“I’ve always had a willingness to take a position that is fundamentally different from the rest of the world and maintain it. I don’t mean that in the sense of investing in a single security; it’s the ability to pursue an intellectual strategy and stick with it. For example, when I arrived at Yale, I increased the equity orientation and diversification of the portfolio. The equity orientation obviously drove the results, but the diversification put us in a position where we were able to generate positive returns year in and year out.
We did have one negative year, in the fiscal year that included October 1987, but you could put an asterisk by that because we were only two years into moving toward an equity-oriented, diversified model, and the negative return was less than 1 percent.
In the late 1980s we hired a number of managers who were indifferent to the markets in the sense that they were trying to make money regardless of the direction of the S&P 500 index. One of my investment committee members, Parker Gilbert, who used to run Morgan Stanley, said, ‘You have a lot of assets classified as domestic equities that don’t look anything like the S&P.’ It was true.
If you had things classified as domestic equities that weren’t going to behave like the domestic equity market, then they were misclassified, because the idea of an asset class is that the constituent parts should respond similarly to important drivers of returns. If you have managers pursuing strategies designed to be fundamentally uncorrelated with a particular asset class, they should be classified elsewhere. Not having any other sensible home for these non-S&P-like strategies, we decided that we would create an asset class and call it ‘absolute return.’ Several years after we started using the term at Yale, I remember some financial institution sent us a pitch book titled ‘Absolute Return: What Is It, and How Does It Work?’ I thought, Hey, somebody is using our term! I had no idea it would become such a phenomenon.
Nowadays a lot of market participants are seduced by the returns reported for the hedge fund industry by consultants, but the image is a lot more attractive than the reality. The consultants’ numbers are substantially inflated by survivorship bias. When managers exit for bad performance, their records disappear. Prospective investors tend to look at historical performance for the industry and assume that they can get low-double-digit rates of return and substantial diversification, but when they invest, they discover that they can get only low- to mid-single-digit rates of return with some diversification, which is not nearly as attractive.
At Yale the most important shift in vetting hedge fund managers over the past 15 or 20 years has been an increasing focus on the character and quality of the investment principals.
Years ago, I would have talked about this investment characteristic or that objective factor. Now we focus overwhelmingly on assessing the managers running the business. The fundamental question is, Are these people you want to be partners with? I think it really comes down to individual characteristics.”
— Interview by Loch Adamson
