Introduction

Patrick: [00:01:21] Our guest this week is David Salem. David was the founding president and CIO for the Investment Fund for Foundations, which served 800 endowed charities under David's 18 year tenure. He's now the CIO of the Windhorse Group, which focuses on long term value orientated investing. This conversation wanders into and explores many different areas of investing and life. The theme is how to think about asset allocation and invest holistically from first principles. But we talk a lot about motivation, incentives, human behavior, and the fear of missing out as key variables in money management. We discuss the history of the Yale and Harvard Endowment Models and how their success has affected the asset management world for better or worse. I also can't stop thinking about David's Mount Everest question, which we explore early on in our conversation. I'd love to hear your answers to that question. So email me or message me with your thoughts. You can find show notes for this episode at investorfieldguide.com/salem. And now please enjoy this great conversation with David Salem.

Asset Allocation

We've had this evolving landscape of asset allocation. Where it's one about asset selection or asset class selection or definition, and, two, about selection and allocation to those different choices. In the time you were at GMO working with Grantham, talking with Swensen and Jack at Harvard, what were the big questions? What was sort of the vanguard or the frontier, if you will, that you were thinking about, learning about, as you were trying to define sort of a baseline asset allocation. Then versus now, what were the principle differences back then versus now?

David: [00:03:03] David came to Yale in '85, as we've said, at a time when the nominal interest rate was still high but where he thought it did not make sense for a perpetual life charity like Yale to have as heavy a weighting to fixed income as Yale and other endowments had traditionally had. So he started to dial down the bond exposure, dial up equity and equity substitutes and in the process it opened his eyes and the endowment to more liquid forms of investing, which made perfect sense from both a theoretical and practical perspective. As long as you have a good sense of what your liquidity needs will be, not only under normal conditions but under worst case conditions. What Jack did at Harvard was quite different. Jack, I think quite brilliantly, analyzed the overall situation and realized in important respects Harvard university, at least then, had the highest credit rating in the world.

It wasn't just triple-A, it was like quadruple-A. Because he could get lines of credit to build a kind of internal, portable, Alpha Engine within the Harvard management company with unbelievably low financing cost. Principally because the institutions, the medias from whom he was borrowing the money, weren't focus on, "Well, what is the overall risk the endowment is incurring?" Maybe JPMorgan knew that they had $2 billion lent to Harvard, but they weren't all that concerned that Citi had also lent them $5 billion over here, and Deutsche Bank had lent them $3 billion over here. Pretty soon it added up to real money. So Jack built something that was very, very different from what David had. And therefore what Harvard and Yale were doing... and I'm just using them as conspicuous examples because there were other leading endowments and foundations. It wasn't just the educational endowments, but some of the very well managed private foundations were doing the same thing.

And, of course, it got popularized by some of the leading investment consulting firms, Cambridge Associates most visibly but others as well. And it led to much more diverse policy portfolios than had been the case, certainly at the enactment of ERISA in 1974, certainly when I joined the industry a bit later, and certainly as the 1900s unfolded. By the end of the 1990s and well into the naught, you started to see the development and the popularization of policy portfolios having seven, eight, nine, ten different asset classes with strategies and tactics being employed that were literally deemed... I'll say illegal, it sounds like too strong a term. But you had lawyers when I first got into the business who said institutions... I remember very well a private foundation based in North Carolina had a white-shoe law firm here in New York City that gave them a legal opinion, said, "You may not buy anything less than investment grade bonds."

Imagine in 2017, Patrick, that a law firm in New York City says to a private foundation, "You may not own anything other than an investment grade bond." Imagine, by the way, the arbitrage opportunities that would be created when something slipped from investment grade to just below it, all of these institutions had to disgorge those bonds. In fact, that was the case when I got into this business years ago. It created enormous opportunities for people like David Swensen to go ahead and say, "Let's do some distressed and maybe high-yield investments." Farallon is a conspicuous example of a firm that David helped support that became fabulously successful by arbitraging some of these artificial barriers to the free movement of capital.

Patrick: [00:06:31] The Yale model itself. From your perspective, what were the drivers or remain the drivers of its success for Yale in particular? And then what are the aspects of it that people seem to continue to want to emulate but do so foolishly, meaning they're trying to replicate something that's not possible to replicate and creating perversions along the way?

David: [00:06:56] My answer to your question is not focused so much on the fact, as I said earlier, that he came to Yale in '85 and dialed down the exposure to bonds, dialed up the exposure to equity and equity substitutes, where the substitutes would include these sort of absolute return-oriented hedge funds. It was the person. It was the man, if you will. Emerson famously, or memorably, said that every great institution is the length and shadow of one man. In 2017, we'd say one person to make it gender neutral and appropriately so. But David has a very distinctive personality. It's not everyone's cup of tea. It's not always pleasant. I actually had the privilege of writing a review for Barron's of David's first book, Pioneering Portfolio Management, when it was published in 2000. And I highlighted in that my very first conversation with him, which again was shortly after he joined the Yale Endowment in 1985. When he looked across the table, we had met five minutes previously, and he said, "You know something, I don't know an effing thing about investing."

And in that instant I said to myself, "This guy is going to be incredibly successful somehow, some way," because he has the self-effacing character in modesty to say what he just said to me after only knowing me for five minutes. And in indeed what he's done in the 31 years since then proves the point. So it's a mindset that is inclined to really push, in a very rigorous way, on first principles. What actually makes a money manager, a money management firm, an asset class, an economy, a way of structuring economic life. What makes it tick? David is a serious, rigorous thinker about those things and a really stern questioner of the people that would deploy capital for Yale. He was an extraordinarily helpful member of the board of TIFF in its early years, and even in later years. Not only in introducing us to money managers that he deemed choice worthy, but in just asking the right questions at the right time. In a way that, frankly, was not always pleasant.

So most people like to move through life without the degree of discomfort and unpleasantness that... and this is not in any way a pejorative. When I say unpleasant, I mean it tends to be unpleasant and uncomfortable for people to ask really tough questions of other human beings. And David is extraordinarily good at that. And that's a very uncommon attribute. So, as I said even in the book review in 2000, and I would repeat it even in 2017, people that just go ahead and try to mimic the strategies and tactics that David has employed at Yale and the others that he's trained and employed, they miss the point. Because you have to have a mindset that says, "I am willing to be wrong and alone." Now, wrong could be in the context of making an asset allocation or a strategic or tactical decision that the market doesn't reward.

But ex-ante, wrong could also be you're in a board meeting, you're in an investment committee, you're in any setting and you ask a question because you sincerely want to know the answer. And maybe the answer that comes back to you is in some ways, I'll put this in air quotes although this is an audio recording, it's embarrassing to you. You wish that you hadn't asked the question. But I would say in our business, in money management, there's really no question that's off limits. I mean, personal questions aside of course. But as to how markets operate, as to how managers deploy capital. So it was that sort of fundamental personal attribute. And it was coupled with something that I thought about a lot back in the day, and I think about even more today. It's a very obvious point but I think it bears mention and emphasis, which is that to get the degrees of freedom that any CIO as capable and as accomplished as David.

And there are many others that come to mind, including Jack Meyer himself. To get that, the degrees of freedom to deploy capital really effectively, in other words to get the discretion to be willing to deploy capital in a manner that could cause you in hindsight to be deemed wrong and alone, you need to be persuasive. And I don't mean persuasive in kind of a Trump-like way where you're a bragger and you're boastful and there's real no substance, there's no fundamental, solid foundation in what you're saying. But I mean to over time develop that reservoir of confidence and goodwill. In David's case, with the members of the Investment Committee of Yale and ultimately the governing board of the university, in Jack's case similarly with the board of Harvard Management Company.

But I could go right around the country mentally. What Scott Malpass has done at Notre Dame in probably the second longest serving CIO in the educational union . He started at Notre Dame, as you probably know, in 1987. How can we quantify the reservoir of confidence and goodwill and trust that Scott has been able to build within the Notre Dame community after 30 years of really hard work? And, of course, the returns have been very pleasing too. Now, part of your question was how has the so-called Endowment Model, which is really an adaption of the Yale Model, how has it become overused? And I've already telegraphed my answer to that question, it's that people have tried to mimic the strategies and the tactics as opposed to the underlying mindset and philosophy. So it's been the polar opposite of a willingness to be wrong and alone, is a proclivity or a tendency to just chase recent returns and put money where others have put it and continue to put it because it's comfortable.

