E261: How Sovereign Wealth Funds Create Alpha w/Peter Madsen

0:00Peter, before CITFO, you ran money in London Vice Pension Plans. What drew you to building a sovereign wealth fund in Utah? Well, candidly, the last dying breaths, if you will, of the fund-to-fund industry were taking place. And we, although where I was working prior, Cube Capital, we had a strong track record, strong team. When I joined, we were managing about a billion across some direct funds and a fund-to-fund strategy. and but after about five years we're still at about a billion um you know money coming in being raised as part of our expansion into north america and some other markets outside of just the uk and the uh but at that same around there were a few like closely linked investors that all decided they'd rather be in private markets than hedge funds and so we the partners decided to wind down and that gave me a nice long runway of you know where to spend my you know next half of my career, so to speak.

0:58So I went to the headhunter person and I said, Hey, I'd like to be CIO in like a mountain town or beach town at a college university or foundation. And she literally laughed in my face and said, you and everyone else. And then just a month or maybe not even two months after she reached back out and said, you know, you're not going to believe this, but Utah has a sovereign wealth fund and they're looking, you know, the money's old as I like to say, but there was no office, so the effort was new in terms of professionalizing it. And I would be the first hire if I were lucky enough to get it. And while I was at RVK, we had clients that were this very same type of entity or structure and worked really closely with the state of Oklahoma.

1:38I even worked lobbying to try and help them amend their constitution, to help modernize that trust. So I had a lot of experience with the potential and how it could grow or be structured, especially if it was going to be brand new. And sure enough, it's 10 years later now, but it worked out that it was an entrepreneurial endeavor, though being part of the state of Utah, still quite entrepreneurial, still a huge challenge. At the Cube, you seem to have a good fund in a bad market. Now on the other side, as a CIO, how important is being in the right market for a fund manager? And how do you assess that as part of a fund manager success?

2:17I don't even know if I'd say it was a bad market so much as just people were deciding they were skilled enough to pick their own hedge funds. But then when they were picking their own hedge funds, they were kind of sorting by AUM or brand name and starting from the top. And so if you had a small hedge fund or a fund of funds, you're neither. And so the industry kind of went the way it did. And now that we're here and we've developed our beliefs in advance of making investments, we iterate on our beliefs. and one of our beliefs is that you're the the i mean i guess two of our beliefs come to mind but one is that mean reversion is real um it may not seem like it and public equity is a u.s stock market etc but especially active management you know it comes and goes in waves for the most part especially if it's a meaningful in size uh you know very low small numbers very low vol that might be persistent but everyone wants higher returns tends to come with some vol and it tends to come in waves.

3:12And so you should be looking at or investigating either managers or markets that have been out of favor or are down and out. And where do you sit on this active versus passive debate? And what are the variables that you're looking to ascertain the market, whether you should be more active or passive? We have some passive that can be useful for liquidity sleeve. But if you don't have a huge concern around tracking error, and you are, what I'd like to say is like you people refer to the total portfolio approach or you know being outcome oriented and less benchmark driven you look at passive benchmarks they're sort of a active decision in that you chose to participate in passive they tend to be momentum in nature and each cycle they tend to become more and more concentrated or less diversified and if the idea is that it's supposed to be mitigating risk i think the only real risk it mitigates is maybe career risk or benchmark relative risk.

4:12But on the other hand, it may give you back some bandwidth or spare you the headaches of active management. We kind of took a middle ground approach where we do have some passive, but we have a lot of what we call rules-based strategies, especially in public equity. And that, for example, what you think of like value momentum quality, weight those a certain way, hold a certain number of names. You're getting broad market exposure. You're getting a beta of one, you're screening out bad companies, including companies that aren't terribly expensive and have some momentum. And that seems to me to be a low cost kind of reasonable approach to diversification that while it does include some tracking error or career risk, I think it's from a total portfolio perspective, it's a better trade-off.

4:56And Fama French came up with this three-factor model. Ken French was my professor in business school, which basically weighted small in value stocks versus, I guess the opposite is growth, large in growth stocks. Do you have a philosophical stance on where the future of the public markets are? Some people say value is a thing of the past. What do you say? I think value will make its way back, but I think it's something that isn't, it is mean reverting, it is cyclical. We're in a really long kind of odd cycle, I think in terms of the value versus growth. It happened in the 90s. It was pretty long, but post-GFC with monetary policy, and then now with the AI and the excitement around AI, I think it's just extending that cycle.

