[REPLAY] Sarah Samuels – Framework and Rigor at NEPC (EP.264)

22:37One is that performance is actually a pretty low weight in the model. We all know that past performance is not indicative of future results. We've all seen that disclosure in the pitch books that we read. And yet research time and time again shows that this is how investors make decisions. It's a behavioral bias. It's extremely elegant and defensible and safe, but it's first level thinking and it will not lead to outperformance making decisions based on past performance. So there has to be more to it. Performance matters, but it's also a super fluid thing. You need to use additional tools and we have some additional quantitative tools that augment the usual performance metrics.

23:12And then the other is an analyst opinion score. My team, these are sophisticated investors with many years of experience, and I want them to be able to use their intuition, use their spidey sense to make sure that the art of investing doesn't go away by using this very structured framework. And then the final thing is the investment edge. We want managers to be able to articulate to us, what is your investment edge and why is it sustainable? And you would be shocked how few managers are able to actually answer what their investment edge is. When you break this framework down into these long lists of questions that fall into those categories, how does your team actually use that to aggregate to helping make decisions?

23:51Warren Buffett is quoted as saying that once you have ordinary intelligence, an IQ of 100 or so, you can be a great investor. The thing that prevents people from being great investors is their emotions and falling victim to the greed cycle. We know that emotional decision-making is not good for investing. I call it a hot state, making a decision from your emotional brain or your caveman brain. It exists to save you from the saber-toothed tiger coming at you. Our brains are wired in a certain way to respond to perceived threats. But in many instances, we're actually not threatened. And using that emotional brain to make investment decisions leads to terrible outcomes.

24:30We see it all the time when people show their personal traded portfolios, where they get scared and sell at the bottom, and then they buy at the top. There are a lot of ways to overcome this hot state thinking and to make decisions from a cold state. And one is to use an investment checklist. We call ours the investment framework. So many benefits. One is that it's created in a cold state. So you create this list of criteria that you believe contains signal, not noise, and you're setting it when you're not emotional. That's one benefit. The other is it gives a lot of transparency in our team decision making process.

24:59And when our team gets together and we're bringing an idea through, we all see this investment model. And we're all looking at the same criteria and are able to challenge one another. And we know exactly what went into each of those sections. So we're speaking the same language. It creates a lot of rigor just by doing the same process. There's research that shows that surgeons, when they use the 19-point surgical checklist, actually reduce the number of deaths in the operating room by 50%, 5-0. It was not a complicated checklist. It just forced them to go through the steps. It memorializes our decisions.

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26:18So leave the days of disjointed deal management behind and define your future with SRS Aquium, the smartest way to run a deal. Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. And do you find that each manager you review is subject to answers on your team of every single one of these questions before you're ready to make a decision? We don't ask the managers to answer every one of these questions. There's 265 questions, data points that we calculate are guideposts for our diligence. Another reason that the framework makes a lot of sense is that our marketing colleagues on the asset manager side, on the GP side, they know what they're doing.

27:05They are really good at telling us what we want to hear. When I'm teaching the team how to invest, my position is that we should really be guiding this discussion and making sure that everything we want to have answered is answered. And another tool that we use is to ask why three times. So if they tell you a story about a stock, you dig a layer deeper and say, well, why is that? Then you can really get to the meat of what is actually happening and go beyond that prepared marketing response. What are some of the more sophisticated quantitative tools that you saw used at MassPrim that you've integrated in NEPC?

27:35There are really three ways that we look at this. When we're looking at marketable return patterns and track records, we want to understand if the manager's excess return in alpha was attributable to luck or skill. We have some proprietary ways of measuring, whether it's within the realm of possibility that a manager's track record was just luck. The other is, will they be successful going forward? This is a helpful heuristic. We're looking at three things, the relationship of the risk a manager's taking, so the tracking error, to the fees, to the excess return that they say they can get. It's essentially a break-even IR, that's what we call it.

28:10What is the IR needed to make back their fees? What's the IR needed to make back their fees and generate the excess return they say they can? And if they need an IR of two to be successful, I don't think they're going to be very successful. So we're able to have that discussion. Something's amiss, whether the fees are too high or they're not taking enough risk or their alpha expectations are too high. So we have a lot of good discussions there. And then the last is essentially factor attribution, but it's our own way of doing it. And we take the return stream of a manager and we regress it against a number of other benchmark returns that we know are present in that portfolio.

