Avoid Over-Diversification Through Manager Selection | Exclusive Q&A With David Demeter, Investment Manager of University Of Michigan
David Demeter is the manager of investments at the University of Michigan. He has been with the university endowment since 2005, managing an endowment pool of $9.7 billion (as of June 30, 2016). In this interview, Demeter reveals University of Michigan’s manager selection criteria and one thing that differentiates great managers with average ones. He also shares his favorite readings that guide his professional opinions and help him be a smart investor.
Demeter holds an MBA from the University of Michigan and a B.S. in economics from Duke University. He is also a Chartered Financial Analyst.
Demeter was recently named on Trusted Insight’s Top 30 University Endowment Rising Stars. He graciously spoke to us on May 2, 2017.
Trusted Insight: What does it mean to you to help support your alma mater?
David Demeter: It means a great deal. I think everyone here, including myself, really enjoys the fact that the work we do benefits the university and the community, and really goes towards things like scholarships and medical research that do good for the world.
Trusted Insight: How has your approach to the markets evolved since joining the investment office at the University of Michigan?
David Demeter: I started off as an entry-level analyst. In general, what I've come to appreciate, especially since leading investments with different managers, is the incredible importance of alignment of interests. I'd say the number one question in any investment we make is understanding the alignment of interests between us and a manager. The next most important thing would be barriers of entry to competitive capital. To be exciting and interesting, there has to be something preventing tons of money flowing into an investment strategy and competing away returns.
Trusted Insight: What is your typical day-to-day like?
David Demeter: It varies quite a bit, but a lot of it is manager due diligence. I help a gentleman named Michael Haessler here on our marketable portfolio, which consists of public equity, fixed income and absolute return. Within that absolute return category, would be hedge funds and private credit. For the last five years, I've helped him with that and I've done quite a bit of work on our public equity portfolio and in our private credit portfolio. A lot of our day-to-day work is monitoring what we have, thinking about where we want to make marginal changes and where that marginal dollar of invested capital should go. Day to day, there's periodic data gathering, reporting and analysis. A lot of it also has to do with meeting new managers and sourcing new ideas.
Trusted Insight: What’s your manager selection process like? What differentiates a great investment manager from an average one?
David Demeter: To start, no one that we're really considering an investment with is lacking in experience in their strategy. They may not have been a portfolio manager. They may not have run their own firms before, but everyone is fairly experienced. As a result, and assuming our other criteria is met, we’re willing to engage smaller firms and I often say we’re willing to be the second investor with a manager, right after the personal investment of the investment manager themselves.
Public equity is probably one of the asset classes that's the hardest to add value in. I think it's all the more important to really stress alignment of interests. We look for groups where the investment team owns their firm, controls their firm, can control capacity of their products and can limit the scope of products so you don't have an endless array of different portfolios they're managing.
In public equity, we tend to also invest with groups that are somewhat more concentrated. We do this for a couple of reasons. The main reason is from our own portfolio perspective; it doesn't take a lot to build a diversified portfolio. If you're hiring a number of managers, you become diversified fairly quickly. Then there's the risk of becoming over-diversified where you're going to start replicating the index but you're paying active manager fees. So we target groups from a portfolio construction point that are more concentrated. That also helps alignment of interests because we really look for groups that not only meet those earlier characteristics but also invest the vast proportion of their liquid net worth in their own products. If they are doing that, then they're even more concentrated in those stocks than we are, which leads to a nice alignment.
As far as more mechanical work, we'll really analyze their track record. It's imperative to understand how people achieved their track record. Just because the top-level returns show out-performance or even under-performance doesn't mean that they haven't had good stock selection or bad stock selection. We'll really go through all of the portfolio holdings searching for systematic risk factors that unduly influenced their track record. Then we start discounting those, positive or negative and really focus on the specific stock selection.
For example, there was a period a couple of years ago where you really couldn't tell if a global manager had good stock selection by looking at top level returns because for a few years, the U.S. had outperformed the rest of the world so strongly. All top level returns told you was whether the manager had an overweight or an underweight to the U.S. and little to nothing about stock selection. So we like to try to see what rolling stock selection looks like over a long period of time.
