E373: What Most CIOs Get Wrong About Alpha

24:52Fast forward 20 years and you see like what kind of innovation they've brought to the economy and the rewards for that innovation, as well as the monopoly positions they've created for themselves. Amazing business. And those are created in the venture capital ecosystem every single year. There's always great companies being born. The challenge is there's thousands of businesses being formed every year. You know that. You're very involved in the space. You know how many businesses there are. And there's a thousand venture capital firms funding these thousands of businesses that are created every year.

25:24Most will fail. Most should fail. That's what's great about markets. And it's that power law where the most successful businesses will be in that bright tail and could get you 100 ,000 X returns or maybe even greater than that. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my rag and bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants. They've got that clean structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day.

26:02And they become one of those go-to pieces I don't really have to think about. Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans, it's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work. The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar Jeans.

26:31You get 20 % off site-wide at www.rag-bone.com using code INVEST. Again, that's 20 % off at www.rag-bone.com with code INVEST. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my Rag & Bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants. They've got that clean, structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day, and they become one of those go-to pieces I don't really have to think about.

27:11Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans. It's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work. The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar jeans. You get 20 % off site-wide at www.rag-bone.com using code INVEST.

27:44Again, that's 20 % off at www.rag-bone.com with code INVEST. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my Rag & Bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants. They've got that clean, structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day, and they become one of those go-to pieces I don't really have to think about.

28:17Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans, it's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work. The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar jeans. You get 20 % off site-wide at www.rag-bone.com using code INVEST.

28:50Again, that's 20 % off at www.rag-bone.com with code INVEST. And every venture investor, their dream is that they have an unusual batting average and they're going to find a disproportionate number of those 100x, 1 ,000x returns. You have to be in the ecosystem. You've got to know the right groups that have the right access to that deal flow. It's very hard as an investor to just wake up one day and say, I want to be an early stage in venture. I'm going to move to Sand Hill Road and see what businesses come my way. They're unlikely to knock on your door. but there's so many venture firms that one could partner with and as well as innovative ways of investing in that we think it's a great place to be invested if you have that time frame i've coined this term strategic ignorance when it comes to venture capital which is venture capital capital v everybody wants it everybody wants to get these funds but if they knew what they were investing to into especially at the time they would not like that they would not like why are you investing in defense tech a decade ago?

29:50How are you going to go against the large primes? Why are you investing in this cryptocurrency? Isn't it going to be hacked? Every single trend, by definition, for it to be an early stage investment and for it to grow 1000x needs to sound crazy. So it makes a lot of sense, especially when people are managing other people's money, and that's somebody to report to to have this wrapper around this portfolio that's called venture capital with these extremely spiky assets that since the 1970s have has outperformed every other asset class on average, if you're in the right managers, not knowing exactly what's in your portfolio, not figuratively, not literally, but figuratively is a huge advantage to investing in asset class.

30:26A hundred percent. And the way we look at early stage venture, let me start with this is one of our partners had a slide a number of years ago that showed what was the best business created in the venture ecosystem every year going back in time. And where did capital flow in that year? Which sector was capital flowing to within venture? And where was the best business? And it was never the same. So the best outcomes was always in some space that people weren't thinking about and all the money was going into the crowded trade. So there's definitely a part of being a great venture investor that requires a discipline, almost being a contrarian and looking for weird ideas, but really great entrepreneurs in potentially very large markets.

31:10The best venture firms have figured that out. A lot of it's about entrepreneur. The business plans adjust, but if they're in a great space and you've got a great team, magic can happen. And we've seen so many examples of that where businesses started with business plan A and then they become known as completely different company. I mean, let's think about an automobile company that's become an AI company, for example, right? Tesla is just the perfect case study of how much they've accomplished that has almost nothing to do with automobiles. And so that's so important in venture. You need this large portfolio, large number of bets.