That's the Endowment Model in 2017. And I see it, the saddest expression of it for me is in very substantial, taxable portfolios where, for whatever reasons, families of very substantial wealth have gone ahead and mimicked the strategies and tactics that have been employed successfully at places like Yale. Taking what had been originally the Yale Model, what became the Endowment Model, and applying it to substantial, taxable private fortunes. And it's a big, big mistake principally because of the interposition of taxes between the cup and the lip, so to speak.

Patrick: [00:13:20] So there's five or six things in that whole arc that I want to pull on. I thought I was going to have to wait longer to ask this question. We were talking about it before we started recording. But your line in your review of his book in Barron's where he admitted that he didn't know about investing makes me think of ego, or the lack of thereof, and the role that ego plays in the world of investing. And you mentioned this interesting idea called the Everest question. So I'd love if you could outline what that question is.

David: [00:13:52] The Mount Everest question is the one you just alluded to, and I'll just outline what that was. It came to my mind right around the time that that terrible accident occurred on Everest, that Krakauer ended up writing about in Into Thin Air. And I asked myself the question, why would these people risk going up Everest? And would they in fact... particularly the very wealthy ones. I don't mean the Sherpa's but the paying customers. Would they go to the top of Everest with all the risk that entails if the universe had a law that said that when they got back down from the summit of Everest they could never talk about it? So it would remain and secretive forever. So the question became for me, my so-called Mount Everest question, was, "Patrick, if you could accomplish just one feat, F-E-A-T, in your lifetime subject to the condition that no one would ever know about it. What would it be?"

And now, of course, certain feats or accomplishments don't satisfy the condition well. I'd like to be president of the United States. Well, everyone would know about it. So it was and remains interesting to pose this question. Typically, if I don't furnish in advance, people will commendably stop, pause and think in somewhere between 5 and 50 seconds and they'll come up with an answer. I did have one person that I posed the question to on stage. I remember it was at the Boston Public Library, pretty large audience. And the answer came back instantaneously. I mean, I'm not sure I even got the question out. And he said, "I'd put a bullet through Bin Laden's head." And I thought, "That might get known publicly but I guess you could pull that off privately." And then, of course, Bin Laden was still alive at the time. Then the SEAL team went in. Now we know who claims to have put the bullet through Bin Laden's head. But there have been some really interesting... solving a cure for cancer and that kind of thing.

Manager Selection

Patrick: [00:15:37] Quick interesting side note, I actually once had to speak to a large audience directly after the SEAL that claimed to have put a bullet through his head. He was one hell of a storyteller. Got probably a 30 second standing ovation when he got up there and maybe a 2 minute one when he finished, and then I had to go up there and talk about quantitative equities directly afterwards. So funny side story there. So let's go back to ego and ego will be a bridge into manager selection as well. We were talking before about how, if you pose the question of would you climb Everest if you could tell no one about it to a lot of hedge fund managers, a lot of them might say no. And I'm sure you and I could tell fun stories about large egos. Sometimes justifiably large, sometimes not so much.

But I'm curious as it pertains to manager selection in particular. I think this is a topic that is obviously really important for the success of any allocator, especially with large pools of capital to deploy and access to manage to managers that, for an ordinary investor, would be impossible to reach. We'll use ego as the bridge to get into manager selection. You've got a great set of criteria that I'd like to walk through. Both things you want to avoid, which I think is always the right place to start any investment discussion, is the negative. What not to do is a powerful tool. And then we'll kind of narrow it down to what specifically are the most desirable aspects. But let's talk about ego first. Is it something that you can harness because a great series of returns boosts an ego? And the pursuit of those returns is what you're after as an allocator, someone that will produce above normal risk adjusted returns. So how do you think about ego as it pertains to managers themselves? And then we'll get into the details of manager selection.

David: [00:17:29] That's a great question. Can we do a quick sidebar in terminology here?

Patrick: [00:17:32] Of course.

David: [00:17:33] What exactly is ego? To me ego is... in my own lexicon, which is maybe not everyone's, ego equals insecurity. So, if we think about a spectrum of the most egoistical people we can possibly imagine, including the current occupant of the Oval Office, at one extreme to it's opposite, polar opposite, which is somebody who displays, moves through life with extraordinary grace at all times. Particularly grace under pressure, which is something we can come back to, it's a spectrum. And so the question then is if you're trying to identify people, not only who you think have an edge but who you want to partner with long term, you're going to deploy capital by entrusting some of it to them. Then the question is where along that spectrum do you want them to be? You don't want to give money to people that, as we said a few minutes ago, are going to be most comfortable and have a tendency to just stick with the herd because it's not a way to get superior returns.

If you want average return, that's perfectly fine, that mindset. And so it could be somebody who's tolerable, be free of ego. Maybe they're not graceful in the way I just described but they don't have that kind of self-confidence of saying, "I'm willing to be wrong and alone." Where it gets taken to excess is if it's a manifestation of deeply rooted insecurities that are inevitably going to cause the manager, maybe it's a firm that they're running, maybe it's one that they founded, and the capital they've been entrusted by their clients to head in the wrong direction. So I do look for one of the negative screens. And as you know my framework, not only for evaluating money management talent but for evaluating just about anything in life, whether it's a political candidate, whether it's the chair of the Federal Reserve, whether it's an athlete, whether it's a potential spouse. It doesn't matter.

It's a four part framework and it starts with disqualifying attributes and then moves to unfavorable and then moves to favorable. So a disqualifying attribute is an excessive ego that's synonymous with excessive insecurity. And the insecurity could eventually manifest itself. If I said to you, "Quick, Patrick, name me in the annals of modern finance, let's say the last 30 years, who's on your top three list of the most insecure characters you've either read about in the newspaper or ever met?" I'd say, "Well, Bernie Madoff has got to be in the top three." I mean, how could he possibly have done what he'd done unless he was a wildly insecure human being?

And so, as with much of what we do in evaluating managers, you build up a reservoir of experience and pattern recognition when you sit down with somebody and you try to determine are they excessively insecure? Are they insecure in a way that's going to cause them to depart from their process or to do something... I'm not saying it's going to be a Madoff-like crime, but it may be the crime with a small C and in air quotes of departing from what they said they were going to do with your capital because their insecurity causes them to maybe chase a rising market or to do something otherwise foolish with your capital.

Patrick: [00:20:30] It's a really great and simple definition of ego. And so I want to pull on insecurity and how to suss it out. And some of this might be subconscious, like you just through experience start to recognize that you can't explain exactly what it is, kind of like you know it when you see it type of thing. So in a conversation, and this is a question not just for evaluating a money manager but all the categories you outlined, how do you assess the degree of insecurity that you're dealing with in somebody?

David: [00:21:03] Yeah. I mean, the single best tell in my judgment, and I'm not saying that I'm completely free of this defect myself, but is to engage in a gratuitous and proactive offering up of thoughts, observations, and connections that the speaker, the person whose insecurities you're trying to gauge, is providing to you in an effort to impress. Because that's also synonymous with insecurity.

Patrick: [00:21:29] Name dropping.

David: [00:21:30] I like to actually... rather than focus on the negative examples, like Bernie Madoff. Or we could talk a brief but really telling encounter with Lance Armstrong, which I'm happy to talk about. Talk about insecurity, which many people say he had a gigantic ego but I would say he's probably the most insecure person I've ever met personally and spent amount of time with. It's just one evening but I'm happy to talk about it.

Patrick: [00:21:52] There's a line, I'm forgetting who it is, but I always think about this. The line is telling people nice things about yourself is a bit like kicking them. I mean, that's a really simple, great litmus test. In the evaluation of a manger though, there's the person or the people, there's the process that they have put in place. Depending on the process, like in my world a purely quantitative process where there is a model. Obviously the people are responsible for the development of that model. And some models change all the time, some, like ours, very, very rarely change. I'm sure there's people behind the scenes but there's no after the fact veto power of a name. So, if Northrup Grumman comes through one of our screens as a stock we want to buy, we buy it. So it's a extremely repeatable process.

When you're thinking about a manager, and then we'll start getting into your four level framework, how do you balance that person, CIO or portfolio manager, versus the process, evaluate how important one is to the other, and do you care? Would you, as someone who's met with God knows how many managers in your career, prefer something that is much more process orientated? Meaning if the person was lifted out, there's a good chance that it would continue. This is always like the succession plan question you get at big money managers.

David: [00:23:22] The starting point to an answer to... that's a great question, is differently than I did when my career began. So I have been evaluating money management talent for, we'll say, three decades. So I have met with quite a few money managers. And when I say I'm doing it differently now than I did years ago, it's because the pendulum is swinging more and more and more in the direction of focusing on the person and the culture and not the processes and not the actual approach. Now, I'm privileged and fortunate to be part of a team, I have partners, I had a staff at TIFF when I was doing it as well. So I'm not a sole figure reaching these decisions on my own and maybe other members of our team are digging more deeply than I'm inclined to at this point in my career into the process.

