In part one and two of this interview, Sam Gallo, the chief investment officer at the $1.3 billion University System of Maryland Foundation, discussed the importance of building a solid team structure, the advantages of being affiliated with a higher education institution and why he’s an advocate of well-roundedness (read it here).
In today’s article, Gallo discusses his investment philosophy, implementation in current markets and why he puts a strong emphasis on risk management.
He was recently named on Trusted Insight's Top 30 Endowment Chief Investment Officers. He graciously spoke with us on Feb. 13, 2017.
Trusted Insight: What’s the approach to your investment strategy and your portfolio at Maryland? How are you looking to develop that, moving forward?
I worry the focus of portfolio construction is more about return generation without paying enough attention to downside possibilities. I operate in reverse fashion – build to survive the downside so that there is only one other direction, up.I get concerned these days in seeing where valuations are, how people are investing, how they stretch for yield and the general sense of market complacency. I worry the focus of portfolio construction is more about return generation without paying enough attention to downside possibilities. I operate in reverse fashion – build to survive the downside so that there is only one other direction, up.
Whenever I think about adding a new investment into the Maryland portfolio, the questions I always ask myself are: am I going to lose, how much and are there multiple ways to exit so as to minimize a loss? The time to answer those questions is not during the trade, not during the chaos, but before the investment is ever executed. This approach requires evaluating investments within a scientific framework and having contingencies available to deal with uncertainty.
When we invest, we are always thinking about downside scenarios. We evaluate what we do to help the investment against a catastrophe or even a normal event harming the principal. There is nothing worse than a permanent loss of principal capital. That is the base from which all income is generated. Lose that, and the potential for future compounded income is gone forever.
Losses and gains are not symmetric. Lose -10%, you need to make +11% to get back to even. Lose -30%, you need to earn a +43% follow-on return to scratch. Lose -70%, and you need a +233% follow-on gain so that your capital is returned. How many people do you know who lose -70%, turn right around and earn +233%? I would say those are not good odds. Therefore, in understanding this mathematical asymmetry, it is critical to avoid experiencing large losses, as with each big loss, it is that much harder to recover.
When I think about my philosophy and investing approach, first I think in terms of the pay-off diagrams. Basically, my x-axis is the market price and y-axis is my profit and loss. Ultimately, I am tracking what the profit and loss will be at different market prices. I strive to create a portfolio that has limited downside risk, yet still has significant profit potential in various types of market conditions.
Second, I think about the concept of compound interest – as Einstein said, "Compounding is the most powerful force in the universe." Our program is structured around being a long-term investor, seeking out growth opportunities and protecting principal. In structuring pay-off profiles that reduce the magnitude of loss, while allowing for significant profit, we are able to grow our assets at a compounded rate, which in turns leads us towards outperformance.
Risk management and compounding are what I think about all day (and night too). Embracing both into a portfolio are great hallmarks of a solid investment program.Investing should be an exercise encompassing the concept of compound interest. If you introduce large terrible losses into your portfolio, you take away all the goodness of compounding. If you lose a substantial amount of principal capital, you spend years trying to earn back the losses, rather than moving forward from a small loss into a growth scenario. Mathematically, it is better to have slow, steady, stable, upward moving returns, than wild volatility in your return profile.
Risk management and compounding are what I think about all day (and night too). Embracing both into a portfolio are great hallmarks of a solid investment program.
Trusted Insight: You mentioned investors getting comfortable in the current market. In that regard, what are the biggest risks right now?
Sam Gallo: A big risk is not being realistic with current market conditions.
Markets can go down, and I mean more than 1-3% in a day. They can sell-off, and do so violently. We have been very fortunate over the last several years to see that sell-offs were brief and that markets quickly corrected.
What I worry about is when markets take an immediate dip down and everyone thinks they will just come back, so the buying commences. Markets do not have to come back. If they are fundamentally strong, there is a good chance markets will recover. However, markets are ruled by emotion in the short run, even though longer term, they are generally driven by fundamentals. If you look at a price chart of any market, pre- and post-the Global Financial Crisis of 2008, on a longer term basis, it looks like a V-shaped recovery. When I was a trader, my mentors told me often, those are the most dangerous. They are dangerous because they lead to bad behaviors in investors thinking that something needs to recover immediately after it has sold-off. It does not have to do so. What if it is a double W-shaped recovery? Or a flat-lined non-recovery?