31:42So if you want a somewhat predictable outcome over time, but you also need to think in a little of a contrarian style, I'm not just gonna put all of my money into the hyperscaler. I'm actually gonna go look at some very differentiated, some of it's in the AI native companies, but some of it's in other areas of innovation. I mean, defense tech is obviously going through a massive innovation wave. And I think the next few years, we're gonna see even more of it. Investors have to kind of pick their spots. Speaking of contrarian investing, you guys are bullish on biotech. Yeah. Many people are withdrawing from the segment and think it's very difficult due to many different issues.

32:23China, the IRA, and other kind of pricing mechanisms that are going against biotech. Why are you so bullish on biotech? So let's start with healthcare. You hear people talking about healthcare is out of control. It's just too high a percent of GDP. But if GDP compounds the way it's been compounding, actually healthcare will grow as a percent of GDP. And it's almost like a rule of economics, actually. The cost disease, there was, I think, a Nobel Prize given for this work, kind of explains why healthcare costs will rise over time. It's one of those things that rises to the top of the right. As a society gets wealthier, the amount they'll spend on the raw ingredients in their meals goes down.

33:09The amount they'll spend on oil or coal or natural gas or rubber or steel goes down. But the amount they'll spend on experiences as well as wellness just goes up and that occupies a greater and greater percentage of income. So we're sitting here in Soho and how many restaurants are there within a few blocks distance. And if we were to go back two generations, how many restaurants were here? People didn't eat out as much. People are eating out more. They want great healthcare. They want wellness. Well, within that basket, so you have GDP growing, you have healthcare growing faster than GDP. And then what's going to take a bigger and bigger percentage of healthcare, technology or manual labor?

33:49And it seems pretty obvious that it's technology. So if you can get the right medicine, even if it's only for a small population, if you can get the pill that helps 1 ,000 or 10 ,000 people, that's an incredible amount of value that you can bring to this world. And compare that to the rising cost of healthcare of staffing a hospital or an outpatient clinic. Yes, it's expensive to develop these medicines, but there's so much leverage and you develop it once and you don't have to hire as many people to treat that population. So the macro is wonderful. You have this tailwind of growing GDP, growing healthcare as a percentage of GDP, and growing pharmaceutical innovation as a percentage of healthcare spend.

34:33Yes, there's headwinds in the form of people don't like hearing about the drug prices, often priced in the thousands, tens of thousands, or sometimes hundreds of thousands of dollars. These are very expensive, and particularly for those very small populations where you have some orphan particular indication where you could be only a few hundred people taking a certain medicine that's going to be very expensive to develop on a per person basis. That's the backdrop. What we like about biotech is that backdrop, but also the alpha opportunity in the public markets. Alpha in general, this is a pet peeve of mine.

35:08People talk about asset classes as if the pricing is fixed. For example, they'll say, I love early stage investing or I hate early stage investing. But if you have the same asset, you're investing at a$25 million valuation, or you're investing at a 5 million if it's extremely out of favor. That is fundamentally a different investment. And people talk about it as if it's good or bad versus what the right way to talk about it is whether it's overpriced or underpriced. There is no really bad asset. And same with biotech. If everybody in the world now thinks biotech's a bad sector, at some point, it becomes one of the best sectors in the world because there's just so many opportunities.

35:40And when everything goes down, even if there are a lot of bad assets, sometimes there's some gems there that no one's looking for? 100%. It's challenging because you get these pro-cyclical moments where when the market turns and becomes pessimistic, it's hard to access capital. And some of these companies, when they can't access capital, like in the venture ecosystem, it means they go away. So you need to maintain access to capital. That's why there's so many public - There's a momentum aspect to it, whether you like it or not. There's a short-term momentum and a longer-term reversal. And so there are great contrarian value investors who saw biotech just getting hammered over the last few years.