But the reason I'm focused much more on personality and culture... and this is true not only in looking at money managers. But it's a deeply held belief I have about how money managers themselves, present company included, can pick for-profit companies in which you want to be an equity investor over the long term because you cannot ex-ante the date on which the process they employ today when you allocate money to them will become obsolete. So what you ought to assure yourself is that the human beings you're dealing with treat money management as a profession, not a business, where their ethical responsibility is to the client to deploy capital well, even if it means returning the capital and saying, "Our process no longer works. We're either going to adapt it or we're going to return the capital to you because there must be other places you can deploy it."

Now why does that apply to investing in a company? Because what if a company's business model is increasingly obsolete? As a shareholder you don't want them to ride it down to zero. You want them to return the capital to you or adapt the business model. And it's extremely difficult, I believe, for outside investors in publicly traded companies in particular, particularly after Reg FD and the profound changes that its enactment by Congress has affected in our business over the last dozen years or so, 15 years since it was enacted. It's changed everything about the communications between the management of a public company and all of its outside constituencies. So, if you're going to focus on where a company is going, maybe you want to focus more on the personalities and the culture. That's true for evaluating whether you want to put money into a single for-profit company as an equity investor. And I believe it's infallibly true in deciding whether to allocate capital to a money manager, whether it's an equity manager or a manager focused on a different asset class or indeed a multiplicity of asset classes.

So it's personality and culture. And getting back to the main thread, which is ego and insecurity. You want to make sure that they're not so riddled with insecurity. Particularly the insecurity packet, to be really blunt and frank, that says, "My definition of human happiness," I don't mean mine, David's, but a money manager I might be evaluating. Their definition of happiness is how much do they have by way of material goods and possessions. Where are they on the Forbes 400 list? How many people are licking their boots because they're writing out large checks to philanthropies? I'm a huge proponent of philanthropy and charity. I think you know that from my career trajectory. But people that engage in it merely because they get their boots licked and they get lauded publicly. And maybe we can talk a little bit later about the privilege I had of working with Chuck Feeney, who did a lot of his giving anonymously.

But I think you get the point, which is that form of insecurity that causes them to say, "We've got a big AUM. Even though the processes that we dialed in that enabled us to magnetize all this capital are increasingly obsolete, we're going to just forge ahead because the fees is so generous and it soothes and satisfies my ego." And it's very difficult and I've major mistakes in trying to read human character in trying to get this right over the years. It's a very imperfect art.

Patrick: [00:27:26] We've talked in the past offline about entrepreneurship and the fact that almost nothing ever goes according to plan, and that the best entrepreneurs are ones who adapt on the fly. And I wonder if there's something in that same vein that you're looking for in managers where the word is really adaptable? That recognition of an obsolete process or individual stock pick or industry or something like that? The ability to change with the times, with the regulations, and so on, might be one of the most important of these attributes. And, again, that comes back to ego because you attach your identity to certain beliefs or principles. That can be actually very dangerous as a money manager because then you're prone to sticking to something that's not working for way too long. What are some ways that you look... I don't want to plant the axiom that adaptability is kind of the key thing. But assuming you agree that adaptability is a good personality trait of a money manager, how do you suss that out?

David: [00:28:29] Yeah. I actually think that's also a great question. I think you have to do it indirectly actually. And it ties backs to something we talked about a little bit earlier. So let's just say that you're a money manager and you come into my office in Boston. And you email me three weeks ahead of time, "I'm going to be in Boston three weeks from Tuesday. I want to come by. This is what we're doing." And I say, "Fine. You have 90 minutes." And you walk in and you go through your pitch book, if I let you do that, which I would seldom let that happen for a full 90 minutes. But let's just say hypothetically that you come in and you leave 90 minutes later and you never ask a single question of me or the people, my partners sitting around me, because it's not just me at the table. It's just all about you, you, you and your firm. And I can assure you at the end of those 90 minutes the probabilities are very high that that's the last meeting we'll ever take with you.

And it's because you've displayed a shocking and off-putting lack of interest in learning ever of these 90 minutes. It's an opportunity... I'm not saying that I have such worldly wisdom to impart to anybody but you won't know that unless you ask, right? Assuming it's a first meeting. Again, I think you get the point. So you got to go at it indirectly. That's why my very first conversation with David Swensen was inspiring and memorable because he said, "I have to tell you, I don't know anything about investing." And then he proceeded to pepper me for the two hours of our first lunch together with 100 different questions. And then the next time we got together it was 100 other questions and it just went on for years and years. And every now and then I try to sneak a question in edgewise too because I try to practice what I preach, right? So in conversations, this is-

Patrick: [00:30:03] It's a different format.

David: [00:30:03] This is very much the exception that proves the rule because I'd rather be peppering you with questions, rather than having you pepper me with questions and going on at such lengths. So I'll stop right there in answering the question.

Patrick: [00:30:13] So let's go through your actual framework. We'll start with the negative, the disqualifying attributes when considering a money manager. We don't have to do every single one but I want to give a flavor for the type of things in the four levels or categories as you're going through the evaluation process. So we'll start with the bad. What are things that, regardless of exemplary returns or whatever positive things, would be disqualifying attributes of a money manager?

David: [00:30:39] Well, there's some obvious ones. Relevant criminal and ethical-

Patrick: [00:30:42] Right. No murders.

David: [00:30:45] They have to be relevant too. I mean, a speeding ticket I'm not sure qualifies. But in this day and age, of course, you can go to the internet and find out a lot of things about a lot of people. So lapses like that. So if we move from sort of obvious disqualifying attributes to unfavorable ones. I mean, the one that's universally applicable is when you ask somebody, "Well, okay, so you think you have an opportunity here, you think you've attracted the right team and you've built the right culture and you've got a well defined process, or so you think. We'll learn that as the conversation and the due diligence process unfolds. But, as we're focused on unfavorable attributes, how big could the asset base to which you would profitably apply this?" And then unwilling to specify those limits is often reason enough to terminate a conversation quite quickly.

So that's unfavorable attribute, among many others. I think, again, along the lines of what we've already been talking about. An insensitivity to external changes in the external environment. My writing's in a different context with respect to asset allocation, call that the fallacy of composition. A manager comes in and you say, "Well, this is all very fine and well but give me a sense of how carefully you've studied what other actors are doing. How much other capital is being applied in a similar fashion? And how much money might potentially be applied over time horizons germane to our employment of you?" That's what you're seeking by making a presentation to me. How much capital could potentially flow in and what would that do to returns? And it becomes pretty immediately obvious whether a money manager seeking to get magnetized capital from somebody, and a capital allocator like me, has thought rigorously and carefully and thoughtfully about that or not. And if they haven't it's game over. The conversation can usefully end.

Patrick: [00:32:34] That hints at one of the key ones in my mind of disqualifying... and I'll just read it directly, which is financial arrangements that subordinate clients' interest to the firms or its employees. And I am currently beyond fascinated with incentive structures, fee structures. This will again tie back, I think to both Harvard and Yale and similar institutions that tend to be early and form partnerships with young or nascent managers. Getting that right seems... maybe there's no ideal, right? I don't think there's any fee arrangement that doesn't create an incentive that wouldn't exist if the manager was just investing their own money. I think it's probably impossible but maybe you can narrow that gap. Is that what you mean by something that subordinates the clients' interest in favor of... so asset gathering would be one example that may be subordinating the clients' needs or expected returns in favor of the asset management business behind it.

David: [00:33:30] No, you're exactly right. And I don't think there's an ideal and there's not an ideal because humans differ. There are people that are passionate about careers in finance for reasons that have very little, if nothing, to do with the potential financial reward. They find it intrinsically interesting, they find the intangible rewards, they get to meet interesting people. As I like to say, for my most of my career I've gotten paid to do what I would otherwise do in my spare time. And that's a pretty good gig. I could point to specific people that, after getting to know them really well and getting down to brass tax on fees and so-called incentives, they've looked at me or I've looked at them and said, "Why not just put a flat 1%? Would that work for you?" "Yeah, that would work for me."

I'll name one name, Andrew McDermott, is a guy that we helped move from Southeastern Asset Management in Tennessee. Now has his own shop on California, manages money for Windhorse and some other institutions whose capital allocation processes we very much respect. It's just a flat fee. There's a hundred different ways you could dial an incentive fee. East Global Money Management happens to be focused on Japanese stocks today. You could have a Japanese specific benchmark with a carry and a hurdle and all that stuff. Just keep it simple. Why would you do that? Because Andrew has almost his entire net worth, so does his partner, John Burford, also came out of Southeastern, invested alongside our capital. He has a lot of pecuniary incentives to deploy the capital effectively.