28:41And at the end of the exercise, we understand where the portfolio's significant tilts are and how much that contributed to returns. The residual, the leftover is a proxy for true skill. That's been a fascinating and really important tool in our toolkit. I'm curious how often you find that the results of those quantitative analyses are meaningfully different than what your intuition tells you if you're the person monitoring a manager. The larger firms generally know what their exposures are because they have risk management teams who are looking at these things. The smaller firms are much more gut-driven in general in terms of managing risk.

29:16And they are sometimes surprised. So one time we worked with a hedge fund strategy that had a huge factor loading to two-year treasuries, and we were all surprised by it. They did some digging and then they understood it was really their collateral. Now on the private market side, we have a similar approach. It's not factor attribution. It's just we can unpack a buyout manager's return pattern to look at how did they generate returns? Did they generate it through earnings growth or multiple expansion or use of leverage. We're happy to pay$2.20 for the first two, not so much for use of leverage.

29:44But it's interesting because some GPs think about the world that way, but many just say, well, it's all alpha. So it's been really helpful to drill down and understand how they're creating value. You alluded to what you called second-level thinking, and I'm curious what you meant by that. Second-level thinking is thinking about convoluted and interacting variables. First level thinking would be saying something like, this strategy outperformed by 400 basis points. Therefore, they must be good. Therefore, I should buy them. It's probably not going to lead to outperformance, but it's super easy.

30:16It's definitely more simple. It's linear thinking, and we want to get away from that because we need to be a step ahead of the market. Second level thinking would say, yes, but what about these exposures that the manager has? And what about this that's changed? And they had a non-benchmark exposure here. That's really what we're talking about with second level thinking. And there are a number of ways that we look to ensure that we don't fall victim to first level thinking. There's a great Howard Marks piece from several years ago that talks about second level thinking. But you have to be comfortable being a little weird, a little out there, a little different and bold when you're doing this second level thinking type of work, because you're probably going to be contrarian.

30:53And how about the CIO mindset, something that you were trained on? How do you bring that into a larger organization? Several years ago, I was speaking with the CIO of an endowment here in town. And the CIO had stepped into the role from the outside. And the senior investment staff, they were all specialists. So they had a venture capital investor who spent all their time doing that, someone doing buyouts, another person doing real estate, on and on. And the CIO quickly found that when she had a question about the overall portfolio, the junior support analyst was actually one of the most valuable team members.

31:26He was the only one seeing the entire portfolio. He was doing reporting on it. He was monitoring overall performance, moving the cash levels and rebalancing and understood why things went into the portfolio. He was the MVP and he's able to answer any question that the CIO had as to why an investment was in the portfolio and how it all fit together. This is the expectation I have for every single person on my team. And there are 45 people on the manager research team at NEPC to think like a CIO. And that means evaluating, are we getting paid to lock up our capital? So that can be any number of exercises that we use, but we really need to be sure that we're getting paid.

32:01We're looking across the entire liquidity spectrum and we're deliberate about where we're putting our clients' capital. So an example might be hedge fund strategy and a long-only strategy or a hedge fund strategy and a private credit strategy. Could be investing in the exact same issuer in high yield, but with very different approaches. And we need to be aware and deliberate when we're getting that exposure. So we do that through using the investment framework creates a common language for us all to talk about things. We also have a number of tools that help us understand on an apples to apples basis, what are we talking about with public and private markets?

32:31And I think that's a big issue with teams, especially when they're specialists in long only versus specialists in privates is creating a common language. You've got multiple uninvested capital and IRR versus time way to return. You've got all sorts of different ways of approaching things. If we can break that down, which takes a lot of work, we're able to have much more robust discussions. Another big feature of what you saw at Wellesley in the endowments is this idea of alignment of interest. With something like 1 ,200 managers, you must see a wide range of what you would consider properly aligned.

33:03So what is it that you care about and how do you instill it in the managers you're backing? Depends on the asset class. But when we're talking about private markets, we want to ensure that the terms are fair. So that's the first thing. We want to make sure that, like I said, if the GPs are getting paid or our clients are getting paid. We want to look at succession risk and key person provisions. Are we set up for success if the founder and star portfolio manager or star investor at a GP is approaching retirement age, hasn't identified or groomed the next generation of talent, and has had a period of underperformance?

33:37What's going to happen? They're probably going to sell to another entity and fundamentally change the investment and our capital is locked up. In many cases, what we see is that the founding partners have not thought about that. People think they're invincible. Really, you need to start grooming that next generation at least five years before its time. And engage with outside counsel is what we advise GPs. Begin thinking about the planning of who's going to buy out your stake in the management company. In many cases, the next generation can't necessarily afford to do so. That's a big one. In the public markets, alignment has a lot to do with the percentage of the fee going to the house and hedge funds.

