as managing accountants and valuation process.

But then 2008 hit. It was a difficult time for our family office’s portfolio, which is essentially a fund of hedge funds portfolio that was highly levered. The patriarch of the family decided to go semi-retired and step into more of an investment committee chairperson role and left me with the task of managing our legacy fund of hedge funds portfolio while my former partner was set to look at other asset classes for us to invest in, including multifamily properties and direct private equity deals.

So, that was really my first foray into investing. From 2009 through 2017, I was managing, initially, the legacy fund of hedge funds portfolio and then a new fund of hedge funds portfolio incorporating some of the lessons we learned, during the TSMC, and eventually also participated in some of the other investments the family does within multifamily real estate management as well as some of the mezzanine financing deals that we had participated in around that time.

[00:04:42] Alan

Very good. And at some point, then, obviously you made the leap to Kansas State University Foundation. So, tell us a bit about your role there.

[00:04:50] Paul

Yeah, so I was the age of 40, back in 2016. I was having a little bit of a midlife crisis and started thinking about the purpose of my life and where I want to be 10 years from there. Part of the reason was my son was turning 4 years old, actually 5 years old, and he started to become curious about what I do for work. And I was not inspiring myself with the description of, I help wealthy people become wealthier.

So, eventually I took a strong interest in philanthropy investing on behalf of philanthropy. I tend to think that seed was planted within me early where I was a beneficiary of philanthropy. I received scholarships while I was in college and had teachers and mentors who saw potential in me before I necessarily saw it myself. Each of them planted the seed and, today, joining Kansas State was really part of my work in making sure that these seeds continue to be planted for somebody else.

So, I was fortunate to join the team back in 2018. We work on a very small team of three investment professionals. The CIO, myself, and we had an investment analyst. And five years in, our former CIO decided to retire and I was fortunate to be kept as the next CIO. And it’s been a great journey, since my time with Kansas State.

[00:06:26] Alan

Okay, very good. So, obviously it’s, I guess, an endowment portfolio. So, maybe to set, I suppose, the scene for our conversation, maybe give us a sense on the kind of objectives, and constraints, and how you think about how you set out, what you’re trying to achieve at the portfolio.

[00:06:47] Paul

Yeah. So, my boss, the President and CEO of Kansas State University Foundation, Greg Willems, has a phrase I really like. He said, we manage the endowment as if the endowment is a forever retiree. So, when you think about it, a retiree needs dependable income, protection against inflation, and enough growth to avoid running out of money. And endowment faces the same challenge with one important difference. The endowment never retires and it never reaches the end of its planning horizon.

So that changed how we invest. We’re not trying to hit a home run in any single year. We’re trying to consistently hit singles and doubles to compound capital, support annual spending, and preserve purchasing power across generations. So, in practical terms, we are building toward a portfolio that can earn, roughly, a 6% real return net of inflations, or around 8% nominal return over the long-term. We know that path will never be smooth, but that objective gives us a destination.

So, top-down, strategic asset allocation is the foundation for us. Every three to five years, we will step back and ask whether the portfolio is still positioned to meet its long-term obligations. Those targets create discipline and prevent us from rebuilding the portfolio around the latest market narrative or trends.

The asset allocation tells us what job needs to be done. And then my team’s responsibility is then to select the strategies and managers best equipped to perform each of those jobs.

[00:08:22] Alan

Very good. I mean, you mentioned kind of the strategic asset allocation as being, I suppose, the foundation of how you’re approaching investing. Has that evolved much over time? Obviously, we’re in quite a changed macro environment, maybe in the last few years in terms of the interest rate environment and inflation, etc., has there been much of an evolution in the strategic asset allocation?

[00:08:48] Paul

Sure. So, in our most recent strategic asset allocation study, we deliberately resisted the temptation to optimize for just one perfect answer. Obviously, market environments are always changing, and a portfolio can look optimal if you just ask one question to maximize return, for example. For an endowment, we have to try to solve several problems at once and multiple objectives. For example, maximizing expected return is one of the objectives. But at the same time, we are really trying to also improve the probability of meeting our real target return over the long-term.

That’s the second objective. It’s not just one year max return. We are also trying to minimize liquidity risk of not being able to distribute scholarships in the next 10 years. We’re trying to reduce the risk of spending decline over a 10 year period and also to limit drawdown risk. We have constructed several optimized portfolios, one for each of the objectives. And we are now looking for one portfolio that ranked number one in just one of the categories and poor everywhere else.

So, we wanted our portfolio to be consistently competitive across the full range of outcomes. And the allocation we selected ranked in the upper half across each of the dimensions. So, sometimes I describe choosing an allocation that wins in more than one version of the future is kind of what we are trying to do. It may not be the theoretical champion under one precise set of assumptions, but it’s resilient across many plausible environments.

