Update: Marketwatch published an expanded version of this article that I would recommend you read here.
Most recent headlines related to Harvard Management Company focused on the 8% returns number. However, a subtle but important point that commentators missed was “Narv” Narvekar’s messaging as he restructures the endowment – focus on overall portfolio performance, and not the individual components.
This is a small, but monumental shift, as it explicitly acknowledges two key aspects of investing – the first is that the objective is overall performance against goals, and not whether asset managers outperform narrowly defined benchmarks; the second is that an investment portfolio is a complex system. Recognizing these two aspects can help streamline a portfolio and lead to greater certainty of meeting objectives, with clarity and transparency.
To understand this, lets look at an analogy used by the complex systems researcher Samuel Arbesman comparing the brain to a traffic. In his thought provoking interview on Farnam Street, he points out that in complex systems such as traffic, looking at how a particular driver applies the brake does not help with understanding a traffic jam, which is a complex system.
If you think about an institutional portfolio as something similar to traffic on a highway, then the objective is to have traffic move smoothly and reach a destination within a given time. In the older model of investing, CIOs were led to believe that the best way to reach their destination was to fill their portfolio with a stable of fast expensive Ferraris and Lamborghinis (smart, talented and expensive fund managers and exotic assets, for example). However, once on the road, these sport cars then face a variety of issues that prevent them from collectively reaching the CIO’s objective – first, there are speed limits (e.g. constraints that get imposed on them). Then, they are subject to movements that happen with other cars on the road (e.g. risk factors, offsetting positions, capacity constraints), resulting in gridlock.
The point is this – the nature of complex systems (such as traffic, markets, portfolios) is such that you cannot determine the outcome based on taking a “bottoms up” approach. You have to examine behavior at the aggregate level.
In the case of traffic, you might be better served by transporting a larger number of people using a fleet of buses that go in a bus lane, and then have a separate lane for a few select Ferraris and Lamborghinis. In the case of managing portfolios, it might be about removing silos and focusing on returns, asset allocation and risk management at the overall portfolio level.
I was faced with this issue ten years ago as a member of the asset allocation committee for a $20 billion OCIO business that I had co-founded – we spent the bulk of our limited decision-making capacity reviewing managers and trying to reconcile performance against narrow asset benchmarks – whether a High Yield manager added value depended on whether you benchmarked them to the Merrill Lynch Index or the Barclays High Yield Index. Ultimately all of that didn’t matter since our client’s objective as a pension plan was to minimize unexpected contributions while maximizing likelihood of meeting benefit payments.
Forward thinking CIO’s such as Narv at HMC and Jagdeep Bachher at University of California have come to this realization and are making the organizational changes required. Narv’s simple messaging change of looking at top-line returns brings into focus what matters most. Jagdeep’s broader approach, as detailed in this article that he and Ashby Monk published, signals a shift toward needing less star power, and a greater focus on leveraging the strengths of the organization, including better governance.
Such approaches will clearly benefit pensioners and students in the long run – for whom we are but stewards of capital.
Even CIOs with limited resources can benefit materially by incorporating similar thinking into their investment processes – there is an emerging cadre of solution providers to help boards and CIOs with this transition – intuitive technology platforms, evidence based fiduciaries (advisors/OCIOs), and pragmatic alternative asset managers with a willingness to check their egos at the door.
Also published on Medium.