34:13It's whether the liquidity of the underlying matches the liquidity of the fund. I'm curious how you think about conviction, having gone from a much smaller portfolio with smaller number of managers to now effectively backing a much larger number. We have a rating system of one through five, the primary way that we articulate our conviction. One rated strategies are our best ideas and a five rated strategy would be something that we're not recommending we put in client portfolios. So the rating scheme helps us out there to reflect our conviction. And then I think it's understanding what it is that clients are looking for.

34:46So you've got your family office or endowment foundation client, they're looking for the highest octane stuff they can get when it comes to an equity portfolio, whereas a defined contribution plan is looking to minimize litigation risk and outperform the benchmark by a little bit, but not underperformed by a lot. We are able to articulate in our ratings and in our recommendations why a strategy makes sense for different client types. So when you think about alignment within NEPC, what gets rewarded for people on your team? We have a vision and mission statement that I set for my team. We're not like the asset management institutions that are going to measure our researchers on their outperformance of names that they pick because it's a long-term measurement cycle, especially with private markets.

35:34So when I'm working with the team, it's much more about culture and are we reflecting on our decisions on a regular basis and is the content of our work coming to fruition? So we have a vision statement, we have a mission statement, and we have five pillars that guide us. One is that CIO mindset. I'm looking for whether people are interacting and learning and talking to each other. I'm looking for a team culture. Super important. Our reputation is really important. And then accountability and efficiency. We do measure our performance on a regular basis, but it can lead to some really scary and suboptimal decisions to trade in and out of managers if you're too short term.

36:10So you spent a lot of time, as you said, on the road traveling to visit managers and your time at Wellesley. And now we're coming out of this COVID period, that idea, that value of culture. How will that travel or work from home fit into what's evolved? We were as surprised as anyone that our COVID era enhancements for remote due diligence were actually quite good. So we added a number of things to our virtual diligence that made our work almost as good as if we were able to be in person. So we were able to get virtual tours of the office, we were able to use technologies to look at SEC examination letters in a safe way remotely.

36:46When it comes to the future of diligence, I do think we can do a lot more virtually, but we still need to be traveling and meeting with managers. You miss a lot of stuff when you're not there face-to-face, whether it's the dynamics of the junior person with the senior person, or we went to one manager we loved, but they had everything in boxes in terms of their storage system. That's a little concerning. Let's dig a little deeper into that. We wouldn't have known that if we didn't go to the office. When it comes to managing teams generally, I could share a lot of thoughts on that and what COVID has done to morale, to motivations, different personality types, and how they all behave differently and generational themes.

37:24So how have you gone about managing your team? I learned how to manage people in my early 30s when I was at Mass Prim and I was put in charge of two men, one in his mid-40s, one in his mid-50s, and then a guy in his mid-20s. So we kind of had each generation. I was curious to learn more about how to manage people because they were all so different in terms of how they wanted to be managed and work with me. So I got a coach, Sloane Klein. She's a wonderful executive coach. I've been working with her since 2016. I did some research and the generations can be quite different and generalized in different ways.

37:52So you've got the baby boomers. Their boss says jump and they basically say how high. They like to perform well. They like to do what's asked of them. The Generation X team members were the latchkey kids. Both their parents worked. They came home after school and they were super independent. They were on their own and they hate to be micromanaged. They do not want you involved. They want to do what they know how to do. Millennials were raised as mini consultants to their parents. Parents would say, where do you want to go on vacation this year? What should we have for dinner tonight? And they want to be part of every decision.

38:24They want to be involved. That's the generational theme. And when it comes to COVID, I would say that the remote work environment has benefits and drawbacks for introverts and extroverts. That's the big way that I would describe this. Extroverts were really miserable being at home. They were really engaged in Zoom meetings, whereas introverts love being at home. It was really hard to pull them out of their shell and to engage them. So I instituted coffee chats where each month we paired somebody with another person to have virtual coffee. And we have a number of efforts like that. So I'd love to turn to some views on the markets.

38:55You mentioned that on the margin, lots and lots of your clients are moving or still moving into private markets. I'm curious what you think about all that movement of capital. I do think that we're going to see a reckoning. The scale of dry powder is huge. The amount of capital in private markets, it's almost$10 trillion in private markets AUM. And$2 trillion of that is held by VC firms, which is astonishing when you think about those numbers for early stage investments. So I do think we're going to see valuations fall. We need to watch out for deal quality and buyout debt, which is tied to floating rates many times.