And then the other thing that we have done in the most recent study has been imposing practical constraints. A strategic asset allocation is not useful if we propose a new target that cannot be implemented before we run the next study. So that’s where we are setting guardrails around liquidity, private market exposures, how we pace existing portfolio commitments so that our new targets can be realistically achieved within two to three years before the next study.

And in addition to that, we have developed a transition plan and a fair benchmarking framework so that when the portfolio moves from the old allocation to a new one, you do not want to reward or penalize the team for exposures it has not yet been able to change. So, that’s essentially some of the changes that we have done kind of transitioning from the last time when we did the allocation study to the present time.

[00:11:26] Alan

Interesting. And I mean, just curious, with the size of the portfolio that you run at US$1.2 billion, it’s obviously not enormous by public pension or endowment centers [standards], but equally it’s a big size portfolio relative to maybe a family office or something like that. So, I mean, at that kind of level of a billion, one and a half billion, does that give you more advantages or disadvantages, do you think? Or what’s your perspective on that?

[00:11:54] Paul

Yeah, I tend to think that we are in a pretty good size in terms of allocations. We are not multi billion dollars in a size where it’s so big that our footprints become very noticeable by the market. And we are somewhat constrained from making investments that can really make a difference or be different from the rest of the market. But at the same time, we are also in a large enough size where we become important partners for some of the managers that we are partnering with.

So, I would say we’re in a pretty good sweet spot. I tend to think that if you’re managing a portfolio that’s less than US$5 billion, you’re probably in a pretty sweet spot. And everybody runs the portfolio at different size ranges a little bit differently. For us, we obviously have to serve our institution. So, ensuring there’s stability and predictability of our returns is very important.

But at the same time, we are always constantly looking for ways for us to generate alpha and identifying idiosyncratic opportunities and unconventional asset classes and areas where we can take advantage of our size not being so big, where we can still make meaningful investments into more idiosyncratic opportunities and try to take advantage of it. So, that’s kind of where we try to operate.

[00:13:16] Alan

And I mean, obviously you mentioned a return objective of about 8% nominal, 6% real. I mean, as you look at the landscape from the current viewpoint, do you think that’s more challenging? Obviously, people will say valuations in US equities are more elevated than they have been for a while, credit spreads are tight, etc. Obviously, government bond yields have gone up, so there’s more to be achieved there. But there wouldn’t be up at 8% in developed markets. Do you look at that 8% target and say, oh wow, how are we going to hit that? Or do you think it’s very achievable over the next number of years?

[00:13:53] Paul

I do think that it will be path dependent, what we have done. And it’s not 100% certainty that we are going to achieve 8%. What we do try to run, and one of our objectives is the maximum probability of achieving your targeted return in the next 10 years. And that’s really where we tend to run various scenario analysis.

We will run Monte Carlo analysis of a thousand different scenarios. Each of the scenarios would have their own set of economic conditions and the resultant inflation. And then once you have the thousand scenarios and you run all of them, you try to see the eventual return net of inflation. Where do you hit? And identify a portfolio construction where you have the highest probability of achieving it.

So, eventually we ended up not getting that maximum portfolio for this specific objective. But we’re really close with our eventual proposed portfolio where we are looking at potentially achieving our long-term return objective at about 51% to 52%. So, it’s not going to be a high certainty but it’s better than half. So, that’s how we are looking at this.

[00:15:07] Alan

Okay, interesting. And I mean in terms of how you view the portfolio and what kind of categories, labels, people have different approaches to doing this. Do you just break it out by asset classes, or do you think in terms of growth assets, diversifying assets, or what kind of labels or what’s your framework for kind of categorizing the different exposures?

[00:15:29] Paul

Yeah, so when you look across our portfolio it is somewhat… When you think about the traditional stock/bond portfolio, a 60/40, 70/30, or 80/20 portfolio, we are essentially a 60/40 portfolio. So, we have 60% of our portfolio in risk exposures that’s equity related and we term that our growth bucket. Equity has historically been the best performing asset class. So, we tend to feel, as a long-term investor of growth, we need to participate in that global long-term growth. So, equity is 60%, one of the highest exposures we have across the book. And within equities we are, again, about splitting about 55% in public equity and then 45% in privates.

Within the non-equity portion, or the 40% of the portfolio, this is where we diverge from a traditional investment portfolio in that when you look at the market environment, when you think about the historical correlation between stock and bond, where investors are expecting bond to act as the hedge to stock market volatility. As a long-term investor who can take on a little bit more illiquidity, we tend to be a little bit skeptical about bond’s ability to hedge stock market volatility. And we think we can do better by having more flexibility to take on less liquid assets. So, within that bucket we do have a sleeve, that we call the liquidity bucket, to allow us that sufficient liquidity to pay for our distribution to campus, to pay for and to fulfill obligations in capital calls in the private asset class investments. But at the same time, we have allocations into diversifier hedge funds in real assets like infrastructure, energy as well as real estate. And we also have a sleeve in private credits.

