Transforming Capital Allocation for Long-Term Gains with Sami Mesrour, CFA

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.

Chapters

• 0:05 Optimizing Long-Term Capital Allocation
• 8:36 Prudent Portfolio Management and Illiquid Assets

Transcript

Lindsey Helman: 0:05

Hello and welcome to the Season 5 premiere of Financial Perspectives, a CFA Society San Francisco podcast, where we interview and discuss trends with leaders from across the investment and finance industry. This month, our host, Tanya Suba-Tang, membership Director with CFA Society San Francisco, had the pleasure of speaking with Sami Mesrour, CFA - partner at Jasper Ridge and CFA Society San Francisco Board President. Listen in as they discuss several capital allocator tips to increase portfolio performance and optimize long-term capital.

Tanya Suba-Tang: 0:45

Sami, great to have you at Financial Perspective Podcast. How are you today?

Sami Mesrour, CFA: 0:49

Doing very well. Thank you, Tanya, great to see you and thanks for having me.

Tanya Suba-Tang: 0:58

Absolutely! So. For our listeners, Sami is a very special guest because he is our current president for CFA Society of San Francisco board of directors and he's also a partner at Jasper Ridge in Menlo Park, and today on our show he's going to share some capital hacks. So, jumping right in, Sami. These hacks a tips and suggestions on how to manage long-term oriented pools of capital, such as foundation endowments, family office, so forth. So, to kick off, what issues do you see with these asset allocation in this space?

Sami Mesrour, CFA: 1:26

Yes. So the first hack I like to talk about is to stop thinking about strategic asset allocation and start thinking about strategic factor alloca tion.

Sami Mesrour, CFA: 1:38

So one of the things that's really interesting is when you open up most endowment annual reports or investment policies for foundations, you'll see a list of asset classes and they'll have an associated percentage target range and what these targets imply for risk and return. So typically you know X percent allocated to small caps and Y percent allocated to mid caps, this much to international stocks, maybe this much to private equity or venture. Now the problem with these percentages is that you end up allocating to stand-ins for the real sources of risk and return that you want to build into your portfolio. T hese asset classes, they're a little bit like shadows on the wall of Plato's caves. They're these categories which are just kind of poor reflections of the actual drivers of portfolio outcomes. They sort of pose as these kind of grand characters in investment portfolios but they're actually mostly just stand-ins for the real actors in the play. What really drives portfolio in terms of outcomes is how exposed it is to defined rewards for taking on certain risks, for making certain sacrifices with your capital.

Sami Mesrour, CFA: 2:51

So what do I mean by that?

Sami Mesrour, CFA: 2:53

Well, there are very few opportunities to make money in today's market without taking on some sort of risk or providing some sort of service. Very few opportunities to employ arbitrage and make money totally risk-free. Most returns are compensation for something. If you're an owner of capital and you decide to postpone your consumption today and push it out to tomorrow, you're allowing someone else to borrow and consume today and you should expect to get paid for that. So if you're delaying guaranteed consumption in real terms for one day, you've just charged that borrower, the market, for overnight real yields. If you're willing to consume later and allow your delayed consumption to be guaranteed only in nominal terms, you've earned overnight T-bills which have inflation risk. If you're willing to lend for an extended period of time and you've charged for that period of time, you're generally earning a term premium. If you charge folks for potentially not paying you back and defaulting, you've charged a credit risk premium, so on and so forth. If you, instead of getting paid back at the front of the queue, you you want to earn a residual claim on the assets or earnings of a company, you've earned the equity risk premium, so on and so forth. So the point is that if these premiums exist out there and you're charging for them. They are the real drivers of risk and return in your, in your portfolio, and so it.

Sami Mesrour, CFA: 4:24

So it feels a little bit strange to be defining your portfolio in terms of some other or more classic asset class definitions, that sort of mix and match, and repeat these factors, these premiums that actually really matter.

Sami Mesrour, CFA: 4:38

So instead of allocating separately, to say, listed equities and private equities as two separate asset classes, it probably makes more sense to allocate to the equity risk premium as distinct and separate from the illiquidity risk premium instead.