36:15And some of them timed it really well, kind of getting in at the nadir and just saying like, okay, yes, there's a lot of headwinds in terms of momentum, but eventually there's a reversal. You get to some point where you're buying businesses for less than the net cash. And you're saying, okay, even a mediocre management team should be able to handle this one. I mean, we're trading at less than the liquidation value. This is amazing. And then if you have a good management team, I mean, it's like many ways to win, right? This is amazing. So you get those opportunities. There are moments in biotech where the beta turns very favorable and there are moments where it's less favorable.

36:49We as a firm don't think we're like the best at market timing. We leave that to others. Kind of got to know what you're good at, what you're less good at. And we tend to focus on the more consistent application of alpha generation. So it's the security selection. How do you get relative value? But there are investors. That's really like the CIO's job at an endowment to say, I'm going to reallocate some money from China to biotech or from biotech to Korea. So there's principal agent issues on your side, which is if you go to these LPs and the LPs know that biotech is out of favor, it's a hard, you need to have a lot of political capital to do that.

37:23But also let's say that the head of biotech or the head of alts wants to do the investment. Now they have to go to their CIO and then their CIO has to go to their board. So it's all these levels of governance and all this complexity that you're going against this friction. Yeah. On your point on market timing, I've actually pretty much come to the determination that market timing is an unknowable force. And the reason I could say that with high confidence is I've talked to some of the best public investors in the world, and none of them know what catalyzes a recalibration. And I actually don't even think it's that they don't know.

37:56I think it's unknowable. I'll give you an example. GameStop, was that a knowable thing? That was fundamentally unknowable. But even smaller aspects of that, sometimes you have somebody come in with an activist campaign. Could you know? Could you predict that? Well, maybe if you knew the activists and they gave you a phone call before that, which would be, of course, insider trading. But outside of that, there's these mimetic things in the market, especially now with social media that are fundamentally unknowable. What will actually catalyze the change? What do you need to do as a great public investor?

38:22You need to make sure that you have enough of a runway for luck to basically run its course. I think that's right. Look, geometrically, you may have some understanding of a market, but it may not work out arithmetically. And let me explain the difference, right? you look at GameStop and you say, I kind of know where this is going to end, but you don't know where the next day, the average of the next hundred days might be very bad if you go against the mania. Over the long run, you might be right, but you might be carried out before you're right. And so particularly when you're short, it's extraordinarily difficult to be short because it becomes more of an arithmetic game.

38:59And on some days you could just lose so much money that you can't even make up for it. When you're a long, biased investor and you're holding a security, you sometimes could fight the crowd. It's possible. You want to diversify because you never know. There could be corporate events that change the ultimate trajectory. But I think fundamentally, the point you're making is right, that it's very, very difficult in these situations to kind of time and to get those dynamics exactly right. We're more focused on the dispersion of opportunity, making a basket of investments where you think the basket is biased towards that kind of top quartile outcome.

39:41When you have a high dispersion market, you don't even need to be 99th percentile. If you're 60th percentile on average in a high dispersion market, you just are going to outperform by hundreds of basis points. Kind of goes back to this strategic ignorance aspect, which is if you need every single investment to work and to get the timing right, you are misusing the asset class. But if you build a basket of it, knowing that on average, you're going to have these very spiky, very high alpha trades, then you could actually have a pretty diversified and pretty predictable alpha producing portfolio.

40:13Yes. Now I want to go back for a minute to what you said, if we can. You said the magic word before, governance. I think so much of this is about governance and agency. And if every investment organization, whether you're an investment manager like High Vista or a pension or a sovereign wealth fund, if every investment organization could clarify what they do, what they don't do, where they should focus their time and how decisions will be made, that will lead to just much better outcomes. There are organizations who we've partnered with who really can lean in and out of markets, who have the governance to do that in a time-effective way.

40:52They can actually move around their asset allocation in a pretty dynamic way. Most organizations can't. And if you have that knowledge of which organization you are and how your governance, do you have to go to your investment committee? Does the CIO have discretion? How much career risk would the CIO be taking, by the way? And can the CIO withstand? And do they have upside? Do they have upside? What if the market goes against them? Will they double down when the market's down? Or do they cut their losses? Why should they double down? Why should they cut their losses? Obviously depends, right?