So, each of these sleeves are expected to produce a return stream that has a lower correlation to the broader equity market, low to negative correlation to the broader market.

[00:17:44] Alan

Interesting. And I mean, do you take that much credit exposure in that side? Obviously, you have private credit. Do you do public credit markets at all, high yield bonds or anything like that?

[00:17:56] Paul

Yeah. So, I would say for us, since we operate a portfolio with a small team, so, the current team has four full-time investment professionals and we also bring a couple of students to work with us. So, with a team of five to six people, we tend to be a little bit more top-down and thinking more about this is our objective and we’re trying to achieve that objective. And we tend to, while we know that there are silos and category definitions of asset classes of public versus private, on the equity side and on the credit side, we tend to take a view that’s somewhat, I call it ‘the poor man’s total portfolio approach’ in that any private investment that we’re putting into the portfolio has to in some way give us some level of conviction on outperforming any public equivalent strategies in there.

So, within our private credit strategy as well as private equity strategy, we do have some allocations to more niche public strategies that we think are somewhat idiosyncratic from our larger, broader, public buckets that we cannot fit within the public bucket. But we’re putting them into the private buckets because we think they can generate a differentiated return to a return expectation that’s akin to a private asset class. And we’re using those as our liquid hurdles for anything that we’re putting into private credit portfolio.

I would say within private credit we do have allocation to structure credit, we have allocations to credit dislocation strategies that actually invest into public credits, but look for periods when valuations within certain sectors of structured credit or other public credit sectors give you a case where you can get a short-term return of 20% plus IRRs. And the strategies take advantage of these dislocations.

So, we look at these strategies to also put into our private credit portfolio as a way to really act as a hurdle. So, for anything that we’re putting in there, they have to outperform any more liquid strategies that we can put in as well.

[00:20:20] Alan

Very good. You mentioned total portfolio approach, which is all the talk these days. Everybody seems to be moving towards TPA. And it’s interesting because people say the problem with strategic asset allocation is you have these big teams that are siloed and they’re all working on their own asset classes. And that’s the problem. Obviously, from that perspective then small team like yourselves might lend itself to doing a TPA approach. But it sounds like you’re more on the SAA approach. Is that fair to say, being more top-down?

[00:20:56] Paul

Yeah, I would say if you look at SAA versus TPA as separate, opposite ends of a spectrum, SAA tends to be more top-down. You set a top-down asset class mix and then you try to construct a portfolio based on the specific target score for each of the asset classes.

While TPA is pretty much at the end the opposite spectrum where it’s completely bottoms-up, you’re looking at the investment opportunity bottoms-up where it will best achieve your investment objective. And you try to, bottoms-up, accumulate and construct a portfolio based on kind of an investment opportunity approach.

I would say both are somewhat wrappers and they tend to be extreme ends, and every allocator falls somewhere in between. In terms of how we are thinking about it. As you mentioned, part of the challenge with running a SAA approach is when you have more complexity within the portfolio, you tend to have a bigger team that becomes siloed. They will be focused and dedicated within different asset classes. And sometimes you have local optimization where each asset class heads are trying to optimize their performance. But then the objective for each asset head may also be to increase their portfolio allocation into the asset class so they will be more aligned to maximize their bonus.

In our case, since we have a smaller team, the strategic asset allocation gives us a framework to be disciplined. We don’t necessarily profess to be the best macroeconomist out there. We don’t profess to have a better market view than anybody else out there. And working through this disciplined three to five year review of our top-down strategic asset allocation mix gives us that confidence that well, we are not impacted by what we are seeing in the short-term market environment where we still have to be disciplined to invest in accordance to a long-term view that’s set by our asset allocation.

But at the same time, when we are looking within each of the asset class buckets, we are thinking hard about what are the most interesting investment opportunities within each of the asset class? And is private really better than public?

And we challenge that premise by looking at some of the niche public security strategies, and putting them into the private buckets, and using them as hurdles. So, in that sense, we can be a little bit more bottoms-up when we are looking to complete each of the asset class sleaves within our portfolio.

[00:23:36] Alan

Yeah, interesting. I mean the other model that gets talked about a lot is obviously the Yale model. When people talk about endowments and that approach to investing which is obviously relevant for a foundation. I mean, are there things from the Yale model that you’ve drawn on, or is it applicable, or what’s applicable and what’s not from your perspective, running your portfolio.

[00:24:04] Paul

So, David Swensen’s work has always been reduced to a simple formula. Own less traditional fixed income and more hedge funds, private equity, venture capital and real assets. And I do think that interpretation misses the deeper lesson, which is the real insight is not that every institution should own the same set of alternative asset labels, but it was really that long-term investors should be willing to search for less trafficked, less transparent, and less efficiently priced parts of the market, provided that they have the governance, the patience, access, and the skill to do so.