5:43Something I'm more convinced of is that the small cap premium, I think the market structure has changed. And I'm not sure the small caps of today are the same as the small caps of years past. There's been a decent amount of ink spilt on this. And I think that's one area where we've changed our minds on thinking that because small cap has been out of favor and because valuations have been more attractive, that that should be a long-term overweight. So in small cap land, we're looking for things that can do that. And that means concentrated micro caps that you hope get taken out. Or, for example, we have biotech hedge fund exposure as part of our small cap exposure.

6:25I have a CIO of Hurdle Callahan, Brad Conger, and he actually believes that small public companies are fundamentally different than they were a decade ago. What does that mean? A lot of them are fallen angels. They were SPAC targets or direct listings that fell down or they were public companies that are now small. And then to the second point of that is there's some companies that should never be public companies, the SPACs or other metrics that constitute the rest of some of these small cap companies. So it's not truly smaller companies. The true smaller versions of the large public companies are actually still private companies in their middle market or large buyouts.

7:00I agree with that. Another maybe way of saying the same thing is companies used to go public earlier, so they were small cap-ish when they went public on average, and they might have been great companies that grow over time. And that's just not the case, as you highlighted. So there's just fewer of those strong companies with momentum going public at small size. They go public at massive scale. And our focus in private markets is really along the same lines that maybe the small cap premium is actually in private equity in very small micro, lower middle market and lower type names. I was going to ask you that exact question, which is, if you believe this, how do you operationalize that strategy in the market?

7:41You would essentially shift some of your allocation from publics into privates, into private equity. yep we actually did that so we're earlier on we were i think one of the ways of thinking about asset allocation is i had the good fortune of hearing um harry markowitz present at a really small conference when he was presenting on something about the 401k how to like optimally use your company stock in your 401k but he started out his presentation by saying i don't want any of you young whippersnappers here to ask me about mean variance optimization and why you know it's so naive or whatever he's like i did that 50 years ago it's how you guys are the ones who are supposed to be improving on it and he said in fact the best you know the best diversifying portfolio the best diversification is just to go 50 50 and that's the naive approach and it tends to be like from an academic perspective the best um diversification if you will and the so we you know i thought about that and then i read another author put together something kind of similar but And then you look at risk parity and what Bridgewater's done.

8:41And it's kind of the same concept of, you know, the naive portfolio is to not, you know, be concentrated in one thing if diversification is the goal. So we started our asset allocation. We kind of started from an equal weight perspective. And, you know, we used optimization techniques and, you know, made sure that we were being quite quantitative in the end to stress test our decisions. But we started with what if we were equal weighted? What would our expected returns be? And then what dials should we turn to get our expected return up? based on the size of the portfolio, the size of our resources, the fact that we have money coming in from land-based revenues, you can call it mostly oil and gas and real estate development.

9:20So we thought we put all that together, and we were more or less an equal-weighted portfolio. It was pretty close, and it was a terrible experience for the first few years. And as we kind of lived with that and tweaked with it and evolved, one of the decisions we made was to take down the small-cap exposure and move it into private equity. That's been about five years or so in the making. It finally was, and being newer, we didn't have enough private equity to have a 20 % target when you're just pacing in your first dollars. It's kind of ridiculous. So it made sense as we evolved over time to pull down our small cap exposure and direct it towards private equity.

9:55The truly diversified portfolio to me is a very interesting thought experiment, which is if you worship at this altar of diversification, this is your model portfolio. You start with that and then you kind of tweak it from that. but you guys literally did that yeah yeah that's how we started the conversation yeah and are you not just trying to and why not just optimize on sharp ratio and come up with this super efficient portfolio that is optimized on this one variable of sharp ratio um i like to uh um say things that are kind of controversial maybe i end up just putting my foot in my mouth most of the times when i do one of the things i like one of the things i like to remark is that that Sharpe ratio is a perverse indicator.

10:36So I think if you're optimizing on Sharpe ratio and you're assuming distributions are normal and you're assuming your inputs are more correct than they probably are. And if there's any mean reversion, you're sort of top ticking, you know, if you're optimizing on Sharpe or targeting the high Sharpe investment based on historical experience. So if you really look out ex ante, and by the way, like what, you know, as being a consultant and having, working on a lot of institutions and a lot of asset allocation exercises, is it's really hard to take a lot of risk when you have all the different asset classes available to us.