More importantly in mind he has psychological incentives to continue to do what he's always done throughout his career, which is try to purse investment excellence. He's self-effacing and modest enough. But contractual arrangements where a manager can rightfully look themselves in the mirror and say, "Heads I win and tails I don't lose," are increasingly on the wane as they should be. But I'm not sure that you actually need the pecuniary incentive that some people that have benefited from those incentives over the last 30 years would claim that you need to have in order to elicit best efforts.

If I can just as a sidebar. And it's interesting and ties back to what we talked about with the Yale Model and the Endowment Model and certainly what Jack tried to do at Harvard. But my only... and it's not even a criticism, it's an observation that David Swensen for years said, "This is a calling. It's a profession. And we don't need to pay people, certainly here at Yale, extraordinary sums to magnetize the talent we need at the university to deploy our endowment effectively." And he was unarguably correct about that. You did a great interview with Ted Seides, who I've known for years, and you've done other interviews in your series with people who've talked about incentives and fees. And it's a combination of art and science. And I think it would be a big mistake to think that an allocator could come up with a template and apply it universally to all managers and all asset classes. That's not feasible.

Patrick: [00:36:35] I've been thinking about this. I'm curious if you agree with my answer, which is if you had to choose one thing to create the right relationship with a manager, what that thing would be. And I think that it would be the highest possible, I'll call it, GP commit, percentage skin in the game that the manager has. And that can be measured a couple different ways. The percentage of their overall net worth that's invested alongside you and your clients, percentage of the overall fund if they've been really successful historically. It seems like an enormous amount, or as much as possible, personal skin in the game is one thing that I can't find much downside in. So I'm curious what you think about the most desirable thing or aspect of one of these arrangements.

David: [00:37:22] Patrick, honestly, I wish it were that easy. And maybe it is and maybe I'm trying to complex that which is really simple. But I actually think that's a misguided focus. And the reason why is something we've already alluded to. Imagine an instance where you're allocating money to a manager and you think they have a lot of skin in the game but maybe secretively, and this might be ethically off-putting and a disqualifying attribute, but they've actually pledged the GP interest in question to a charity of their choice. And you don't even know it. So they're not actually working for their own pecuniary benefit. No, I mean, within limits. Maybe they're taking a modest salary and they have modest living standards. They're just doing it for the intrinsic gratification. And yet they're coming to work every day maniacally focused on generating the best possible risk adjusted return without the pecuniary incentive that might cause you to say, "I really want to focus on that."

So there's an example of where I think you could prudently allocate capital to somebody whose interests are dominantly psychological and not financial. And it's not explicit in the framework but it's sort of between the lines, this four part framework that I employ. But if you said to me, "David, gun to your head, what is the single most essential attribute?" And particularly as you look over the arc of somebody's life, whether they're a 28 year old newbie to the business or they're 58 or 88, and you're thinking about allocating some of your precious capital to them. It would be to say if I go back through the arc of their life, whether it's 28 years or 88 years, do I see evidence that they've consciously pursued excellence in just about everything they've done? And I don't mean karaoke night where they're an amateur. That doesn't matter. But serious professional pursuits. Have they consciously pursued excellence even if they've never achieved it? Maybe they've had some conspicuous failures. But you can see that the effort was there.

Because the ultimate judge in my judgment of success for people who are going to be good at doing this is going to be themselves. They're going to look themselves in the mirror, not just at the end of your career but every day along the way, and say, "Am I doing my best work in the best manner I possibly can?" Even to the point of having to go back to the client and saying, "You know, I don't think I'm capable of doing what you think I'm capable of doing. Here's your money back." I mean, what higher and sterner test of integrity can there be in a business that entails asset based fees than that? So I don't want to be Pollyannaish about it but I do think you can go back and ask questions. They're not off limits to say, "So, Patrick, what sports did you engage in? What were you like as a high schooler? How did you choose your major in college? Who were your favorite teachers? How did you decide what your first job would be? What was that like? How did you wind up where you are?"

And you go back through that career and you can... again, highly imperfect pursuit but try to get indicia of the conscious pursuit of excellence. That is the ultimate safeguard, I think, to dialing up the probability of success in a business where, if you're discernibly north of 50%, whether it's picking stocks or picking managers, you're going to do just fine.

Patrick: [00:40:51] It's such an interesting way of thinking and it's kind of the theme of our whole conversation to this point. Just being introspective about that, I would've failed that test until I was probably 25, right? So, if you ask me a series of questions of talk about your pursuit of excellence or really pursuit of anything, up until that age there wouldn't have been any. And I wonder how much of... I don't want to say it was a switch that flipped in me. I can't tell you why it changed. But I've also met people like that where there's a long history of lack of pursuit or lack of direction that changes. And what an interesting thing to have to evaluate in somebody. I met a fascinating, very young, clearly brilliant investor. I think he's in his 20s, I won't mention his name, who was already managing quite a large sum of money for some of the people in the world that we've been exploring today.

So the investors were willing to give this young man sizable sums of money and acknowledge that they wouldn't be able to know what he was buying with it. Which I think is... you tell me, I'm sure that's an enormous rarity in this space. And his contention in what he was willing... he wouldn't tell me what he owned either. But his contention was when evaluating a company to buy, he bought equities, the only things that could possibly last over the horizon, back to your point about horizon, that he was trying to hold companies, very long holding periods, were personality and culture of sort of the culture as like the equivalent of personality when you're evaluating a manager. And that if that culture is right... and he wouldn't tell me how he found the right culture. I would love to hear your opinion as having run firms, evaluated firms on what to look for in culture. But that seems like a fascinating, very hard but fascinating way of evaluating anything.

David: [00:42:51] Looking at individuals, looking at societies, looking at political regimes. Their adaptability to change, their resilience, and, in the case of individuals and money managers in particular, their constant yearning and appetite for improvement. Whether it's improvement in the case of an organization or self improvement in the case of an individual. I believe, maybe over confidently, maybe arrogantly, that you can determine that you can determine that through conversation with people. Also there's a separate little sidebar conversation about the extent to which a capital allocator. I don't want to put myself exclusively in that bucket but that's certainly the focal point of my professional labors, is allocating capital. The extent to which you can rely on the written word to distinguish between luck and skill. So that's an important part of this framework that we've been talking about for the last several minutes, the four part framework.

Because people often say, "Oh, it's kind of impossible statistically to prove that a winning money manager has been skillful as opposed to merely lucky." And I often scoff at that assertion. I understand statistically why you need a certain number of observations to prove with a certain probability that something is the result of skill rather than luck. We all get that. Somebody can step up into the... at first they bat in the major leagues and hit a home run. You don't want to extrapolate and say, "Well, if they have a 1,000 trips to the plate they'll have 1,000 home runs." So we all get the point. But what if there's an ex-ante explanation that's written out very carefully ahead of time that says, "I'm buying this stock for this reason. Here is where I think the upside is, here's where I think the risks are."

And let's say that that memo is put in the file in 2003 when the stock is accumulated and it's not a winning stock until 2005 or 2006 or 2015. But that memo is timestamped in the file. And you can then ex-post go back and say, "Not only were they right, but were they right for the right reason?" And, of course, in our business you can often be wrong for the right reason because there's no certainty. You're dealing with a distribution of probable outcomes, not a single point estimate. And that's another disqualifying attribute frankly. It's not just an unfavorable attribute in my favor but a disqualifying attribute when you talk with money managers, whether it's a single asset class focused only on U.S. stocks or a multi-asset manager. And all of their observation and comments in the discussion about their current portfolio seems to be premised on the unfolding of a single scenario, which is sort of their... not only their base case but it seems to be their sole case. And I find that extremely off-putting because the world just doesn't work that way.

Patrick: [00:45:30] For people interested in that thread, I found Howard Marks writing on this to be probably the best. Just the understanding of the distribution of potential outcomes and how often it is the case that a decision was made for the right reasons and it just doesn't work out. That doesn't mean you should stop making similar decisions for the same reasons. It's such a hard thing to get your mind around because we're deterministic thinkers, right?

David: [00:45:55] Yeah. Howard is... I have great respect for him. I try to read carefully what he publishes, his books and his memos and things. And I agree with your assessment of him. And even more helpful mentor to me in this arena of uncertainty was, of course, the late Peter Bernstein. And my sort of single favorite quote about investing comes from Peter, where he said, and this is your point I think, Patrick, "Diversification is the only rational deployment of our ignorance."