39:30We're seeing layoffs happen at venture-backed portfolio companies. Wage inflation is just killing them. We're going to have more clarity in the next couple of years on the winning and losing GPs that are out there. And manager selection is going to be more important than ever. But in this low rate environment, it all makes sense. Risk that's being financed that maybe shouldn't have been. So companies that maybe are not the highest quality that wouldn't have gotten the financing and the backing if there wasn't so much capital slashing around. So we need to pull back. It's not going to be pretty and it's going to take some time to work through valuations.

39:59In the shorter term, we're also seeing a lot of clients struggle with and grapple with what to do given the denominator effect and the swiftness of the raises and the sizes of the funds that are coming back to market. So what do you do from a commitment pacing plan point of view? How do you reconcile those two things? A couple of things. One is remember that you're giving away a call option to the GP. We don't know when the GP is going to call this capital and invest it and put it to work. Some of the best vintage year returns are in years like this, leading up to and during a market correction or recession.

40:34What we advise clients to do is look at your pacing plan. Pacing plans are really important. Don't try to time vintage your allocations to private markets. You can't do it, especially with some clients who maybe are dipping their toes in the water to private markets and don't have this experience and haven't gone through enough cycles to understand how it works, they might want to try to skip a couple of years. And that's not a great idea. This can be a really good entry point. If your budget is eaten up really quickly, more quickly than forecasted, which we are seeing this year because of the swiftness of the raises coming back to market and the bigger funds, we're advising clients to continue to commit, but maybe cut your check size a little bit, especially to your highest conviction GPs, because as you know, you're going to lose that access if you step away from a fund.

41:13And then setting up liquidity guardrails is the next thing that's really important. So understanding when you're going to get out over your skis through regular reporting and measurement of percentage of capital committed over the last three years is a percentage of NAV. For example, percentage of uncalled capital is a percentage of spending, things like that. There are a bunch of metrics that really help investment committees and investment staffs understand if they're going to get out over their skis. We're definitely seeing the actual allocations jump up pretty meaningfully because the public markets are coming down.

41:40What are some views that you have that you're trying to get some of your leading edge clients to adopt that aren't as common across, say, your whole client base? We think that healthcare is for sure a theme in healthcare in China. China is a little scary for a lot of people right now. It was a big part of a lot of portfolios. And I would say it's a little scary for investment committees to think about committing new capital to China right now. But we think there are tremendous returns to be had. Just got to watch out with Chinese managers. is the DPI there? Are they actually distributing that capital or is it just in the marks?

42:13There's a lot of interesting next generation alternatives out there. When you think about the David Swenson model, people think it's this recipe that you can replicate by just throwing ingredients into a bucket and throwing them into an asset allocation model and you're going to get the same results. And the reality is you have to be quite careful and unique and different, which is what Swenson was doing 30 years ago. You've taken everything you've learned across these steps to your seats as chair of investment committees, you mentioned UNH, what do you do on those committees to impart everything you've learned?

42:46One of the committees had about 12 voting members when I joined and pretty sparse attendance and the different people would attend each meeting. So the first thing we did was shore up the committee. Ideal committees should be five to seven people. It increases accountability. It increases the preparation. The discussion is different in the room. Then clearly articulating roles and responsibilities. It doesn't sound that interesting. It sounds mundane. It is super important. This one committee I was involved with wanted to interview every manager that would be hired for the endowment and interview any manager that would be fired.

43:18Imagine the schedules and the coordination and poor decision making that could potentially result from something like that. They were also quite interested in making tactical decisions. When I came in as the chair, I did a survey. I had about 20 questions and I wanted each committee member to answer them blindly. Nobody knew what other people answered. They submitted the survey. It was things like how much illiquidity risk can we take? What's a drawdown we can withstand? Why are we here? What's the return we're looking to get? Where we had dispersion of results, we really honed in and spent time trying to understand why we had different expectations.

43:48What we ended up deciding on is that our highest and best use, and I think this is the right way, is to focus on strategic stuff as a committee. So asset allocation, risk management, investment policy, statement and spending, and to really de-emphasize that tactical trading and the manager interviews. Another best practice is conducting a pre-mortem or a crisis plan. So what are you going to do when things get really hard? To try to have a circuit breaker around that emotional caveman brain. Trying to get the institution to only look at the longer term returns in the performance report, it's really tempting to look at three months and zero in on that.

44:24But making sure the time measurement period aligns with what the institution has. And then being a strong committee chair means a lot of things. You probably should do very little speaking and try to get people to engage. And it's also managing grandstanding behavior. There's a funny dynamic that happens with volunteer committees and boards where people feel as though they need to contribute. So they go on about something they know about. We were building up our private market portfolio, as I mentioned. So there was education, understanding how much can you put to work in a given year. We went from 10 % to 20 % in terms of target, 10 % in privates to 20%.