41:18Sometimes market moves against you. You say, information's on my side, and this is just random or even worse than random. It's just some nonsense fad trend that's going to reverse itself. I got to add even more to this position. There's other times where kind of more of the classic hedge fund approach, which is, hey, it's moved against me. I just have to get out, cut my losses, and I'll reevaluate and see if my thesis is intact. Both have their place as risk management or investment philosophies, but you need to think that through in advance. You need to know if you're going against the crowd, if you're making a big decision, what will you do on the day where it goes against you?

41:52And how will your teammates, how will your colleagues, how will your supervisor or your committee react? It reminds me of this famous pension fund study that found that 90 % of a pension fund's performance could be predicted by their asset allocation and their sub-asset allocation. And then you think upstream of that, what is that? That's governance. Going back to alpha, governance is probably the most important, least sexy thing on the planet. And yet when I interview people, especially former CIOs, where I love to interview former CIOs because you get the full picture from them. They're no longer within the organization.

42:21And I interview people like Larry Cochard, who's former McKenna, UVA, Georgetown, or Britt Harris, who's actually become an advisor of us, former UTIMCO CIO. They all say the same thing. A, it all comes down to psychology. They basically realized 20 years into their career that they're a psychologist. And then two is it comes down to governance. And even current CIO, Scott Chan, if you ask him, how do you return 13 % on$360 billion at CalSTRS? The answer is he had a decentralized system. Because how else do you move with so much capital? You need to empower everybody in the organization to be able to make decisions.

42:57Now, of course, you have risk guards on that, certain check sizes require discretion, all these things, but you have to allow people at the edges to execute their discretion. 100%. It's really aligning between the particular dynamics of the capital source, the organization that's formed around that to get to the right governance model. There's no one governance model. I think in our own case, because we're investing across lower middle market private equity, early stage venture, asset-backed private credit, as well as biotechnology, there's a lot of ground to cover and we couldn't do it without having a really strong platform, which means governance.

43:35And it also means, of course, having great client functions and operating functions so that investment teams can really focus on making great investment decisions. There's different investment committees, different composition for each of our different areas of focus. And so those investment teams can focus on their craft, on making good decisions and partnering with an overall broader platform that supports that craft. You mentioned this whole aspect of career risk. My favorite example of this is Scott Wilson at University of Wash U, St. Louis, and he meets with his managers. They've done well.

44:05they've done exceptionally well he's one of the top CIOs in the country and he meets with the top managers in his portfolio and he asks where are you at your concentration limits in other words you're 20 % in this position I want more of that what he's implicitly saying is that even at 20 % you're underweighted why because little Johnny still has to go to college because that CIO still has a certain risk factor that they could take so he fundamentally goes and meets with every manager figures out where they fundamentally cannot put in more and actually doubles and triples down on that which is very counterintuitive.

44:36Usually you would think about in portfolio construction, you want to do the opposite. But because he's so diversified across managers, going back to the structural alignment, he's able to take these asymmetric bets in their highest conviction bets. And that, I think, was pioneered by the pod shop. The pod shops really came up with this idea of a center book where you're upsizing. We do that across all our portfolios, actually. So we're doing that in private equity, venture, private Credit and Biotech where we'll partner with specialist GPs and then you're trying to lean in. You have to build a lot of diversification to be able to lean in because if you lean in on an undiversified portfolio, in the end, you're just taking too much idiosyncratic risk for the client.

45:15But if you have 100 plus company diversification in a portfolio, you could afford to lean in and still not really be taking on that much risk. How do you get to 100 plus company diversification in any program? You need to do it through partnership. No organization's really set up to invest directly and know hundreds of businesses cold. You need to know the businesses, but also have really good partners that you can rely on and then co-invest, whether it's an independent sponsor or a small venture manager or a hedge fund, co-investing alongside them or upsizing a name is a very powerful tool. I think this is one of the fundamental flaws in asset management, this idea of over-diversification.