Patrick: [00:46:24] That's great. I've never heard that.

David: [00:46:24] And I've repeated that over and over and over again. Oh, you not?

Patrick: [00:46:26] No, I've never heard that before.

David: [00:46:27] Diversification is the only rational deployment of our ignorance. How can you summarize what we do better than that?

Patrick: [00:46:33] That's awesome.

David: [00:46:33] Right? Now that doesn't mean you want to have an overly diversified portfolio. That's my critique of the Endowment Model, right?

Patrick: [00:46:40] Sure.

David: [00:46:40] These portfolios are way too costly and complex and opaque. But I think that the kernel of truth in what Peter said is so obvious. And it's not dissimilar from what Howard Marks has advocated over the years. So we just don't know how the future's going to unfold. That doesn't mean that I don't want to ultimately allocate capital to people who've thought rigorously enough things so that they actually have a point of view, but it's a point of view around a broader distribution of outcomes rather than a single scenario. Single scenario thinkers are very dangerous in our businesses. I think you would readily agree.

Endowment Model Through Yale and Harvard

Patrick: [00:47:14] My favorite thing about conversations like this is when they very far from our original question. So I promise we will get back to the attributes to look for in money managers because it's really a great list and essential. But that makes me think about, again, back to the comparison of Swensen at Yale, Meyer at Harvard. I want to get into a little bit about the difference through which they achieved their results, the different methods, because I think people would just be fascinated by that. And, frankly, because I know much more about Swensen than I do about Meyer. So I'm just curious to learn. But I think that one of the things you've written a lot about is people now seem to have these, we'll call them, buckets that they need to fill up in a portfolio.

And a bucket might be infrastructure or hedge funds or alternatives. And I think a lot of that comes from that Endowment Model, right? So maybe that's kind of three questions but I'll pick one to start with, which is what was the difference between, and you've alluded to it a little bit, of internal management versus external hiring of managers for Swensen? You said something earlier about Meyer's... I'll just go to Meyer. Meyer's ability to kind of do what Charlie Munger described, which was... he was asked one time what their secret was. And he's like, "Well, it's basically that we can generate funds at 3% and invest them at 13%." And you mentioned Harvard having the quadruple-A credit rating. So very cheap access to capital, almost like insurance float that Buffet utilizes. And then on the other side very profitable investment of that capital. So maybe you could describe for people, and me, since I'm ignorant on it, what Meyer's edge was during his tenure at Harvard? And how it differed from what Swensen did?

David: [00:48:55] Sure. And we can do this by sort of a... I'll try to be as brief as possible, kind of a historical review because I do think the world is radically different in 2017 than it was when either David arrived at Yale in 1985 or Jack arrived at Harvard in 1990. And a lot of the low hanging fruit, and a lot of even the high hanging fruit, has been picked. So I think if Jack were starting in tenure as the head of the Harvard Endowment in 2017, I think the policies and the strategies and the tactics that he would employ. He had a 15 year run at Harvard. So we'll stipulate if he was starting 2017 and he had to think about how am I going it manage it between 2017 and 2032, I think it would look almost nothing like what he actually did. David's approach has morphed too. So hold that thought. But you're starting in '85 and 1990 respectively. And in fact they had buckets, right?

So David's genius, of course, was to say he arrived and there were two buckets, U.S. stocks and U.S. bonds. And by the time we get to 2017, there are more buckets. Although the tendency in the best managed institutional funds these days is to have fewer and fewer buckets. So it's sort of a total return bucket and a hedging bucket. So you may be down to two. And that's because people recognize the growing, if not complete bankruptcy, of some of the buckets that have been used in intervening 30 years. And as you know in my writings I've said there're a lot of marketing schemes masquerading as asset classes. There's infrastructure. It's not an asset class. Obviously hedge funds is not an asset class. It's a contractual arrangement. It's actually a series of contractual arrangements.

But there were buckets and they were disciplined approaches to allocating capital. Again, in David's case it was to pursue opportunities, to have a greater degree of liquidity because it enabled him to put capital into markets where there was a large dispersion of results. Venture is, of course, the best example. Buyouts is another example. But even in the foreign stock arena, even back in the day in the U.S. stock arena. So a wide variety of asset classes and subclasses where the very best managers could transfer wealth from other managers to themselves and their clients. That's dispersion. That's still the case at Yale. And it's something that Jack tried to do. So, if I can move from Yale to Harvard, Jack arrived at Harvard. He adapted a policy portfolio. I can't remember how many buckets there were. Buckets sounds like a perjurer. We'll just call them fund segments, less pejorative. There were probably seven, maybe nine. He added timber along the way, he added tips when Uncle Sam started floating tips in January of '97.

But Jack had a big internal team, as we discussed several minutes ago, trying to exploit dispersion in each of these asset classes. So they were doing it internally, in the main. They had some outside managers. But doing it internally in the main. And then what really distinguished the Harvard Endowment under Jack's leadership from Yale was this internal Alpha Engine. And that's what eventually became convexity. So here we are talking in late April of 2017, just last week the Wall Street Journal published a headline story about what's gone on with convexity. The compression of volatility from central banks. I'm sure you read the article, probably most people who will listen to this podcast read the article or can go back and find it with Google. But that internal engine worked extraordinarily well for many years at Harvard. Not only for the reason we already ticked off, which is low financing costs, but because Jack could take a lot of capital within the endowment and essentially spread the alpha that was being generated by that specific team.

We can call it fixed income arbitrage, although it's morphed into other asset classes and subclasses. But essentially it was fixed income arbitrage. And they were doing things back in the day that were very profitable, particularly if you put a lot of leverage on the book. Simple things like on the run versus off the run treasuries, where you thought there would be over time convergence of the one to the other very reliably. But other people weren't positioned to borrow a lot of money, put on that trade, where you'd, of course, go long the off the run and short the on the run waiting for convergence of the two. It could be the 30 year versus the 29 year, the newly issued versus the one that was most recently issued. I'm sure you're familiar with those techniques. And it was extraordinarily profitable, particularly with a lot of leverage, and in great risk management.

That was not being done at Yale. It's never been done at Yale. But over time now I think you're seeing commendably a shrinking of the number of buckets as people recognize that under the conditions that really matter for prudent capital allocation, which are worse case conditions, where you want to look at the outlier events. When things start to really correlate, there really aren't 15 different asset classes in the world. There's kind of stuff that's tied to equity beta, there's stuff that tied to sovereign, full faith in credit, and then there's some other flotsam and jetsam lying around, like timber.

Patrick: [00:53:52] Let's come back to that hypothetical foundation. And I'll just pick a number. Let's say it's a wealthy family that says their tolerance for drawdown is 30%, something like you might see out of an old school 60/40 portfolio several times in this century, something like that. And they said, "Okay. So that's my measure of downside risk." From your seat at Windhorse then advising them on how to build a portfolio. With those two buckets in mind, what is the process then? So you've got absolute return, you've got hedge. Maybe describe in a little bit of detail kind of why those two buckets versus other formulations.

David: [00:54:30] Can I just modify your terminology? It's total return.

Patrick: [00:54:33] Sorry. Total return.

David: [00:54:34] On the one here. Absolute return is a term that David Swensen invented, at least the first time I came across it, and it's a subsegment within the overall endowment or Yale Model mix. But total return strategies, they're actually... these days, just to be really clear and precise about it, the norm increasingly these days is to have three generic buckets. And they are total return, hedging and diversifying strategies. And what the hell does that mean? And how much overlap is there? Because you can have equities... what if you have an equity long short in the diversifying strategies, which you typically do. But those are the three buckets that you tend to see. And I don't have a real, big conceptual or intellectual problem with them. I think it's fine. The reason it's fine is because what are the total return assets there for? They're there to generate very attractive long term returns, particularly in a taxable setting you need to be sensitive to turnover and all forms of returns leverage, particularly taxes.

So you've got the total return bucket. You may have just one other bucket, which would be hedging. Or you may have this third bucket, which is very common in institutional funds and in families of substantial wealth, which would be called the diversifying strategies. So how do you go about building a portfolio, which is your question. So let's just stipulate that the portfolio the day we get involved is all cash. Maybe they sold a family business or it's inheritance, what have you, because you don't have any legacy managers to deal with. I personally think the soundest process, and I've written about this and I've done it in a context most recently where I quoted my friend and classmate, Seth Klarman, we went to business school together.