So, alternative investment assets are not inherently attractive simply because they are private or complicated. Complexity is not an asset class, and illiquidity is not automatically alpha. So, as I mentioned, we apply that principle within every asset class bucket. We really try to begin with the role of looking at each of the asset classes, what are they meant to play? And then ask where are we seeing the less conventional opportunities within this asset class? Where is the market less efficient? And where should that inefficiency persist? And what capability is required for us to capture this inefficiency? And are we actually being compensated for the additional complexity, the illiquidity, or active risk?

So, that’s where we do think about the Yale model in the spirit of allocating to unconventional opportunities. But while we think about that, we also think about if we deviate from that benchmark because we are governed by top-down asset allocation framework, and if we do go in a lot of unconventional opportunities. We want to know why. We establish a limit or a risk budget to how much deviation we’re willing to accept. And the goal is not, like I said, to be unconventional everywhere across our portfolio, but the goal is to be unconventional where we have a compelling reason to believe that opportunities real.

[00:26:13] Alan

Okay. I mean, you’ve talked about unconventional there and you mentioned kind of idiosyncratic opportunities. Can you give us a sense of some of those examples in that diversifying side of the portfolio, the 40%?

[00:26:26] Paul

Sure. So, I will share, for example, within private real assets, we have been allocating to traditional oil and gas in energy and we’ve actually decided to increase that allocation about two years, three years ago. And part of that came from just going to some of these annual meetings of our energy partners and realizing that they are experiencing difficulties and challenges in fundraising where there are a lot of larger institutions that are not recommitting to the funds, not for reasons where the investment opportunity is not compelling, but for other reasons that’s related to governance and other aspects where it’s non-economically related.

So, in this type of environment, we tend to find the investment opportunity to be even more compelling when money is flowing away and not for true investment reasons, but before any other reasons. Similarly, we have been a net buyer in the secondary markets, over the last two years, when larger institutions are forced to sell some of their higher quality private assets due to reasons that’s also not investment related. Whether it’s the pending endowment tax.

There was some uncertainty surrounding the endowment tax where some of the larger endowments were forced to plan for additional liquidity, whether it’s with the endowment tax, whether it’s with some of the governments restricting budgets into research where they have to find endowment as an additional source of liquidity to pay for those resulting in higher liquidity needs across the board for some of the larger institutions.

And also, just general impatience of retail investors and also employees that may have been in private equity backed late-stage tech companies that may be staying private for too long and some of the people need liquidity and will be willing to sell shares of their companies at a discount. So, all of these are things that we feel whenever you have outflows of capital out of a certain asset class and it’s for reasons that’s not economic, then those become something that we look at and we become interested in.

[00:28:59] Alan

And I mean you mentioned the private real assets, the oil and gas type exposures. Is that… I mean are you seeing direct kind of loan opportunities or is it via kind of a private credit manager specializing in that sector? I mean, what would that exposure look like in your portfolio?

[00:29:22] Paul

Yeah, so we also look at, well we know that traditional energy was under some stress for non-economic reasons. And then we look at the spectrum, we think about, do we want to own equity, do we want to own debt?

Which one gives you a little bit higher upside and is that risk justifiable to take on that take on so that you can reasonably achieve a higher upside? So, we ended up making more commitments on the equity side. We did make a commitment on the credit side as well. But as you may have seen over the last couple of years, the financing environment surrounding traditional energy has actually improved.

And what you are seeing, especially the large publics, within the traditional energy space, has been that even with the financing conditions improving, they are not all of a sudden spending or taking out a lot of leverage on. Certainly, the players in the space have practiced a lot of fiscal discipline in how they deploy capital.

That has made things a lot harder for the credit manager in energy. When the banks and some of the other lenders are coming back to the market, that makes it less of an unconventional opportunity as we were seeing a couple years ago. So, I would say that the credit investment in traditional energy actually hasn’t worked out too well for us.

[00:30:51] Alan

Okay, interesting. You mentioned, obviously, diversifying hedge funds are part of the allocation in that 40% side of the portfolio. How do you think about the hedge fund universe and how do you characterize and categorize that element? Obviously, you’ve got everything from multi strats to long/short equity credit, long/short credit, and then macro CTA, long vol, I mean, do you have a particular characterization there or how do you think about building a hedge fund portfolio?

[00:31:21] Paul

Yeah, so the way we are thinking about diversifier hedge fund is another way for us to diversify our return stream so that when equity market experiences volatility, we have something that continues to generate returns in a way that’s different from how the rest of the portfolio generates returns. So, for us, hedge funds are more liquid compared to say private credit, private real assets. But on the other hand, they can also be idiosyncratic.