Sami Mesrour, CFA: 4:54

Or thinking about your real estate allocation in your portfolio as both bringing in an equity risk premium as well as buying back or reducing your inflation exposure. Your mid caps and your small caps both contribute to an exposure to illiquidity or size, or whatever you want to call it. So that's the primary hack that I have in mind when thinking about the shortcomings of traditional asset class compositions. Now you might still want to express your strategic asset allocation as a traditional asset allocation, both for intelligibility purposes and implementability purposes. And the world is still populated by specialists who know the nuances of their particular areas of expertise, but reinterpreting the strategic asset allocation, translating it into the actual bets that you're taking whether it's in absolute terms or relative to the risks in a benchmark is likely a better way to illuminate the true forces at work shaping your portfolio outcomes.

Tanya Suba-Tang: 6:09

So I know that from your time running a hedge fund at BlackRock, you're familiar with the use of derivatives. Any thoughts on that topic?

Sami Mesrour, CFA: 6:16

Yes, yes, so many boards, committees, cios that oversee long-term pools of capital. They rely on this touchstone of received wisdom, which is that prudent, value-oriented investors don't use derivatives, and their views you know. Derivatives are, and this is things like futures options, swaps. Those sort of things are prudent, these risky tools of mass financial destruction. They're responsible for all sorts of predictable blowups and skewed returns, and so you get these sort of thoughtful, experienced investors who've been around the block, but they're often viewing the use of leverage with a lot of suspicion, and this isn't totally unwarranted.

Sami Mesrour, CFA: 6:58

Derivatives are very complex. They're hard to trade, they're likely to be abused. The leverage that they come with is hard to manage. But here's the thing they can also be one of the best, maybe the only ways to reduce risk in an allocated portfolio while still hitting your return targets. So let's talk through an example here to illustrate.

Sami Mesrour, CFA: 7:19

So imagine you are running a $100 foundation which, based on its risk tolerance and its objectives in terms of payouts, has a policy portfolio, or benchmark, that allocates 70% of its portfolio to stocks and 30% to bonds.

Sami Mesrour, CFA: 7:38

So day one, the foundation you know simplyates $70 to a global stock ETF, $30 to a global bond ETF. It runs a portfolio, with zero tracking error, to that benchmark. Now you, as the investment manager, likely have better ideas on what investments should outperform this benchmark, and so you might believe that a hedge fund to which you have access has a great chance of generating, let's say, 10 percent in terms of returns annually, with no exposure to market factors like equities or the term premium. So 10 percent per year of alpha, unrelated to the markets. Two and a half percent per quarter, since there's no exposure to the market. If the equity market goes down, you know, hopefully you should continue to earn that two and a half percent per quarter from the hedge fund and it shouldn't be impacted, at least not systematically or in any biased sort of way. So this hedge fund, you know, you look at it and you say it's probably a good idea, good addition in the portfolio. So let's say you decide to put 10% of the foundation's capital into this hedge fund. So what you're going to do, out of that $100 that's invested in 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 in expectations for the hedge fund. Importantly, all of your assets are invested. You're fully capital deployed.

Sami Mesrour, CFA: 9:13

So what happens if the stock market rallies by 20% over the course of that coming quarter? So the benchmark is going to appreciate. It's got $70 in equities times that 20% in gains. So it appreciates by $14. However, your portfolio only appreciates by $12.6, since the foundation only has $63 in the stock market, not 70 like the benchmark. The hedge fund is going to make up for some of that. So it's going to do. It's two and a half percent per quarter, so that's going to give you another 25 cents or so.

Sami Mesrour, CFA: 9:44

But despite the hedge fund doing exactly what you want it to do, just to give you this sort of diversifying, unrelated return, you've underperformed the benchmark because you simply have less equity beta than that benchmark. So unless you've actively had a negative view on the equity markets and it didn't happen to pan out actively, had a negative view on the equity markets and it didn't happen to pan out. You're probably running an unintended bet relative to where you want it to be. So the obvious solution in this situation is to keep the target amount of equity exposure in the portfolio to be the same as what you have in the benchmark, assuming that you have no views. But how do you do this while also investing in the hedge fund and respecting the fact that you only have $100 of capital total that you can deploy? The answer I'm suggesting is levered exposure through derivatives, prudently, judiciously used.

Sami Mesrour, CFA: 10:38

Leverage for the purposes of reducing tracking error risk makes sense. It is derivatives, and so there are. You know you want to be cautious about, and have expertise with respect to, how that portion of the portfolio is implemented. But you end up generally in a better place, and in this example that we just walked through, you might buy equity futures to plug the exposure gap, or you might sell puts and buy calls, you might enter into an index swap, and this principle applies not just to equity and duration gaps, but also to smoothing out other deficiencies like sectors or geographic factors or other types of active, unintentional portfolio tilts. So the next time you're talking to a CIO who's managing a benchmark portfolio of assets and it's got some allocation to hedge funds or absolute return or uncorrelated investments, ask them how they're ensuring that they're plugging the gap that those uncorrelated assets are creating in the book. It's a good example of why an endowment or foundation or intergenerational family wealth might actually need derivatives to meet their goals, despite the negative press on that type of asset.

