The goal of our investment policy is to support current and future generations of MIT scholars with significant resources. To meet this goal, we must generate high real rates of return over the long-term to maintain the purchasing power of the Endowment. At the same time, we must maintain adequate stability in our investment portfolio to avoid overly disruptive volatility in the annual flow of funds to the operating budget. To achieve these objectives, we have built our investment policy for the Endowment around several core principles. Each is described in more detail below.
We earn returns through long-term business ownership and the application of specialized skills
On a long-term basis, we see two primary ways to earn the high real rates of return needed by MIT. First, we want to partake in the long-term returns of high quality businesses. To the extent we can buy holdings at attractive prices in well-managed businesses with strong and sustainable competitive positions, good growth prospects, and high returns on capital, we can earn significant rates of return through the patient compounding of capital. Usually, it will be very difficult to identify even a small handful of these opportunities in rationally priced markets. At less frequent times, such as during a market dislocation or period of severe economic stress, these opportunities may be offered to us in great quantity.
Second, we want to participate with exceptional people applying specialized skills to add value to assets. Examples of this would include real estate operators who buy and fix properties, venture capitalists who help start-up entrepreneurs grow businesses, energy firms that discover and extract commodity reserves, capital allocators who buy distressed credit instruments at opportune points in the cycle, and private capital managers who buy and improve the operations of well established companies. In these cases, the investment returns consist of both the underlying intrinsic growth of the asset and the value added by applied expertise. In this way, even lower quality, low growth assets can offer substantial rates of return.
We maintain a value-oriented investment approach
MIT is a value investor with a focus on fundamental analysis. A value approach emphasizes the ability of investors to calculate the intrinsic value of assets by forecasting expected cash flows across a range of potential future outcomes. Value investors look to purchase investments at a significant discount to intrinsic value to account for the uncertainty inherent in any attempt to predict the future. Determining that a sufficient “margin of safety” exists between the price paid for an asset and a conservative projection of future value is the primary determinant for potential inclusion in the portfolio. Intrinsic value provides a framework around which value investors can act. Rather than being swayed by emotions, market sentiment, or short-term news, a thoughtful, deliberate value investor can assess if investments are priced below or above long-term intrinsic fair value and decide to buy or sell as appropriate.
Our approach leads us to prefer certain types of investment strategies. We prefer strategies in which managers are willing to hold cash if opportunities to buy assets at a compelling discount to intrinsic value are not available. We prefer strategies in which managers can easily articulate why their advantage in buying assets with a margin of safety is repeatable and sustainable over time. We prefer strategies with long-time horizons because it usually is easier to identify which assets and businesses will revert to their intrinsic value over the next few years rather than those likely to revert over the next few months. Finally, we prefer strategies in which investment managers have an advantage over other market participants in determining the intrinsic value of a security. For example, an advantage could arise from a manager’s focus on a large specialized and complex market niche such as biotechnology or from a focus on a small subsector of securities that most other investment managers ignore.
Our approach causes us to avoid many types of investment strategies. We avoid strategies that are fully invested regardless of asset valuations. We avoid strategies that define success as beating a benchmark even if that benchmark loses money. We avoid short-term trading strategies that attempt to capture small pricing anomalies. We avoid purely momentum based strategies that buy and sell positions depending only on recent stock price or earnings trends. We avoid strategies that are opaque or too complicated for us to understand. We avoid strategies that focus on areas in which pricing is determined by sentiment such as works of fine art because we do not know how to calculate long-term intrinsic value if the assets do not produce cash flows.
A value orientation does not preclude high growth investments. On the contrary, growth potential is often the primary driver of long-term intrinsic value. For example, venture capital investments in companies such as Google, Facebook, and LinkedIn meet our value criteria when the expected value of their future cash flows is multiples of our entry valuation. Of course, once the growth potential in these companies is recognized by the market and asset pricing builds in overly rosy projections of the future, we look to exit.
Our approach leads us to be contrarian. As markets appreciate in price and reduce the margin of safety between asset pricing and future expected value, we look to reduce our exposure. We simply are not comfortable maintaining exposures at overly expensive valuations no matter how much longer we believe the euphoria might last. In contrast, when markets decline in price, investors become frightened, and press articles turn negative, our interest increases. While we will never blindly buy because prices have fallen or because other investors are fleeing, we believe that we are much more likely to generate returns from finding bargains in the overlooked, underappreciated areas than attempting to time our way in and out of the frothy, overheated arenas.