So, that’s where, for the rest of our liquid book, we may have growth assets. Where for endowments like us it tends to be being very patient, buy and holding assets in a reasonable valuation and wait for it to grow over time. But certain hedge funds, they may be looking into tactical environment changes and they will try to trade tactically. So, you have a lot of the arbitrage strategies, whether it’s convertible arb, whether it’s volatility trading strategies, they provide a different driver of return where you are looking at short-term deltas and short-term volatilities and you are trying to take advantage of that environment. And to us that’s a differentiated return driver from the rest of the portfolio.

We tend to think diversifier hedge funds as that differentiated zero to negative correlation bucket, within our portfolio, that can still give us 8% of long-term nominal returns or above our 6% real return targets. Just in a different way.

So, the way we’re looking at the point portfolio, we have part of the portfolio being more absolute return oriented that will give us the 8%-plus regardless of the market cycle. And then second part, in fact we are trying to target that part of the portfolio to be higher than 8% to compensate for the smaller sleeve within the diversified hedge fund bucket where we are looking at higher convexity strategies when volatility spikes up. And in other words, these are more of the insurance type of strategies that will essentially create a put option to the portfolio, which will cost you. So, these strategies will have a lower expected return during certain periods. And that’s where we want the rest of that absolute return oriented bucket to make up for the cost of putting on some insurance.

[00:33:53] Alan

Interesting. And I mean obviously we’ve seen great growth in the multi strats and the pod shops. You know, these firms that have grown really very exponentially. And I mean, some investors I guess are attracted because they offer something of a one stop shop, a hedge fund solution. I mean, do you find that attractive or do you think it’s better to build out your own customized hedge fund exposure?

[00:34:20] Paul

We find both attractive. So, now we do have a part of our diversified hedge funds bucket in the pod shops. This is where we do think that some of the best pod shops, historically, have everything that you will be looking for other than the less investment friendly terms. You can have absolute return of above 8%. You have very strong high quality return stream of really high Sharpe ratio and very stable and it’s lowly correlated.

I think the part where we tend to be a little bit more concerned are periods when you have a lot of market crowding. And that’s where we pay a lot of attention on checking in with our multi strat hedge fund managers. Whenever we see environments where you experience bigger scale deleveraging events, and see how they react, how are they responding to some of these events and how the fund performs in these type of environments. That’s something that we try to track since some of the pod shops are getting bigger and bigger with a lot of investor interest.

[00:35:36] Alan

So, obviously, you touched on the high economics, the high fees for the multi strat pod shops. Clearly that’s obviously contentious with some investors. But you’re obviously, from your perspective, happy enough to pay the higher fee.

[00:35:53] Paul

Yes, I am. So, we have an annual process where we will collect and present our manager fees to our investment committee each year after the end of the fiscal year. And that process is a point of pride for us, for the size of our team, we are able to collect this information and be as transparent with our investment committee as possible to let them know the cost of conducting business.

Whether it’s the operational expense by the team over the last five years to manage the endowment, or fees that we paid managers in generating the investment returns. So, we have always made it very clear to our investment committee that within the portfolio there are certain asset classes where we want to be less concerned with the fees. We typically try to look at the return dispersion between the top quartile performers within the asset class versus the bottom quartile.

And try to really understand what’s that return difference between the top quartile versus the bottom quartile? And do fees really make that big of a difference? It’s really all about net-of-fees performance within those asset classes if you want to make a differentiated return. While there are also parts of the portfolio where fees do make a difference. For example, when you look at treasuries and liquidity buckets where you probably do not want to pay high fees to an active manager to manage your treasury allocation. So, this is where we tend to go passive or we even just own, buy and sell treasuries ourselves. So, that’s how we make that distinction across the portfolio.

[00:37:33] Alan

And you mentioned then, within the hedge fund side, having kind of the more absolute return versus the more higher convex strategies, and that may act as more of an insurance. I mean, how do you think about that side? Are you looking for literally insurance, or long volatility, or where does kind of macro and CTA type strategies which have some kind of that kind of characteristic, where do they play a role in the portfolio? Are they part of that side?

[00:38:02] Paul

Yeah, so I would say CTA strategies in the past had played a role within our portfolio. Currently we do not have an allocation in CTA strategies. I think that’s an area where it’s always a little bit more challenging for us to underwrite simply because if you are a classic trend follower or momentum, or reversal, some of these investment return drivers have become more commoditized. And that’s where you can nowadays replicate some of these return factors on your own with lower cost.

But if you are investing in a CTA or a managed future strategy that’s less conventional in terms of their return factors, that’s where it becomes more or less of a black box. And it’s a little bit harder for you to really have an understanding of what drives the returns and what you can expect when things in the market environment changes. And that’s where we tend to struggle a little bit.