He said, paraphrasing, there's nothing wrong with holding cash. Cash should be the default asset, not the S&P 500. For a lot of financial advisors the default asset is either the S&P 500 for a younger client or it's a 60/40 or a 70/30 portfolio. I think by my likes the default asset is cash. And in our example we're starting with all cash. So it's kind of easy. So what would cause you to shift money from to a riskier asset? And it would be, of course, depending on your time horizon, if the time horizon is long term and it's governed by, say, a minus 30 drawdown constraint, that gives you quite a few degrees of freedom, particularly if you've thought carefully about liquidity. Because it's not enough to just say, "We're willing to have a 30% drawdown." You need to be crystal clear up front about what are the liquidity demands on the portfolio under worst case conditions.

This is a big mistake that Harvard made, of course, in 2008 and early 2009. So, if you get drawdown specified, you get some clear specification of the liquidity constraints, then you can go to work. And in the current environment I'd say in the main I find U.S. stocks, publicly traded stocks, as a group to be pretty off-putting. So the work that we do, and it's not at all dissimilar from the work that's still done at GMO, there are many models you can look at say, "The projected real return on U.S. stocks over seven and ten plus years is derisory, if not negative and at reasonable rates of inflation." So that's not enough to cause you to give up the optionality of cash and put money to work in a broadly diversified U.S. stock portfolio. But there are pockets of opportunity elsewhere in the world.

But probably the most controversial one that we're funding today is something I already alluded to, which is Japanese stocks. And a lot of outside observers who I think have thought less rigorously about Japan than they perhaps should as capital allocators. But the outside thoughts is, "Well, Japan is circling the drain." Demographically, even debt wise, and by every metric that's germane to an outside investor. And we ought not invest in their securities. And by the way, the central bank of Japans owns more than half of all ETFs and they're starting to take a big bite out of the equity market. And I say, "I know. I get all that." I've seen all those numbers but nonetheless there are pockets of opportunity to get attractive risk-adjusted returns in the Japanese stock market in general and in Japanese domestic facing small caps in particular. So we have some money allocated to that.

We also have some money allocated under present conditions to, I'll call it, Asia ex-Japan, ex-China. Here's where a careful study of long term capital market history will tell you. And my favorite source of this, of course, is Elroy Dimson and Marsh and Staunton's book, the Triumph of the Optimists, and all the sequels to it. It will tell you that high growth economies that are flattered by relatively high economic growth rates of the GDP level and by favorable demography tend to generate, surprisingly perhaps to many people, subpar returns. So you're a value guy, I'm a value guy. We get that. So why would we be chasing return for long term capital in Asia ex-Japan, even ex-China? And it's because, I'd say notwithstanding the favorable demographics and the relatively favorable debt profile, the prices, the current prices, at which interest can be acquired in well-managed businesses where the managements have a sufficient, not perfect but a sufficient, alignment of interest with the outside shareholders. They tend to be family controlled and family dominated.

It's not that there aren't many, many, many such companies in the United States. There are. There are many more that are privately traded than publicly traded, but there's some that are even publicly traded. But they're just not priced attractively. So we hoped to maybe have an opportunity later in my career, and in that in of my partners, to redeploy some money from other pockets of opportunity we're pursuing today, or from the cash reserves that we're maintaining, into U.S. domicile companies. But generally speaking, generally speaking the prices are unattractively high at present. Fixed income, generally off-putting. Certainly the sovereign investment grade, the ongoing effect of Dodd–Frank and other regulatory changes that have created and continue to create some opportunities in credit markets. They're not infinitely scalable, they're on the smaller scale end of things. And they may go away with regulatory reform but we're doing some of that as well.

Favorable Manager Attributes

Patrick: [01:00:41] Let's use Japan as a way to circle back finally to some of the desirable attributes in managers that you're looking for. We've talked about some of the disqualifying or negative, undesirable things. Let's talk about some of the things you look for. So when looking to put money to work in, say, Japanese small cap securities. Obviously I'm assuming there's a manager behind that that's not some sort of ETF or index, maybe it is.

David: [01:01:03] Yeah. No, in our case that's Andrew and his team at Mission Value in California.

Patrick: [01:01:06] Great. So we can use them or a generic manager that you like to describe some of the positive screening things that you look for when considering and giving money to an asset manager.

David: [01:01:16] Yeah. And you're focused on the manager as opposed to the underlying companies-

Patrick: [01:01:19] Correct.

David: [01:01:19] … and securities that they're buying.

Patrick: [01:01:20] That's right. Yeah.

David: [01:01:20] Yeah. Well, I can be very brief about it because we've already talked about it. It's essentially you're looking for a high degree of ethical integrity and a high degree of intellectual integrity. I mean, I could stop right there. The ethical integrity I think is rather obvious. We've talked about somebody engaging in acts of either omission or commission that seem to be against their short term economic interest. That's something that you can kind of confirm. You can ask how somebody moved through life. How they actually consciously and proactively engaged in acts of omission and commission that would've reduced, at least over the short, if not medium term, their income. And that's a good thing. That's a very favorable attribute. I'm not saying it's essential but it's favorable.

But the intellectual integrity manifests itself in the kind of curiosity that we've already described and we've discussed, which is endless questioning. Not only of the people they're interacting with, but of their own premises. And to come back to me proactively, to my partners and I, and say, "We thought we had this figured out but we gave it more thought and we don't." And have the courage to say, "We were wrong. We're going to attack in a different direction," or, "We're going to give you the money back," at the extreme. So those are things that can be sussed out.

Memorable Encounters

Patrick: [01:02:33] There's two stories that you mentioned earlier. And I'm going to let you pick between the two of them. And the personalities were Feeney and Lance Armstrong. Or we can do both if you want, but I'll let you choose the first one as one of the closing thoughts and questions.

David: [01:02:51] Yeah. No, I can be very brief actually. So I did have the great privilege, as I think you know, of getting to know Chuck a bit. This is right around the time that duty free shops, DFS, was sold to LVMH for a big chunk of cash. And years earlier with the help of a gentlemen that I respect hugely. He lives right around the corner from here, Harvey Dale, professor at NYU. They had moved Chuck's interest in DFS into a Bermuda based foundation. Anyhow, I got to know Chuck and my favorite tale about Chuck is when I got asked to meet with him. This is when the veil was still lowered on Atlantic and nobody knew that he was already engaged in very large scale philanthropy on a completely anonymous basis. That wasn't just because he's shy and self-effacing guy, which he is as I'll describe in a second. It was also because they didn't want... and I smile when I say this, he didn't want the world to know how profitable DFS was.

Because DFS was in... the business model was essentially get concessions from governmental entities to do airport DFS's, duty free shops. And so if people knew, then the excess return would've been competed and arbitraged away. But they had to lift the veil when they sold the whole thing to LVMH in the mid '90s and when they started to arrange the deal. In any case, my quick tale about Chuck Feeney is I got asked through an intermediary if I would meet with Chuck in London. And I remember exactly where he took me. He took me to lunch at Sartoria, which is right around the corner from Atlantic's offices, at 17 Savile Row. I ended up actually moving over there and being based there for a bit for various reasons that go beyond the scope of today's conversation. But they said meet at noon and nobody has lunch in London at noon. I mean, you start at like 1:00. And particularly a pretty nice restaurant like Sartoria.

But I walked in at noon time and the place was completely empty except for an older gentleman sitting at a table with a plastic bag with a bunch of papers stuffed into it. And that was Chuck. I never met him, I'd never seen a picture of him. It was early days in the internet. You couldn't Google him. I didn't know much about him. I didn't quite know why I was being asked to lunch. In any case, we sat there. And about two minutes after I sat down at the table a young waiter with a heavy Italian came over and put a basket of bread on the table, as the case in many restaurants including Sartoria. And Chuck looked up at him, this is the Billionaire Who Wasn't, that's the title of book by Conor O'Clery, and he said, "What's that?" And the waiter, "Sir, it is bread for the table." And Chuck said, "Is it free?" And the waiter nodded yes, and he said, "Okay. You can leave it." That was like the first two minutes of what became a multi-year-

Patrick: [01:05:26] Amazing.

David: [01:05:27] … process of crossing paths with the billionaire who wasn't, so-

Patrick: [01:05:29] That's a great book.

David: [01:05:30] The Lance Armstrong story actually ties in, I think, almost directly to some of the conversations we've had about what attributes do you look for and what criteria do you apply in sussing out money managers, for example, and capital allocators generally. As you, and I'm sure all your listeners will recall, as he was marching his way toward... riding his way toward seven consecutive wins in the Tour de France, they introduced the yellow bracelets with the Lance Armstrong foundation, made a pretty big deal about how he's trying to advance all the good work at the foundation. And TIFF, the Investment Fund for Foundations, for reasons that go beyond the scope of this conversation, was tapped to manage all that money. Not only for the foundation but there was an endowment tied into the foundation. And so when he finished his successful seventh attempt to win the Tour, I got a phone call from the then CEO of the foundation down in Austin.