We partner with exceptional investment managers
We execute the vast majority of our investments through external third-party managers. This external manager-centric approach has a number of advantages. First, this approach allows MIT to access unusual expertise. External managers have specialized insight into attractive market niches and deep roots of local market knowledge in other countries that would be very difficult for us to replicate internally. Second, individual decisions can be very long-lasting. The hiring of an exceptional manager can impact the portfolio for decades as these managers compound capital through a variety of market conditions. Finally, this approach establishes a virtuous cycle of learning and improvement. As we hire exceptional managers, we gain insights and knowledge and better connections to new opportunities. These learnings allow us to make better future decisions, thus continually improving the quality of our decision-making process.
We focus our time on the understanding of microeconomic situations
The global investment staff spends significant time understanding specific microeconomic situations. Our focus on microeconomic situations consists of reviewing and understanding the underwriting of specific investments at the asset or company level. These activities improve our capability to underwrite investment managers, inform our capital allocation decisions, and help us identify potential tactical opportunities.
We believe the focus on microeconomics is the best way for us to generate compelling returns over time. In specific microeconomic situations, we have the opportunity to build an advantage over other market participants. Because there are many thousands of micro-opportunities worldwide, we can selectively focus and understand more about a subset of these than other investors. With this knowledge, we have the opportunity to identify significant and compelling opportunities that other market participants miss or misunderstand.
Of course, we do not ignore macroeconomic factors as they play a key role in determining investment outcomes. Here, however, our approach is very different. We view it as very difficult and perhaps impossible for us to generate an edge forecasting macroeconomic events. As a result, we undertake no primary macroeconomic research. Instead, we seek to construct our portfolio with diversification and margin of safety in mind so that our portfolio will perform well under a variety of macroeconomic conditions. Still, we must be aware of possible extreme downside scenarios and therefore strive to identify the likely macroeconomic outcomes that could overwhelm our microeconomic work. As a result, we stress test the portfolio on a periodic basis to estimate the impact of extreme events. Where the impact on the portfolio is unbearably large or positions appear unusually vulnerable, we look to moderate exposures or add new positions to mitigate these possible impacts. One of our favorite managers summed up this philosophy very well when he said: “we invest bottom-up and worry top-down.”
We have confidence in independent thinking
We believe in independent thinking and seek to build our portfolio without regard to peer positioning or benchmark weightings. This stance is not oblivious to the reality that MIT competes with other institutions for talent and access to world-class resources. Nor does it ignore the fact that a passively-managed benchmark can be an important measure of effectiveness over the long term. However, worrying about the consequences of deviating from other investors or indexes would limit our ability to make the meaningful investments that provide the best way to produce high returns. We believe this stance to be a meaningful potential differentiation for us as most investors are forced to stay close to peers and benchmarks and remain fully invested given that they are subjected to frequent relative return comparisons. In practical terms this means that MIT is willing to have significant holdings in individual securities and strategies that behave nothing like peers or broad benchmarks.
We maintain a long time horizon
MIT maintains a long-term investment horizon. In contrast, most market participants are forced to show results over short-time horizons to stay in business. As a result, we have a vastly reduced level of competition for ideas that take many years to realize and we regularly invest in opportunities that take time to mature. An excellent example is an investment MIT made with an investment manager in unconventional energy reserves in the early 2000s. At that time, the reserves were uneconomic because of the low oil price environment. These dynamics were likely to persist for years, making this investment unlikely to produce cash flow for a long time. Indeed, our investment was held at cost for many years. If oil prices remain high as we expect, this investment could ultimately realize many multiples of our initial investment. Only by being willing to wait for many years without realizations or cash flows are we able to participate in this type of investment.
Shown below is our approximate current asset allocation. As can be seen, the portfolio has a strong equity bias with less than 10% of the portfolio dedicated to plain vanilla fixed income securities. The portfolio is focused on inefficient markets with over 70% of the investments in private equity, real estate, real assets, and marketable alternatives. The portfolio is well-diversified with no more than 31% of the portfolio in any one asset class.