What we try to do is we try to look at historical correlation versus the other markets. And then we also try to identify strategies that have high Sharpe on the absolute return side. In terms of the convexity side, we tend to be more specific on what risk are we trying to guard. Whether it’s the interest spread that has been really tight, whether it’s kind of currency risk, whether it’s inflation, some of the investments are specifically expected to provide that protection. When, for example, you have an inflation spike, or where, if credit spreads start to widen significantly, we tend to look at just potential risks and can we get convexity if those things happen to have some predictable outcomes when things do happen?

[00:39:57] Alan

Interesting. And obviously all of these strategies will feed in as part of the strategic asset allocation and the modeling, etc. I mean, how do you think about formulating return expectations even for multi strats, etc.? Is it purely based on the historic performance or do you apply a haircut to that?

Or how do you think… how do you get comfortable that you’ve got a reasonable return expectation for strategies which are trading strategies, so there’s no kind of inherent valuation of assets, it’s purely alpha, I guess?

[00:40:30] Paul

Yeah. So, I always say some of the multi strategy managers have very long track records and you can do a reasonable analysis of their performance in various market cycles. And that’s how we gain comfort in being able to have somewhat of an expectation if the market does go a certain way.

[00:40:52] Alan

What about early stage emerging managers then? Are they a possibility for you or not?

[00:40:58] Paul

Yeah, so I would say, I have spent much of my life as an outsider just kind of pivoting in my career multiple times and being a first generation immigrant to this country, I try not to confuse pedigree with capability. So, we do not begin… When we are looking at managers, we do not begin with a bias of either established manager or emerging manager. So, established organizations may offer deeper resources, mature infrastructure and institutional stability. Emerging managers may provide, on the other hand, a stronger alignment, a greater focus, and access to less crowded opportunities. But neither label is an investment thesis.

So, for us the sequence really remains that the opportunity must fit the portfolio and the strategy must fit the opportunity. And then we try to identify the people who can fit and become good partners for us for the specific strategy. So, when a manager comes from a relevant, wherever the manager comes from is relevant context, but it’s not really for us the deciding factor.

So, when you look at our portfolio, we do have an interesting mix of established and emerging managers. And to us, especially to me, I don’t really see a difference other than it’s really all about just opportunity, strategy, and people.

[00:42:30] Alan

Okay, interesting. I mean in general, what is that process for kind of manager selection? Obviously, I guess you have the whole spectrum of managers that are approaching you, etc. Do you kind of rely on consultants or is it very much, I mean, on the manager selection side, more top-down as well? You decide you want exposure to a particular strategy and then you do a search or are there elements of bottom-up as well?

[00:43:01] Paul

Yeah, I would say there’s both elements of top-down and bottoms-up. Obviously, we manage the portfolio based on a top-down strategic asset allocation framework. So, there will be times where specific areas within our portfolio need some additional allocation.

So, for example, when we are in transition period from one asset allocation to another, there will be some portfolio rebalancing and shifts where there may be a need for us to add a new manager in a specific area. So, in those times we tend to be more specific on the type of managers that we are looking for from a top-down asset class perspective.

But as I kind of talked about earlier, we do think about the top-down, each within the each of the asset class bucket. Where are you seeing the unconventional investment opportunities and where are you potentially able to generate the alpha? And that’s where the bottoms-up part comes in. So, we will always pay attention to our benchmark and think about, can we produce a return that’s on par if not greater than the benchmark? Where are we getting those returns? If we are finding it challenging to outperform our benchmark, maybe going passive at the low fee is the way to go.

If we think there are unconventional opportunities that exist within that asset class, then we try to look at the opportunities, the strategies and the people fit. Are these the right people? Is this the right strategy? Are we okay with the potential deviation from the benchmark and the amount of active risk that the specific investment will introduce and then putting a cap? So, I would say it’s both.

When we look at managers, we do, like every allocator, we get a lot of inbound inquiries and emails and for us, sometimes we do use that top-down screening as a way for us to quickly determine whether this is a manager we want to spend time with or not. But then once the manager may fit that top-down narrative, then we spend a lot of time with the bottom-up.

[00:45:06] Alan

Okay. I mean, obviously you’ve been doing manager selection and fund hedge fund management for quite a while. Obviously, in Kansas State and, obviously, in your previous role you were managing a fund of hedge fund portfolio too. I mean, what’s the challenge? What do you think? You must have learned a lot over that time about the challenge of manager selection and what are the difficulties? I mean, what would you say? Do you think it’s a different skill to asset allocation in the first place?

[00:45:39] Paul

Yes. So, manager selection is quite different from asset allocation. I would say we as allocators are all prediction machines. We are trying to find ways to predict future investment success, which is never an exact science. There’s never 100% certainty that one investment will lead to a certain outcome.