Also, I am concerned when I see by short-term statements reflecting that what happened in the last couple years, post-crisis, is just going to continue happening for the next couple years. We live in a different investment landscape than what existed a few years ago. We will probably see pockets of volatility on the rise and people should be cognizant of that. I am not saying volatility is bad. In fact, I like volatility because it gives our managers and our team opportunities to enter and exit markets. Investors should understand that what existed in the past might not exist in the future.
Trusted Insight: What is your approach when the market declines?
Sam Gallo: We have a list of securities and funds that we like to compliment into our portfolio, on the margin, when markets decline. These can, at times, be good opportunities to rebalance positions too. Our team is constantly talking about strategies, and we know what we are going to do, when it happens. We have dry powder to take advantage of short-term noise, and provide some marginal improvements to our portfolio. Like many long-term investors, we are patient.
We structure our investments in ways where we are cognizant of how they perform in different market cycles. We have already added positions in the portfolio that we believe, during a downward cycle, will be stronger than other alternatives. That just speaks to the whole story of risk management.
Trusted Insight: What particular areas are you looking for in a diversified portfolio? Are there any particular asset classes you look for?
Sam Gallo: It is not so much asset classes. We're looking for structures that create that asymmetric return profile, where we could get paid very well in an up market, okay in a sideways market and not get hurt in a downward market. If you can find that structure in any asset class, I would absolutely encourage that form of portfolio construction.
We definitely have our target allocations across our asset classes and we remain disciplined around our policy portfolio. Further, each year, we perform statistical studies on the portfolio based upon varied return forecasts and expectations.
At the end of the day, we care a lot about the structures across asset classes. That means finding investments, whether they are through external money managers or liquid securities, where in combination, we will earn profit in many different market conditions.
When I look at investments, I see payoff diagrams in my head. My approach to investing is the risk management piece. I look at the payoff diagram of the existing portfolio. I am looking towards how it changes with each incremental investment action as well as how much (in terms of cost) I paid for that payoff.
Trusted Insight: Are there any particular data points that you find difficult to identify when looking for a manager?
Sam Gallo: The industry has gotten a lot better in terms of its transparency over the past several years. It was always difficult to evaluate any structure if information is not shared in a meaningful period of time. We like to work with organizations that are highly transparent and give us timely information, so we could assess the aggregate portfolio. Ultimately, we are managing a portfolio of different securities, managers, structures and liquidity time horizons. It is a lot of different things, a lot of balls in the air that we are managing all at the same time. It certainly makes it easier for us to do our jobs if we have both transparency and timely information.
I have a lot of respect for the investment professionals at Yale, and certainly do not see earning returns for higher education a competition, but a mission-based endeavor.We have spent a good amount of time over the years partnering with organizations that can provide us with great data. They work with each of our managers to collect data on a timely basis. That allows us to slice and dice the portfolio any number of different ways.
Trusted Insight: The Yale endowment model is nearly ubiquitous. What trends have you identified that might compete with that model?
Sam Gallo: I have a lot of respect for the investment professionals at Yale, and certainly do not see earning returns for higher education a competition, but a mission-based endeavor.
In not comparing anyone, an increasing trend I am noticing is of investment programs becoming more aware of the impact that fees have on the long-term performance of the endowment. For example, we used to pay 2% on assets and 20% on profits, as an industry, for many alternative oriented investment products. Let’s say the product returns 10% in a year. That means, on a $100 investment, the endowment pays an expense ratio of 4% (i.e., $2 management and $2 profit-sharing). Now you are talking about a gross return of 10%, turning into a net return of 6%. In that scenario, fees made up 40% of the return. In a world of 5% equity market returns, 60% of the return would be paid away.
The question is: How do we make this work for everyone? Where the allocators get the returns they need, the managers earn the fees they need/earned and everyone can walk away feeling okay about the process. I think answering that question is the trend we are going to see, and I do not know what the answer is just yet. However, I do think that over time the industry will find a nice solution.
See the full list of Top 30 Endowment Chief Investment Officers here.
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