44:55And they want to do it overnight. You can't. You can't increase it more than 1.5 % to 2 % a year. The roles and responsibilities comes down to what are you here for and how do we tie that to the programmatic needs? What are your next initiatives on the research team at NEPC? DEI is really important to me personally. I have two little girls, Holland and London. They're eight and five. I have my own diverse career path. So we're really interested in improving diversity in our industry, whether it's through working with girls who invest, through underwriting and putting money with diverse managers across all stages.

45:29We're working hard on ESG and being able to reflect missions. Right now, we're actually integrating that investment framework into the private markets. So it's going to rhyme at the high level, but there are going to be very specific things that are applicable for each of the private market segments. That's been a really fun thing to engage people on. And then I think it's just team building. It's a really weird labor market and we're doing everything we can to keep our highest quality people. As you dive in on the DE &I, I'm curious where you see low-hanging fruit in the industry and where you see unexpected challenges?

46:03The low-hanging fruit is there are awesome managers out there that are diverse-led or diverse-owned. So diverse-led is like a third of the ownership is diverse, diverse-owned is 50 % or more. We have an annual event where we invite diverse managers to come and meet with our researchers. And it benefits them because we're able to tell them what we're seeing in their strategy or their firm and how they've set it up and maybe how it could be optimized or done better. And it's opening up our aperture so that we're able to see these awesome strategies. And last year, we underwrote 17 diverse-owned strategies that are in client portfolios now.

46:35That was low-hanging fruit. That was simple and easy, and we've got to give them an at-bat, kind of like the Rooney rule. Challenges, I think a lot of times these types of things are deeply rooted traditions, whether it's being for or against something. And what I mean by that is many times for public pensions, for example, an initiative like that needs to be legislatively mandated. So to have a certain threshold to invest in DEI strategies needs to be legislatively mandated. And if that hasn't come from the top, or if it doesn't come from the students at a university, it might not be a huge area of focus.

47:05When it comes to more diversity in terms of women running money, we got some work to do there. And I think Girls Who Invest is making a really big dent, but it's a big ask to overcome some of the old networks and some of the older beliefs out there. Why don't you touch on what Girls Who Invest is doing today? Absolutely. So Seema Hingarani is the visionary behind it. And in 2015, I saw her speak about it. It was the kernel of an idea and I chased her down after she spoke. I said, how do I get involved? It was 30 students that first year. The design is to pull women out of career tracks that maybe they weren't aware of investing or don't have the ins or the connections.

47:40So non-traditional candidates to bring them into a program where they get taught at Penn or other institutions for a month. And then they have actual internships with private markets or long only firms actually touching the money, moving capital investing. We have hundreds of students now each year. and the idea is to have 30 % of the world's capital managed by women by 2030. So it's a fantastic program. Those internships are invaluable. And if anybody would like to know more about how to work with the girls who invest intern, I'd love to hear from you. Well, Sarah, I want to ask you a couple of closing questions before I let you go.

48:11What is your favorite hobby or activity outside of work and family? I kind of gave that away in the intro. It's skiing. A couple of years ago, I just went to Switzerland and went heli skiing and then COVID struck. So I'll be going back soon. What's your biggest personal pet peeve? When people crunch on ice. But I read somewhere it's a sign of genius if crunching bothers you. So I was comforted by that. How about on the investment side, your biggest investment pet peeve? Ego. Ego gets in the way of all good things. Which two people have had the biggest impact on your professional life? Sloane Klein.

48:44She is a wonderful and recognized executive coach who I've been with for six years. And Mike Evan. He is a good friend now. He was a committee member who taught me a lot during my time at Prim. What's the biggest mistake you've made and what did you learn from it? On the managing of people side and coming in really hot and micromanaging as a new manager and not knowing how to delegate, that makes your life pretty difficult. What teaching from your parents has most stayed with you? Living within my means and a sense of a right sizing of where I stand in the world and no entitlement. Sarah, last one.

49:20What life lesson have you learned that you wish you knew a lot earlier in life? I wish I knew this much earlier, but the advice that I got from someone once is just have 30 seconds of bravery. If it's asking for a promotion, if it's interviewing for a job, doing something bold, speaking up in a meeting, just be brave for 30 seconds. Even if it makes you sweat, even if you feel like you're going to throw up, do it. You will reap the benefits. It's fantastic. Sarah, thanks so much for taking the time. Thank you, Ted. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list, and sign up for premium content.

49:58Have a good one and see you next time.