So, for us, it’s always about how much information can you collect to give you that confidence and that conviction? But at the same time, there’s also a delicate balance where you probably don’t want to collect 100% of the information to almost feel like you’re certain. Because by the time you collect your 100% of information about a certain investment opportunity, chances are your investment opportunity has already sailed, the boat has already sailed, or it’s already fully priced.

So, for us, it’s always that balance of, well, you are about 60% certain or 70% certain in terms of the information you are given. How do you make comfort for the rest of the 30% to 40%? And to me, it always comes down to the people. And we are all prediction machines of people and their future success. And for me, I think in my career, I believe one of the biggest predictors of success for people is their grit. When you decompose grit, I’m not the original person in saying that, but grit can be decomposed as passion plus perseverance.

You must have something you truly love, and then so much so that when things get tough, you have the perseverance to work around and continue to try without giving up. So, I try to assess the grit within the people I am potentially becoming partner with. And specifically, I’m looking at the passion portion a little bit differently from maybe some. I’m also not original in saying that there are two types of passion.

There is the kind that’s what we call harmonious passion. So, the harmonious passion is really one that’s kind of serving a specific purpose. It’s not about yourself. It’s a strong interest, curiosity in something you want to do, and you genuinely want to improve. Not serving yourself, but serving your greater good.

This contrasts with the second kind of passion being an obsessive passion, where it’s about serving yourself. It’s about doing things at whatever the cost for you to get to a place where you want to be. Both passions can be very impressive. You can see some very impressive success from people with both types of passions. But people who have obsessive passion tend to be less healthy. They can potentially run into problems when things don’t go their way. They can get frustrated easier.

And we typically try to assess by trying to understand the people we’re going to work with, understand, is this person easy to work with, what happens when this person faces adversity, how is he or she dealing with the times when it’s just not going their way? And through those, we try to understand, is this a genuine obsessive passion, is this a genuine harmonious passion? And we try to partner with people who are doing things for the right reasons and they are persistent in trying to achieve their goals.

[00:49:17] Alan

I mean, do you find a wide range of scores? If you were to score people on these metrics, you find, I mean, it seems like there’s… it would seem that some people, if you’re working in a large multi strat, and you spin out, and you’re launching with tens of billions, you haven’t really gone through lots of struggles, it would seem, on the outside. But I mean, what’s your perspective? Do you generally find people that have gone through a lot of challenging periods? Are you just naturally screening for those?

[00:49:55] Paul

Yeah, so I would say, obviously, people become a bigger factor when it’s really dealing with the more emerging managers, the people who don’t come with that strong pedigree, people who may not come with the set track record over 5 years, 10 years for you to really be able to model it with a spreadsheet. So, the grit, the passion, the perseverance really comes, more importantly, for the people that tend to be less established.

For the more established, you also try to understand their source of passion. Are they still as hungry and as motivated as they were when they were the emerging manager? And how long do you think that passion and perseverance are going to persist? So, I think these are a little bit different in terms of how we evaluate. But you always have managers going through different cycles. And when you do see an established manager with harmonious passion that helps us build conviction that this person will continue to do well, just not because he’s already made his money. He still has the thirst to do well for a greater good.

[00:51:04] Alan

I mean, obviously, as an allocator myself, you’re kind of conscious of various behavioral biases that you might bring to the decision to allocate to certain strategies or managers. I mean, do you notice that about yourself or people on your team? And what are the biases you’re trying to be aware of and overcome?

[00:51:25] Paul

Yeah, that’s such a great question. I have come to learn, over my years, that our portfolios are all reflections of parts of ourselves. And it’s really fascinating. When I joined Kansas State University Foundation, I made a number of changes to the portfolio. But at the same time, I tried to understand the managers that were within the portfolio.

And when you get to know these managers, and knowing as much as I do with former team members that have been a part of the decision making process, I learned a little bit about the person who made the decision. And it’s fascinating to know about people’s preferences. And we are all creatures of habit. We all tend to be more comfortable with people who are more similar to us.

For me, I tend to have more of, obviously, a tolerance for people who may be coming from kind of an underdog mentality, who have been outsiders trying to break into the space. For others it may not be so, but it could be for good, it could be for bad. And I think just understanding your personal biases and the things that make you feel more comfortable and things that make you feel less comfortable is the first step.

The second step, for me, specifically over the last three years, has been to construct a team of people who think and come from very different backgrounds than I do. And trying to, for me, as a CIO, I would say the one lesson that stands above the rest is that this job is much broader than just picking and choosing investments. Investing matters, of course, but being the CIO, the real responsibility is to build a durable decision making system. One that combines clear mission, sound governance, a strong team, a disciplined process, and the willingness to act when the evidence changes.