11:11If you have some exposure to those and you're thinking about it pretty clearly, it's pretty hard to have a really terrible experience that you can't survive, even in 08 and 2022. I mean, those were really dark and terrible periods. I had clients that had a lot of problems to deal with, but in the end, it was fine. No one missed a benefit payment. No one had to go out of business, it is fine to have a decent amount of volatility ex ante. And it is fine to optimize on the return and not the Sharpe ratio. Like if you need a higher return, you're not going to have a great Sharpe ratio. And that's...

11:46So as part of your investment philosophy, you avoid investing from buckets. Instead, you focus on factor exposure. Tell me about that. And how do you do that from a bottom's up? Yeah. So we actually like to sometimes refer to as purpose-driven investing. So we do live in the kind of conventional world, if you will, with we can't pick our trustees. And just thinking through that and again, having that experience of sitting across from all types of trustees over a decent number of years, wanted to make sure that we were having good conversations with stakeholders as well. So we do have categories and asset classes, but they're pretty broad and vague.

12:25And so for example, we have growth and within growth, We have public and private equity. And for us, we're like, okay, that's the high risk, high return part of the portfolio. So for something to be in that portfolio, we don't really care what the structure is, what the vehicle is, what the liquidity is. It could be public, it could be private. But, you know, obviously, you know, like a venture fund, traditionally structured, wouldn't go in public equity. Maybe a crossover hedge fund that has 25 % private markets could be in public equity, an evergreen private equity fund. We could put that in public equity or private equity.

12:58But as we try and keep that generalness or that vagueness, that allows us to be really opportunistic or open-minded about how we invest and what we invest in. And we have pretty healthy ranges and latitude that our trustees have afforded us. But at the end of the day, we run a factor model that, and we try to have straightforward benchmarks that also represent the factor. So obviously you have ACWI for public equity, for real assets, we use S &P real assets index. For income, we use high yield one to three because we don't want duration in that portfolio. We want credit risk. and so as you're thinking about that and communicating that with stakeholders that's pretty straightforward then when we go behind the scenes so to speak we're looking at that benchmark the set of factor exposures and how we can add value from it and we either want to have intentional overweights across factors that we think will be rewarded or we want to neutralize the factor exposure but have a high residual we're not necessarily trying to have our factors beyond the benchmark.

14:00We just want to know that, for example, we have equity beta coming from high yield. If you de-smooth and interpolate private market returns, you have equity beta risk coming from private debt, from private real estate. You might have interest rate exposure coming from infrastructure or private real estate, et cetera. So we just want to make sure that we have a holistic view of the portfolio, what risks we're bearing and whether or not we want to bear them or whether or not we think they'll be rewarded. And that's a sophisticated regression type analysis with factors is cheaper and easier to do than implement than say a risk system that looks at all of your holdings and then tries to give you the sector weights, geographic weights, et cetera.

14:40And even still, I'm like, I'm not sure how much my equity beta really actually is just seeing of how much tech exposure I have when I also have data centers in real estate, for example. And are those correlated? Well, the holdings-based analysis doesn't tell you that, but a factor-based analysis can. And what tools are you using to break it down on a factor basis? Originally, we were using MPI, Markov Processes. I can't remember if it's International Incorporated, but that's a great system. Very sophisticated, very robust. It's a little more technical for the average user. And given that we're a smaller team and some turnover at the younger level where you would want people running the systems, we switched from that system to Venn, which is, you might be familiar, it's a software company started by Two Sigma, the hedge fund group.

15:31and they have a really robust suite of factors and a user-friendly interface based on the web and it can connect with your custodian, for example, and just an easier way when you have interns and people with a couple of years experience kind of helping you with analysis. Let's talk about your private book. You go pretty far down the risk curve on the venture side. You like funds under$100 million, Oftentimes, super angels are funds one and funds two. Why play and not part of the market? What's the risk reward like for you? How I invest is celebrating 400 episodes. Join me live in San Francisco on Wednesday, June 17th for an evening of drinks, hors d 'oeuvres, and a toast to this milestone.

16:16The event is free and space is limited, so don't wait. Go to wastebirdcapital.com slash events right now to register. That's W-E-I-S-B-U-R-D capital.com slash events. We first started as we were first building out our portfolio. Like I said, we have these broader categories and we have private equity as one. And then it's left to us to iterate on our allocation between buyout, growth equity, venture, etc. And we put venture to the side initially at first. And because the conventional wisdom and experience I had working with larger institutions and being a consultant is that if you can't access the really well-known brand names, then you're probably not going to do well in venture.