And he said, "Now that Lance is sort of retired, he's really going to throw himself into the philanthropy. We're going to really build it up. The asset base is going to get bigger and I think you two should meet." And I said, "Okay. We can do that of course." They were already a pretty substantial client of TIFF. What he didn't know, Greg Almond, when he placed that call to me, is that my wife, Emery, is a very accomplished athlete and had been an endurance athlete at a pretty high level and very successful. In our very first conversation years earlier, because Lance Armstrong was already on the world radar screen. I don't know exactly how I put the question, but I said, "What do you think of Lance Armstrong?" And she said, "He's a complete fraud and a cheat." And I was stunned. We ended up getting married and we've been married for many years and have children and I think we have a very happy life and a great relationship. But that's how it started.

And so roll the clock forward, not a few years, and I said to Emery, "I just got invited to go down to Austin to have a conversation with Lance. Do you want to come with me?" And she said, "Sure." So we went down there together. And what got arranged was a dinner. So I didn't know what to think. But I want to be really clear, and I'll try to come to the end of this tale really quickly here, I still had a very favorable view of Lance. I actually thought as I sat down at the dinner table... and he arrived late, which is part of the story here. I thought at that moment I'm about to meet probably the greatest athlete of all time because what he had just done, it was earlier that summer, seven in a row. It's just astounding. I don't know how that it would be ever eclipsed. And, of course, my wife is sitting next to me thinking the guy's a complete fraud. So we're at almost opposite ends of the spectrum. And we sat down for dinner and we meet at 8:00. We got picked by his CEO.

And it's 8:05, 8:10, 8:15. Greg Almond apologizes, Lance is running a little bit late. He's out at the ranch with his kids. He's on his way in. 8:30, 8:45. We order a bottle of wine, maybe a second bottle of wine. And then finally he says, "Oh, he's on his way." Because everybody's got a Blackberry at the time or something. And then we hear a buzz in the restaurant and everybody sort of whips around and the big cheese has arrived. And I'm still thinking I'm going to meet the greatest athlete of all time. And he walks up to the table. He doesn't acknowledge me or my wife and he sits down. And he's glued to his Blackberry and he's staring at the screen and without looking up he goes, "Tiger Woods." I mean, what the hell? What? And then he taps out a few keys and he goes, "Robin Williams." And in that 45 second interval, I knew that my wife was completely right. I had been completely wrong. He was a complete fraud.

And why did I deduce that? Because the insecurity that was being telegraphed through that behavior was so stunning and profound that I thought there's no way anyone could've achieved rightly and legitimately what he professes to have achieved and be so utterly lacking in grace. And I took away from it a very important lesson about detecting deception because there are some tells. And what Lance has engaged in, what he did engage in, in arriving ultimately in his famed interview with Oprah. The path that he took along the way of attacking his enemies and attacking his critics, and being so strident and virulent in his condemnation of people that would challenge what he was asserting. We see that behavior in other people. To some extent you saw it in Madoff, you obviously see it in Trump. And it's a very powerful and I think important life lesson when you're in the... in part, my day job is assessing talent and all the things we've been talking about over the course of this conversation.

Patrick: [01:10:11] What was the most memorable meeting that you ever had with a money manager?

David: [01:10:16] The one that was probably the most gratifying was very early in the formation of TIFF, because of the way it was initially structured, in buckets if you will, one of the buckets was international equities. So we were putting together an internationally equity commingle vehicle. And the usual suspects in endowments we'd round up at the time included certainly the Capital Group on the West Coast. They had 500 portfolio managers and analysts. They were looking at every company in the world. And I said to the board, including Jack and David and some other people that we've talked about, "I don't even want to interview them." And they said, "Well, why is that?" And I said, "Because we don't need to look at every company in the world. We just need to look at a few and have the right culture, the right mindset, and the right capital allocation process."

Anyhow, cutting right to the chase, we brought in the three co-founders of Marathon, London, which was Jeremy Hosking and Neil Ostrer and Bill Arah. And they came in and presented to that board, including Jack and David and myself and other people. Just an incredibly compelling approach to allocating equity capital. And actually ended up in the form of a book by Edward Chancellor.

Patrick: [01:11:22] That's great.

David: [01:11:23] Yeah. It's a terrific book.

Patrick: [01:11:24] Two books actually. The most recent one is just fantastic.

David: [01:11:25] That's true. Yeah. But the original book was just a compilation of letters, some of which were furnished to us in advance of the very meeting that I'm alluding to. So that was really gratifying because the end of the meeting... so it was memorable and gratifying because at the end of the meeting, I wasn't necessarily sold on them but I was sort of semi-sold or quasi-sold on it before the meeting commend because I had done careful review of their writing. But by the end of the meeting I was completely sold and I could see that the consensus of the board was moving in that direction, so it was quite gratifying.

Patrick: [01:11:53] What was it? If you could try to put your finger or a couple fingers on the things during that meeting that tipped the scales? So their investment approach obviously is really interesting, thinking about the capital cycle.

David: [01:12:04] Capital cycle. Yeah.

Patrick: [01:12:05] Capital allocation, the capital cycle. A really good understanding of duration, I think. What happened during the meeting? Maybe it was just what we've already talked about, which was that you got a sense for their ethics, their integrity, their passion, that they viewed it a profession, all these things that we've mentioned. But was what basically the summary of what-

David: [01:12:23] You got it, Patrick. That was it.

Patrick: [01:12:25] That was it.

David: [01:12:25] What they said tied in with what they'd written about in advance. It was just a coherent whole.

Patrick: [01:12:30] As you know, I'm actually going to ask a couple extra, very rapid fire questions after this one. But it's one I always like to put near the end, which is to ask you what the kindest thing that anyone's ever done for you?

David: [01:12:39] Yeah.

Patrick: [01:12:40] I knew you knew this one was coming.

David: [01:12:42] I did-

Patrick: [01:12:43] Everyone does though.

David: [01:12:43] If you don't mind, again, I'll try to be brief. I'll separate it. You've got personal kindnesses and professional kindnesses. So overwhelmingly the kindest things that anyone has every done to me, certainly emanated from my wife and they're private and I won't talk about it. But there is some personal kindnesses I'll come back to. But before I do I just want to tie back on the professional level. The professional kindness I think I would cite was extended by Peter Bernstein himself. As you know, Peter died in 2009. And I don't quite know how he started to get the stuff I was writing at TIFF, but this is one of the most gratifying aspects of my career and I regard it as truly kind acts, plural, because it was multiple occasions. I would write quarterly stuff and almost invariably between, say, 1999 and Peter's death in 2009, with a six or seven week lag I would get a letter from Peter. Typically typed out by his lovely wife, Barbara, and signed by Peter.

Not hand written, but typed out on an old-fashioned typewriter. And it would be a critique of my immediately prior quarterly letter. Often a page, sometime a page and a half. Never longer. But he took the time to both read and write and to critique. I mean, that was both extraordinarily helpful to me, flattering, gratifying, but kind too. He was helping me think about how to think through. And I would say if I could go back and I have most of those letters, of course. They were more critical than complimentary. And what greater kindness than to take the time to try to help people get clearer in their thinking? So that was a professional kindness.

On a personal note, probably at the very top of my list would be a memorable evening I spent at UVA Medical Center, which was the evening of Memorial Day of 1989. Earlier in the day I had fallen out of a tree and broken my neck. And I was rushed to UVA Hospital and I could move my lower limbs. I couldn't move my left arm. And it was very clear my neck had been broken. They X-rayed it right away. It was the top of my neck and the bottom of my skull. And I was sort of bolted to a bed and they'd say, "Keep him under observation. We'll see. We'll get the whole team in here tomorrow and figure out what we're going to do with this guy." And the entire evening I was awake, I had a big, splitting headache. But I remember very well, and I cannot recall her name, but there was a nurse who I think had immigrated from the Philippines who spent the entire up with me awake. Never left the side of my bed, just talking about life, her path. And it was just extraordinarily kind.