So, I would say finding a team of people who think very differently from you and making it inclusive, where everybody has the audacity and the courage to speak up when they don’t see things the way you do, and be honest about our decision quality, be willing to admit vulnerability. These are things I look for when we are trying to make an investment decision. And that’s the same attitude I have with my committee and the board. When I make a mistake, I don’t try to sugarcoat. I try to be honest and try to explain what we can do going forward, based on the lesson learned. And that’s kind of my attitude.

[00:54:13] Alan

In terms of investment committees and decision making by team. Obviously, it makes sense to have different viewpoints, team members with different skills. Ultimately, should decision making be by consensus or is it ultimately the call of the CIO? Is that the right way to do it, do you think?

[00:54:35] Paul

We have a small team, so for us the answer is simple. We try to strive for consensus. If there’s even one out of the six members on my team that has a strong opposition to an investment we want to make, even as CIO I will respect that opinion, and we will not make the investment.

[00:54:54] Alan

Okay.

[00:54:54] Paul

If it’s a bigger team, then I think the answer may be a little bit different.

[00:54:58] Alan

Yes, exactly. I guess, in terms of governance and the interaction with your board, what do you think is important there from governance to allow the team to operate effectively?

[00:55:12] Paul

One of the biggest lessons I’ve learned is that being an engineer by training, I came into my job really trying my best to be transparent, to be completing the information I provide to my board. And what I’ve learned over the last two years is that may not be the best approach for a lot of the board members who may not come from a background of investment management. They have been way too thorough, and being way too technical was actually a kind of a way to turn them off and made them feel discouraged from participating in the conversation.

So, the lesson I’ve learned is when you have a mixed board of people coming from the different backgrounds, you have to really focus hard about optimizing that board experience for everybody who’s a part of the table and learning how to explain things in a way that is more about clarity of direction as opposed to the completeness and the accuracy of the data or the information that you present is so important.

For me, the lesson I’ve learned is to spend a lot of time with each of the members on the committee just to understand where they come from, what background they have, and be able to meet them at the level that they are at, to be able to make them feel they are a part of the community just like everybody else, and they are empowered to speak their mind and not feel discouraged just because they don’t come from the background of investment management.

[00:56:49] Alan

Okay, interesting. Well, maybe that’s a good segue into the final kind of topic. We always like to wrap up just getting your perspective and advice for people who maybe want to build a career in investing and maybe as a CIO.

I mean, as you reflect on the things that have been beneficial for you, things you’ve done, things you’ve read, advice you’ve got, what would you say has been helpful for you, and what advice would you have for people?

[00:57:19] Paul

I always liked the phrase from the American TV series Ted Lasso, where you have a scene where Ted was challenged to throw a dart, and then at the end, he kind of said the phrase that, well, you want to be curious and not to be judgmental. I think everybody comes from different backgrounds. We all tend to, kind of like the book written by Daniel Kahneman on Thinking, Fast and Slow, we all tend to use our fast brain very often. We try to identify patterns, and we try to make conclusions very quickly in our industry to make decisions sometimes based on our fast brain as opposed to thinking hard about using our slower brain to think things a little bit deeper.

I would say, for people who are investing for the long term, sometimes we are all trying to strive for a better balance between our fast brain and the slow brain. And being long-term, serving a forever retiree allows us to take the time. We don’t necessarily have to rush into decisions and we really have to think deep. And it’s always about truth seeking. We’re trying to predict the future, but we know that humility counts a lot. We are never going to be 100% right. There will always be times when we are wrong and there will always be good and bad times. But finding ways to kind of persevere and believing in what you have decided through the good and the bad is really what we’re trying to do as allocators.

[00:58:59] Alan

Very good. Well, listen, thanks very much for coming on to talk to us. It’s been fascinating to hear about your role and how you’ve been operating, managing the foundation. I guess people can follow the foundation and its performance to get a sense of how you’re doing. But thanks again for coming on.

And from all of us here on Top Traders Unplugged, thanks for tuning in and we’ll be back again soon with more content.

[00:59:26] Paul

Thank you, Alan.

[00:59:29] Ending

Thanks for listening to Top Traders Unplugged.

If you feel you learned something of value from today’s episode, the best way to stay updated is to go on over to your favorite podcast platform and follow the show so that you’ll be sure to get all the new episodes as they’re released. We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review.

It only takes a minute and it’s the best way to show us you love the podcast. We’ll see you next time on Top Traders Unplugged.

This podcast expresses the views of its hosts and the guests appearing on the podcast as of the date of its recording, and such views are subject to change without notice. Top Traders Unplugged do not have any duty or obligation to update the information contained herein.

Furthermore, Top Traders Unplugged make no representation to its accuracy and it shall not be assumed that past investment performance is an indication of future results. Moreover, wherever there is a potential for profit, there is also the possibility of loss.

This content is made available for educational purposes only and should not be used for any other purpose.