We also really try to understand the manager's philosophy around concentration. I think a number of more intelligent people than me have talked about the need for having greater quality characteristics as you concentrate. So, for example, having a less levered balance sheet, having at greater moat or competitive advantage, is important as you concentrate. We examine that very carefully because we do invest in somewhat concentrated managers. Position concentration will vary some from manager to manager and stock to stock, and that amount should vary with the quality characteristics prevalent in the manager's strategy and the specific security. You don't want to be concentrated in something that can fall 50 percent, because you'll have to make 100 percent later to make up that loss.
Trusted Insight: What trends, topics or risks are affecting how you approach markets now?
David Demeter: Like all of our peers, we're confronted with the problem of low returns for the foreseeable future, especially across public markets, but to some degree in private markets as well. I think to combat that somewhat and to reduce some of our public equity risk, our marginal dollar has been going into various niche, private credit strategies. When we can really find managers and niches where they can provide downside protection and a healthy return to compensate for illiquidity, that makes a lot of sense now given where public markets are priced.
In private credit, we really look for managers in niches. There has to be some sort of barrier to entry of competitive capital. Private credit, unlike private equity or other assets, has a yield. It's not hard to figure out expected returns. As a result, I feel that as you go up in transaction size, private credit becomes a commodity quickly. A primary barrier to entry for us in any private credit strategy is transaction size. We tend to look at smaller managers and deal with smaller transaction sizes. It takes roughly as much work to due diligence a small investment as a large investment. That extra work per dollar of investment can sometimes keep competition out of smaller markets.
A lot of managers will try to raise bigger and bigger funds to scale and get better economics. That inhibits returns because there will be more and more sophisticated competition as you go up in transaction size.
Trusted Insight: Is it a trend at Michigan, across the board but particularly in private markets, to look for more niche managers given the low-return environment?
David Demeter: Yes. Barriers to entry of competitive capital are very important. I would say across the board we definitely look for more specialized managers, more niche managers, and in some asset classes that's easier than others. We really want to be long term partners with our investment managers. Dealing with a smaller, more niche, managers, also naturally helps us achieve that because with smaller managers your investment will be more important to them. That tends to evolve into more of a partnership type of relationship as opposed to just being a passive investor and source of capital.
Trusted Insight: Do you find that these niche strategies are more in new funds that spun out or in larger funds that are creating subset niche strategies?
David Demeter: It's hard to say. I would be biased toward saying more of the former, but then again, my own personal investment process is more going to be biased towards dealing with smaller firms. A larger firm that's trying to do a lot of things faces the challenge that being fantastic at a lot of things is very difficult. You can certainly have different investment teams to try to tackle different investment processes, but as an outside investor knowing how resources get allocated and really having transparency into that is always difficult with a larger firm.
Trusted Insight: What advice would you give to someone looking to entering institutional investing and what should they know?
David Demeter: I would just encourage, as I do here with our analysts, to read widely. There's a vast number of new things to learn. That's really what the job is. I find the job really interesting because, every one of those niches that we have to look at, that's a learning curve. You've got to march right up it if you want to be competitive in a fundraise. You get to learn about new things. I find that interesting. I encourage our analysts here to read widely. There's so much in finance and economics. You'll never be an expert in everything, but many people don't take the time to keep learning. Yet, it really is a profession that requires continuous learning.
Trusted Insight: What do you enjoy reading on a regular basis?
David Demeter: It’s varied quite a bit. There were a few years where I read every value investing book out there. I was an economics major at Duke and have always been fascinated with economics. I liked reading the original economic treatises, like Keynes' books. Then I actually got quite involved in reading the works of the Austrian School of Economics and those continue to guide a lot of my own economic opinions.
Throughout all of that, I've always been fascinated with stories of economic history, like prior economic bubbles. Those stories are always at least entertaining and interesting in trying to understand how people got to extremes. On the wall of my office is a bond that was issued by the country of Poyais, which is a fictional country. In the 1820s, a mercenary named Gregor MacGregor fraudulently issued these in the London market when there was a boom going on in Latin American bonds. Many Latin American countries were becoming independent from Spain and Great Britain wanted to pull them in their sphere of influence politically. One way to do that was to allow them to issue bonds in the London market. It's an interesting story.
There’s been numerous entertaining stories in not just the 19th century but also in more modern times. It’s been my experience that many people don't have much insight beyond their own careers as far as economic history goes and I’ve never quite understood why that is.
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