17:00and you know that our trustees agreed with that kind of sentiment and i met some local investors here who were seed stage investors running smaller funds and um and you're doing it in utah and they kind of made their case had some data to back their story up and so we worked on our philosophy for venture and decided that we probably don't have the connections or the bandwidth or the time or energy to try and get ourselves into, say, Sequoia or whatnot, if they're actually going to be capacity constrained, then you would want that. And if they're not going to be capacity constrained, they're going to raise many different funds and kind of push you or require you to invest across all the different strategies and not just be in the early stage funds.

17:46That wasn't ideal either, but perhaps there are, in our initial philosophy, was early stage, meaning pre-seed, seed, maybe series A, and kind of off-the-run markets that might feed up into the food chain of venture or some of these other shops that you need to write bigger checks and as we spent time on that uh philosophy you know we we deviated from it a little bit you know we got in the in the heyday you know we got nudged into some bigger funds that an opportunity funds and so forth that you know we call them um you know stapling on and but we really honed the philosophy after we worked with a group called sindana fund to funds and they run an advice.

18:25Michael, I'm a two-time guest. Okay. Yeah. So you know the story. So we were drinking the Kool-Aid from Michael and his team. And then we also ran across another group of individuals that run a venture fund, a fund called Pattern. And you read some of their work, look at some of their data. Moonfire also has a great website with a lot of data. And if you think about not just fund size, but also portfolio construction, and you think about relative ownership early on when valuations are arguably cheaper and you have the ability to size up your ownership early on and your check sizes are smaller, the deal sizes are smaller at that stage of the market, then your ability to generate a 5x or higher mathematically should be easier.

19:12Even if you have a$100 million fund, you kind of need five unicorns to get a 5x, right and are you reliably going to get five unicorns each each fund each vintage uh that's it seems a lot easier the smaller the check size the smaller the fund size the smaller the deal size it it's it's similar for us in private equity so all things being equal you'd love to access the sequoias and the other capital constrained strategies but knowing that you can't access those instead of going to second or third tier brands in that same space you decide to go down market where you could get similar returns, maybe with some more vol, but you actually had a shot to get those kind of great venture returns that you could get in the name brand.

19:57Yeah, I think I agree with that summarization or simplification. And another interesting thing to us is, you know, you wouldn't think of it as, we didn't think of it as a good way to invest. But if you're a solo GP and you have a small fund, you're really well networked, really well connected. you're able to add value one way or another to the ecosystem, people will invite you or allow you to write what's often called a collaborative check. And those funds tend to do really well. And so it's just us trying to make sure that when we're investing in venture, we're not just doing venture for diversification, we're doing it for as large of outcomes as we can.

20:37Taking a step back, how did you go about educating yourself in the venture space? Is this through the fund-to-fund construct and what's some best practices for an LB that wants to educate themselves on a new space? Yeah, regrettably, we didn't start out with a fund-to-fund adventure. I think in hindsight, we're a small team. We're trying to be clever and implement our ideas and work with a mid-sized consulting group. And it was really hard to try and build out a portfolio across all the potential opportunities for investing. And arguably, we should have started with, I could speak to kind of the collaborative model we use now at maybe a later point in the conversation, but either a more collaborative model or just allocating to a fund to fund to make sure you're in the market, you're getting some decent exposure, getting your diversification from those asset classes that are harder to implement.

21:26And then over time, building up your experience and capability. I think that's how most people do it. That's how we should have done it. We spent, you know, it's kind of a funny story. One of the fund-to-funds we did was China, venture in China, early stage, met all our criteria, except we were like, you know, we'll never get to China in terms of being good at selecting venture managers. So the fund-to-fund was a pretty kind of a no-brainer if you wanted China exposure anyway. And it was supported by our consultants. So that was something we did in 2017-ish or, you know, plus or minus. And at that conference, I met someone who I was describing, you know, this conversation we're having.

22:07And he said, oh, you need to meet this guy, Michael Kim. I couldn't find it. I spent a decent amount of effort trying to get in touch with Sandana. And it wasn't until a few years later that we actually synced up and ended up, you know, partnering with them. But the amount, the venture community, the GPs there, the fund-to-funds and some of the advisors, there's a lot of data that they're working with. It seems, you know, maybe it's just, you know, my familiarity or recency bias, but it seems like since Sindana has grown in size and garnered attention, there's been a lot more thoughtfulness around fund size, portfolio construction.

