In the midst of the current doom & gloom regarding equity markets, it is important to maintain a sense of perspective. The MIT Investment Management Company (MITMCo) manages MIT’s endowment and they celebrated their 15th anniversary last month. Their 15th anniversary letter is worth reading in the current circumstances to maintain a sense of balance and poise. Three things stand out about the newsletter:
Firstly, the MITMCo are very clear about their long term goal [“Our primary long-term goal is to generate sufficient investment returns to maintain the purchasing power of the endowment after inflation and after MIT’s annual spending”] and the returns they need to generate to meet this long term goal [“Assuming inflation will average around 3% over the long-term and MIT’s spending rate will average around 5%, we need to earn approximately 8% annually to meet this goal.”]
The team goes on to explain that they have met this goal and then some: “Fortunately, we were able to return 18.9% annualized over the past five years, 14.5% annualized over the past ten years, and 11.7% annualized over the past fifteen years. We are the first to acknowledge that our returns in recent years are significantly above what can be reasonably expected on a long-term basis and will be subject to the forces of mean reversion.” The underlining is ours and highlights how MITMCo are doing what Kenneth French says he does when he invests money: https://marcellus.in/story/
Secondly, MITMCo understands that if they do what everyone else does (in terms of choosing fund managers), they will get ordinary returns. So, they have to think differently and act differently:
“Maintaining an edge in the investment management business is incredibly difficult. The potential for outsized financial rewards draws in innumerable participants and provides ample motivation for intense effort. Early signs of success are usually followed by a flood of capital that crowds out opportunities and drives up prices. Market environments change rapidly, making formerly useful strategies and techniques quickly obsolete. These forces make it very hard for anyone to generate compelling returns over long stretches of time.
While there probably are people who can continually outwork and outsmart the competition, we find the more sustainable route to differentiated results usually involves adopting an approach that others do not pursue. Adopting an industry standard approach leads to viewing the world through a similar lens as most others and to more competition for investment opportunities. Adopting a different approach leads to less crowded playing fields and an opportunity to build strengths where others may not be focused. To offer one brief example, we know of a stock picking firm based in Europe that maintains the discipline of studying a company for at least a year before being willing to purchase it. While this discipline probably sounds bizarrely rigid to most investors and surely results in missed opportunities, it creates an atypical investment process that few others are willing to adopt. (Imagine for a minute all the things you might approach differently if you had a year to work on them.) Not surprisingly, the firm has constructed an unusual portfolio and generated atypical return outcomes.
We have tried to take a different approach in several areas. One example is our investment manager selection process. Historically, we sought out established firms with long track records of success. Such firms were easier to diligence, quick to get internal approval, and much less likely to result in disastrous return outcomes. Unfortunately, these firms also were harder to develop relationships with (due to numerous demands on their time), harder to garner capacity from (due to significant interest from other investors), and often facing headwinds to future investment success (due to larger asset bases and more complicated organizational structures.) As an experiment, we began to target smaller, more off-the-run managers such as brand-new firms, firms started by people who did not have “traditional” backgrounds, firms delving into new arenas, firms with unusual organizational and fund structures, and any other type of firm that did not match the typical institutional playbook. We discovered that we very much liked the arena of overlooked firms. By definition, there were fewer other investors competing for manager attention and manager capacity, giving us the opportunity to develop deeper, longer duration relationships. These managers also were more likely to be an outlier in some way – perhaps they had been forced to be innovative to survive or perhaps they simply viewed the world differently because they did not have the advantages of being an incumbent.”
The third, and perhaps most interesting part of this letter, is ‘mistakes’, how MITMCo deals with them and the specific example of the ‘mistake’ cited in the letter: “Organizations benefit enormously from candid disclosure of what has gone wrong. Unfortunately, mistakes are always made by an individual (or a group of individuals) who typically suffer loss of stature and diminished organizational confidence when they share all the things they did badly. When faced with such incentives, we wanted to find ways of creating an internal culture in which the sharing of mistakes is not just a habit but also valued and rewarded. One way we have tried to lessen the stigma of sharing mistakes internally is to discuss some of them in open forums, such as this letter.
One mistake we made in recent years was a failure to capitalize sufficiently on coinvestments in late-stage venture capital companies. While pattern recognition is one of the great benefits of experience, overreliance on pattern recognition can be a hindrance to good decision making, particularly during periods of secular change. Based on our historical experience, we believed that late stage venture capital co-investments generally were poor risk-reward because that these rounds of fundraising often were priced by investors hoping for a quick gain in the IPO process and such transactions were likely to be pro-cyclical investments made at market peaks in the largest and least attractive of fund investments.
As a result of our pre-conceived notions, we were slow to recognize that the market environment had changed dramatically. The rise of bigger, winner-take-all global technology companies and the tendency of these companies to fund themselves longer in private markets created numerous situations in which MIT’s venture capital managers had access to compelling late-stage private investments that they wanted to share with limited partners. Instead of the negative selection bias we had experienced historically, the late stage venture co-investments offered by our partners in recent years were actually some of the most attractive investment opportunities around. By focusing too much on the historic base rate and not enough on the opportunity set in front of us, we missed opportunities to earn compelling returns for MIT in companies such as AirBnb, JD.com, and Stripe.”
If you want to read our other published material, please visit https://marcellus.in/blog/
Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