Tanya Suba-Tang: 11:51

Wow, thank you for that very thorough explanation. Any other suggestions on managing 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 of excess risk providing some sort of service to the market that the market is then going to price for you, and usually that price that the market gives you should cover you for a bit more than the true cost of the risk that you're absorbing, and so hopefully you end up earning a premium above that true cost of that risk. And so there are a lot of sophisticated long-term pools of capital that have gravitated to earning a return premium in exchange for investing in assets that are illiquid, so not readily marketable. Think of things like private equity and venture capital funds, real estate, infrastructure, private credit, that sort of thing. When allocators are thinking about how much to allocate to this source of risk and return, they often talk about targeting some percentage of the portfolio in this or that illiquid asset class. And beyond what we already discussed in terms of asset classes versus factors, what we see is that the quantum, the amount of illiquidity, is usually discussed as a target in and of itself. We want this percentage of the portfolio in illiquids because it would be imprudent to have more or having less would leave money on the table, but irrespective, it tends to be expressed as a target percentage of the portfolio. Now the problem is that this is a pretty imprecise way of sizing exposure to illiquidity.

Sami Mesrour, CFA: 13:36

Imagine you've got two identical endowments.

Sami Mesrour, CFA: 13:39

They're the same size, they've got the same spending needs, they've got the same level of risk aversion, but one of them invested in the illiquidity factor via commitments to venture capital funds, while the other invested in illiquidity by investing directly into investments, say company cap tables, on a fully funded basis.

Sami Mesrour, CFA: 13:59

So cash out the door on day one.

Sami Mesrour, CFA: 14:02

The first endowment would have large amounts of unfunded commitments that come along with those fund investments and they act as liabilities for the portfolio. So those liabilities start to look very similar to other liabilities, like its spending needs, for example, and the higher these unfunded liabilities, the more of the endowment's capital or net asset value has to be kept liquid to meet those potential liabilities. In contrast, the endowment with direct investments could, in theory could run 100% invested in illiquid assets, for example, if they had no spending needs in that particular case, and so its liability profile is dramatically different and therefore the percentage allocation that it has to illiquid assets is substantially different. So, in other words, the amount of illiquidity that you might want to take in an allocated portfolio doesn't depend so much on the appropriate level of investment risk or some quote-unquote reasonable percentage allocation. It depends more on the specific structure of a specific pool's liabilities. Where those liabilities are things like unfunded commitments we talked about the spending policy margin requirements Maybe there's some small amount of taxes or something along those lines.

Sami Mesrour, CFA: 15:21

Many times, endowments want to invest in illiquids in a smooth fashion as well, so they might want to have dry powder for re-ups or reinvestments with existing fund managers.

Sami Mesrour, CFA: 15:32

So they need reserves, and pacing their commitments is important too. So there's a variety of different liability influences that make a portfolio very specific to its own conditions. There are models out there that can guide you in sizing this illiquidity exposure and figuring out how you pace investments to get to the right place. But the right place is not a standard one size fits all percentage of capital, even though there are ways of expressing it that way. The right place to land is figuring out how much illiquidity a portfolio can tolerate in the context of its own specific liabilities, as well as the comfort level that the managers have with respect to any risks for not covering those liabilities in various scenarios. And there are models out there equilibrium ones, scenario-based, romano-carlos and so forth that do a good job of helping managers and CIOs and so forth arrive at the right exposure to the illiquidity factor, and so it does make sense to use them. But the hack is really to think about the liabilities of a specific plan, not what others are 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 on our 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-provoking insights. I'm sure the many tips you've shared will have a lasting impact on not only mine but our listeners' perspective on allocations.

Lindsey Helman: 17:06

Join us next time for another Financial Perspectives episode airing on the last Tuesday of the month, and make sure to send in a message to the show using the link at the top of each episode description or by emailing podcast@ cfa-sf. org. We'd love to hear what you think of this episode or any suggestions on future topics you'd like us to cover. Thank you for being a dedicated listener.

Lindsey Helman: 17:34

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 at cfa-sf. org or connect with us on LinkedIn.