22:43and now when I'm on LinkedIn, I often see a lot of data-driven analyses around these topics and they don't always all point to the same thing. But just back to the actual question of how you educate yourself, I think there's a ton of stuff online that's data-oriented in nature that lays all of that out for you. The manager selection part, really difficult. Like I said, we ended up partnering with a couple of fund-to-funds as scout funds or sourcing partnerships, if you will, just because of the sheer volume and difficulty in taking care of the portfolio while also trying to find$50,$75 million funds run by a single person or a couple of people.

23:22Tell me about this collaborative model that you alluded to. So working with consultants is, having been one, I think it's okay for me to say, and we still work with consultants. We appreciate the value they bring. They're an extension of staff. They have a lot more resources than we do. but their business model is such that they need to serve the, I don't know if you'd call it the largest common denominator, but it is kind of a business of solving for a lot of clients. And if you have a custom approach or a niche approach or a niche interest, that's a one-off for them. It takes away from their bottom line.

23:56And when you're working in a more collaborative model where consultants would collaborate on the sense that you're sharing ideas and you're asking for services or getting some stuff off the shelf provided. But if you enter into more of a commercial relationship where, for example, we're anchoring some evergreen funds and with some advisory type firms and we're receiving in exchange either revenue share, discounted fees or advisory services or database access or other software, one or more of those in each case. And now we have this commercial kind of relationship where we, you know, we are in business together, so to speak.

24:38And when we want access to XYZ researcher database, if it's, if it's, if that work is done by them, then we, you know, can roll that off the shelf and we don't need to roll up our sleeves and do as much due diligence or underwriting because those very capable people with a lot more resources than we have. and in some cases a lot more experience have done that underwriting. So that frees us up on what you might call more conventional type exposures. And then we also have the ability to either bring to them what you might call like satellite or niche type fund or strategy. And they're obligated to work with you in some capacity, depending on the nature of your collaboration, commercial collaboration.

25:22and we or we just have that extra bandwidth to work on that ourselves and on those kind of satellite exposures if you will and in addition to that we're able to in certain areas where we think the upside is more limited like private we call it private income call it private debt private real assets which includes real estate infrastructure all kinds of natural resources maybe some other things you'd be really hard pressed to get like a 2x net or 3x net from those strategies, right? The odds are really good that your downside is really well protected, but your upside is pretty capped. And I think that's like the diversifying benefit.

26:00There's partially that those types of strategies bring. But in order to really drive returns there, we looked at the structuring and fees on committed or how long it takes to deploy or both. And we've, as part of our collaboration, we're able to structure co-invest accounts that are with minimal expenses. So we're not paying management fees, we're not paying carry, we're not committing capital, paying fees on committed capital. And so that kind of call it like structure alpha, if you will, from the nature of those relationships and how those deals are packaged. We have that uplift of being, we're going to pretty easily get median gross returns, if not better, but then we're adding back all of those fees, that fee drag over time.

26:47And that allows us, again, more bandwidth for putting private markets money to work or hedge fund exposure to work where we can really focus on making sure we're picking the right strategy or the right manager that might be a little more difficult to require a little more heavy lifting. Professor Steve Kaplan, who was on the podcast a few months ago, he came up with this Kaplan Shore Index and he figured out that 2 and 20 on a per year IR basis was actually six percentage points. So to your point, if you have half of your funds in a 2-in-20, half in a co-invest with 0-in-0, you're actually getting 3 % alpha across the entire portfolio.

27:25It was a pretty significant alpha when it comes to co-invest. 100 % agree. You're also using AI tools to screen decks. What are these AI tools and how are you using them strategically? We tried to be early adopters of AI when ChatGPT first came out, but then we realized the confidentiality concerns and we weren't really able to put, you know, manager material in there. You can obviously have it proofread a memo that doesn't contain any confidential information or all the other things we might use ChatGPT for. But we really thought we were going to be able to, you know, adopt it early on. we had a working group we called Skynet but each time we met we were like I like we're kind of locked out because the you know because of our confidentiality provisions that we agreed to with managers and uh put it to the side and then we finally you know got our hands around the corporate for lack of a better term like you know subscription chat GPT and then we were like you know individually using it with you know everyone's working on their own different prompts and with more or less success.

28:26And, you know, it's actually a lot of work to get, you know, those prompts right and to get it where you need it to be. And meanwhile, we were working with and looking at software providers. You know, there were quite a few out there, but we spent about a year looking at names because each time we looked at a new name, things were moving forward, things were evolving. And each time we had a question or like, well, we're looking for a CRM solution as well. They'd say, They'll give us a month and we'll have that programmed in and we'll talk again. And sure enough, people are coming back. And so it took us a while.