45:55There's this rule of 22 two and a half, which is completely arbitrary. It just means that you have like 97 % diversification. If you take it to the most extreme, you have many founders that have a hundred percent of their money in one company. And then you think, okay, how diversified I'm in one asset? That doesn't sound very diversified. And it's not, of course. Then you think, well, now I do nine more investments. I have 10 investments. How diversified am I? It's actually a very easy math equation. You're now 90 % more diversified. And now you do another 10. Now you're 95 % diversified. This is where the 22 and to have, it's just this, it's an arbitrary rule.

46:28It's this number that people have come up with, but there you're 97 % diversified. But at what cost? And a lot of, this goes back to principal agent problems. If you're an endowment and you're a CIO and you don't necessarily have the upside, you want to make sure that if everybody else is at 8%, you're between 7.5 and 8%. So from principal agent problem and a principal agent position, it makes a lot of sense to be hyper diversified, but from a net return to the underlying capital pool, it makes much more sense to be spiky in the way that Scott Wilson does it and you guys do as well. So a couple of comments on that.

47:03I think that's right. When you diversify roughly, the idiosyncratic risk that you take relates to the square root of the number of investments you have. So if you go from one to nine investments, you cut your idiosyncratic risk by a factor of three. When you get to 25, you cut it by factor five, assuming they're all kind of different sectors and that you're, at some point, you're actually making many bets in the same sector. And so that's where that diversification really does start to matter less once you get to the 10, 20, 30. You feel like diversified, but you're not. Yeah, because when you start diversifying cross geography or sector or themes, in the beginning, it's very powerful, but then you have many bets in the same theme or the same sector, it's not as powerful.

47:49For the capital allocator, their job is actually not to over diversify and to not think, I need to hold equal weight US, Spain, Vietnam. That gives me more diversification. That's nonsense. When you're thinking about capital allocation at the highest level, your starting place should be the world. Take the ACWI index, for example, and say, hey, that's a pretty good index. And then if you want to lean in one direction or another, sure, lean. once you drill into a market and say, hey, how am I getting exposure to Vietnam or Spain? Well, yeah, you don't have to index in that country because it's not really going to matter.

48:25If you made three bets versus 30, it doesn't matter. Then it's just about agency risk. Once you're in the drilling down one layer, it becomes about agency risk. But agency risk, I would argue is real. I think even when you invest for your own portfolio, if you don't have enough diversification, you might make the wrong decision at the wrong time. Makes you more fragile. More fragile. You might lose faith in a strategy that you had thought through pretty carefully because you don't see enough evidence that it's going in your direction. That's the other thing I'm obsessed about, rootedness of thesis.

48:58An example I use on Bitcoin. If you had invested, if your friend, you went to MIT, your friend came to you and said, there's this awesome thing called Bitcoin. You have to invest and you invest at$10. And then it goes up to$160. And you're like, great, I'm up 16X. And then it goes down 20 % to$120. What are you going to do? Yeah. So actually a friend of mine from my days in Cambridge did come to me 14 years ago, and he's a brilliant computer scientist. Actually, this is his field. And he said, this was going to change the world. And he was, I think, on a professor's salary. So I don't know how much he invested, but he was advocating that everyone should invest.

49:34I actually just had no idea what he was talking about and couldn't understand it. So I didn't invest. I think I I'd be in a very different situation today had I taken his advice. But yeah, you have to understand what you're investing in. You have to have core beliefs and you have to be willing to stick to those even when the evidence is a little murky. Well, Rafi, this has been absolutely a masterclass. Thanks so much. And thanks for being a partner to our firm. And thanks so much for jumping on. Thanks for having me. It's really great to be here and look forward to our next conversation.