I don't know how I could've gotten... because you can imagine the anxiety. I wasn't sure whether I would ever walk again but there were signs that I wouldn't ever be able to use my left arm again. So that extraordinarily kind. There was a... if I can just finish the tale. But the very next morning there was a different form of kindness that was professional in its aspect. And I actually think ties into a lot of what's going on in our world today. And that was because, as I was sort of bolted to the bedding, couldn't move my arm. Because it's a teaching hospital, the head surgeon, John Jane, who ended up six years later almost to the day treating Christopher Reeve for the very same injury essentially. Christopher, of course, had a different outcome. But it was basically the same team of surgeons headed by John Jane.

And I knew him a little bit socially. And he walked into the room and said, "Okay. What's up?" And the residences and the others who had already looked at me the prior day explained briefly and succinctly to Dr. Jane what was up. David can't move his left arm, he's got some movement in his lower extremities. He broke his neck, the X-ray show that. What do you think? And John Jane looked at the whole situation and said, "You can't move your left arm?" And I said, "No, I can't move it all. I have no feeling in it." And he said, "Strip him." And so the nurses came over and they stripped me. I had a hospital gown and they stripped me clean. And it took him about 30 seconds and he took my left arm, which had been covered by the hospital gown. And he turned it over and he could see my left elbow was completely shattered. It was completely smashed. And he said, "Well, that's why you can't move your left arm. It has nothing to do with your neck."

And that was a telling moment. And now it applies to 2017 and beyond because you think AI and machine learning is going to displace all this knowledge and wisdom and all the jobs are going to go away. And there won't even be a need, even in medicine, for that accumulated wisdom and reservoir of experience that caused John Jane that morning, surrounded by summa cum laude graduates of the leading schools in a highly selective residency program and one of the leading medical institutions in the world, to come in and apply just common sense. And they strip him. So I think about that a lot actually in my day job.

Patrick: [01:17:21] The last question I'll ask you, and it's a prescriptive one, which is if you could choose... someone out there is effectively trying to answer the question that we've been trying to answer, which is I have a slug of money and I want to invest it. And obviously that could range widely from an enormous amount to a very small amount. And you had to prescribe three books for them to go read. And it doesn't have to be books. I'll just say three things for them to go read to start to build a foundation for their own education on investing. What would those three books be?

David: [01:17:55] The one that comes immediately to mind is Poor Charlie's Almanack by Pete Kaufman, who I do know a little bit personally. And it's just fantastic. It's both fantastically fun and it's just replete with wisdom. There are some really good, highly curated collections of writings of both Buffett and Munger that ae done by serious scholars, not just the annual letters which are terrific too. And so those would be on a short list. I'm not sure that it would make the top three but they would be there.

I can tell you as well to finish the answer that I dearly wish and hope to someday obtain a complete collection of Peter Bernstein's writings, meaning the letters that he published, Economics & Portfolio Strategy. I was a subscriber for years and then I had the privilege of talking with Peter about many of them. But I wish that I had a complete compilation of that. There are other things that come to mind because you liberated me from the condition that it just be a book. So I think you'd just go back and read David's annual letter to the Yale community, the Yale Endowment Report. And come away with a rather complete education about investing just from reading-

Patrick: [01:18:58] I've never read them.

David: [01:18:59] Oh, they're terrific. They're all on the... Well, I'm not sure they're all on the website. But a lot of them are on the website. So those are terrific too. But, Patrick, we're in a profession where I think there are so many intellectually curious people. Some of whom who are really quite skilled writers in my view. We haven't talked about it. We earlier said that I believe that ego and insecurity are synonymous. But I think that clear writing and clear thinking are synonymous. Many people disagree with that by the way. They think that there are people that can be really, really clear thinkers. They just can't write very well.

And I think if you give people a pass for maybe some flawed grammar and syntax, I just don't think that's true. I think, if you give them a pass and let them engage in some flawed grammar and syntax, really clear thinkers will get good, clear cogent stuff out on paper as well, or maybe they'll do it orally. So it's a very, very long list of people. You mentioned Howard Marks earlier, obviously Seth Klarman's done a fair bit of writing. He just did the one book, Margin of Safety, but I've had the privilege, along with many other people, of seeing each of his annual letters along the way. And they're terrific. They're as well a pretty good crash course in capitalism.

Patrick: [01:20:06] What is your most memorable day of your life?

David: [01:20:09] It was right here in New York City. And I'm going to tell it because it's a closing compliment to Jack Meyer in particular. But we had a TIFF board meeting here at The Harvard Club on 9/11. And so we started promptly at 8:00. And I can't remember the exact timing but Mike McCaffery, the head of the Stanford Endowment, pretty new to Stanford at the time, was on the board, had been to some prior meetings but was late. He wasn't at the table. And we started promptly at maybe 8:00. And it's... whatever the timing was. Maybe we started at 9:00. But he arrived maybe 40 minutes or so late. And when he walked into the room. I was at the head of the table because I was kind of presiding the venture, the board was at the opposite end of the table.

But I was closest with my back to the door. And he came in, he was just ashen faced. And he communicated the news of what had happened in lower Manhattan. So we terminated the meeting immediately. And I don't know if Jack was sitting right next to me but he was pretty close by. And I thought to myself, "Okay. I'm sort of the head of this organization. I'm the CEO. What am I going to do?" And one thing I thought about among many other things is I'm kind of responsible for getting all these people back to where they need to get to. And Jack's running the largest educational endowment in the world and he's sitting right here and the world has just changed profoundly. So I felt some obligation to somehow figure out a way to help Jack get back to his desk in Boston.

But, of course, as you maybe remember, you couldn't get out of New York. So we were all staying at The Harvard Club. So we adjourned the meeting and I just said to Jack... I happen to have my car in New York City because I had come down from a home that I own in New Hampshire. And I said to Jack, "I will get you back to Boston somehow, some way." And so what we decided, and this is the end of this story. And Jack was unbelievably calm under conditions in which, let's just say, some other people in the room weren't so calm. And many, many people, even thought we were in Midtown and not in Lower Manhattan. So we weren't directly affected by the tragedy but rather indirectly. People were not displaying universal calmness, to put it that way.

But Jack was extraordinarily calm and graceful under the circumstances. And you could only imagine what was going through his head because, as we discussed earlier, the sort of portable Alpha Engine at Harvard had a lot of leverage on it. So it could've been quite problematic. In any case, the reason I'm telling this story is because I saw in those instances almost an extreme manifestation of grace under pressure and calmness. At the very same time within not more than an hour we went down to the sidewalk because in the pre-iPhone days we were in... this was 2001, of course, not 2007 when the iPhone was invented. We all had Blackberries but it was impossible to get information in real-time. So I said to Jack, "There's an electronics store around the corner. Why don't we go and we'll each get an AM radio for $9 and we can listen to different stations to listen to when they're going to open the Third Avenue Bridge so I can get my car out of the garage and get you back to Boston."

So we did. And we went down to 44th Street. We bought the radios and we were just standing there. And then we looked to the east towards the then Pan Am Building, now the MetLife Building. And at some point, and we were there for multiple minutes listening to the radio and just talking, figure out. And we could see some people strolling up 5th Avenue with soot on their clothes that were coming up from Lower Manhattan even at the time. And I'll never forget this, Patrick, at a certain indistinct moment we heard this sort of roar coming up from the Pan Am Building. And we looked to the east toward it and there, no exaggeration, at least 150, maybe 200 human beings, coming at us as if they were a extraordinarily frightened herd of cattle. And they were running into hydrants and running into telephone poles and running into each other and knocking each other over.

And what we found out after the fact is that there had been a rumor circulated that the MetLife, now MetLife then Pan Am Building, was going to collapse as had just happened in Lower Manhattan. And so I saw on that day, that very memorable day, two extremes of human emotion. Grace under pressure and calmness, in the case of Jack Meyer, and some others but most tellingly Jack. And it's utter opposite, which is just complete panic. Utter, almost animal-like panic. And the juxtaposition of those two made that day, for those and other reasons, certainly the most memorable of my career. But to see that extreme of human emotion and the panic side of things, and to see the things that people would do reflectively, was a sight I will never forget.

Patrick: [01:24:38] I mean, I remember... I think I probably mentioned this at some point on past episodes, but my dad was actually scheduled to be in the second tower. And I had vaguely known of that and didn't know that the meeting had been canceled. To your point, you couldn't call. No cell service was working. So I remember being in high school. I was in AP Psychology my junior year of high school and was desperately trying to figure out where he was. He was in New York most days and that day in particular. And when I interviewed Gerry O'Reilly at Vanguard, his answer was the same. It was 9/11 and he kind of just... everyone has this story of a day like that. And it's a tough place to end but an appropriate one and a great story of that day. Thank you very, very much for your time, for your insight, for all the great stories. This has been really fun.

David: [01:25:33] Thank you, Patrick. Enjoyed it.

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