Wesleyan Looks at Outsourcing:

Another shoe drops at Wesleyan University (the one in Connecticut — not to be confused with all those other Wesleyans) regarding the quiet departure of chief investment officer Thomas Kannam last month.

The campus paper reported just last week that replacing him may take several months. Or he may not be replaced at all. President Roth noted that some endowments use “outside organizations” instead of hiring a CIO, and that they are reviewing all options.

So, Wesleyan adds to the ranks of those considering outsourced management.

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Scott Wise Carries On:

In October, Rice University officially moved its endowment over to the new Rice Management Company. Scott Wise, previously VP-Investments and Treasurer of the university, will serve as president of RMC.

I spoke to Scott down in Houston recently, and he’s pleased with his new role. He’s glad to give up some of the administrative headaches he had as treasurer to focus full time on getting the best possible returns on the endowment. He says, “The more you focus, the better you perform.”

Scott was just 39 when he took over Rice’s $900 million endowment twenty years ago. By 2006, he’d grown it to $4 billion — an average compound return of 13 percent over 17 years.

Institutional Investor magazine recognized his achievement that year, naming him one of four finalists for their Endowment of the Year award. He’s a Rice alumnus, with a BA in economics and a Masters in accounting from University of Texas.

For the fiscal year just ended, the Rice endowment was down 17%, still well ahead of Stanford, Harvard and most of the other mega-endowments. And I have no doubt that the Rice nest-egg will bounce back big-time as it benefits from Scott’s now-undivided attention.

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And now some thoughts from clients, colleagues, and passing strangers about the big economic and investment picture in these interesting times:

Risky Business:

Chief risk officers: do we need them?

What you need to do about risk depends on what you think it is.

“Gravity” once just meant the “heaviness” of something. When Newton got through with it, it was an invisible force understood only by mathematicians.

Investment risk is a little like that. Except, Newtonian gravity can actually predict precisely how the future will unfold. Math-modeled risk indicators, not so much.

Still, we soldier on, trying to corral uncertainty and turn it into measurable risk. And, as portfolios become more complex, a niche has opened for someone who can stand apart from front-line management and judge the whole picture using the best available techniques, both quantitative and qualitative. Hence, the rise of the Chief Risk Officer.

Among major financial companies before 2007, only Bank of America had a designated CRO.

Over the following year, Citigroup, Merrill Lynch, J.P. Morgan Chase and Morgan Stanley announced chief risk officer appointments. And most major hedge funds have acquired CROs or CRO-like people.

Highly-paid risk officers and risk committees proliferate, but do they help when they’re really needed?

The exploding landmines at the center of the 2008 meltdown were the quasi-governmental mortgage-buyers Fannie Mae and Freddie Mac.

Fannie hired Enrico Dallavecchia as CRO in 2006. Shortly thereafter he told his bosses that Fannie had one of the weakest control processes he’d ever seen, but that nobody seemed to care. His budget was cut by 16% in 2008, and he soon left the company.

Freddie Mac had a CRO named David Andrukonis, who told his boss way back in 2004 that the company was buying bad loans that “would likely pose an enormous financial and reputational risk to the company and the country.” His boss responded that they couldn’t afford to say no to anyone and Freddie continued to buy riskier and riskier loans with the approval of its Congressional patrons. Mr. Andrukonis left the risk management business in 2005 and became a teacher.

These people could all do the math. But what good are the impeccable calculations if no one wants to understand them?

An officer reporting to Robert Lewis, SVP and Chief Risk Officer at AIG, reportedly blessed nearly every credit-default swap that later exploded in their faces. Mr. Lewis, who was CRO before and during these monumental miscalculations, is still aboard.

Bear Stearns, which was carrying a book of derivatives leveraged at 36-to-1 when it collapsed, employed a chief risk officer named Michael Alix. When the dust cleared, Mr. Alix was hired as a senior vice president at the New York Fed. As a banking supervisor.

Harvard (of course!), has a CRO, or had. Daniel Kelly was the long-time CRO at Harvard Management Company until he was lured away last month. Now, he’s chief risk officer of alternatives for UBP Asset Management, the hedge fund-of-funds arm of Union Bancaire Privee of Geneva, a hire they made as loudly as possible, after losing $700 million of their investor’s funds placed with Bernard Madoff.

The endowment at my own school, University of Chicago, is now looking for its first CRO, and I had a chance to chat with their new chief investment officer, Mark Schmid about the challenge.
He emphasized that the CRO would have to be a state-of-the art risk analyst, but would also have to understand qualitative factors, and be able to knit them together. And, it’s not just a defensive, policing function. The CRO should also be able to play offense, thinking opportunistically about asset classes, relative valuations, investment themes, and hedging opportunities.

This is a tough search given the broad skill-set that’s required and competition from hedge funds and investment banks.

And, even with the best talent available, understanding and controlling risk is still as much art as science.

Russell Read, the former CIO of Calpers from 2006 – 2008 (and another University of Chicago alum), points out that at Calpers they “used what we believed were the finest resources available including some terrific external vendor packages [to manage risk]”…Unfortunately that didn’t lead to us being able to assess properly all the liquidity limits that we faced”.

For all but the largest institutional funds, a CRO hire is as unlikely as getting a private chef for the snack room.

One other option, as Russell mentioned, is to buy some outside risk-analytics help.
Companies like RiskMetrics, which was spun out of JP Morgan in the mid-90s, or Investor Analytics, peddle the VAR (Value At Risk) methodology that has become a standard investment tool. Hundreds of big banks and hedge funds buy their wares, but they haven’t had much luck breaking into the foundations and endowments world because of their user-unfriendliness. And the major advisory firms like Cambridge Associates and Wilshire Associates don’t provide any equivalent kind of sophisticated risk advice to nonprofit investment committees.

I recently had an interesting conversation with Bill Ferrell of Ferrell Capital Management (and a distinguished fellow-alumnus of Culver Military Academy!) who has some thoughts along these lines.

Bill is a capital markets vet who has a longstanding interest in risk management. He’s now launching an advisory service which keeps the math behind the curtain and offers a user-friendly dashboard. With it, a CIO or investment committee may test what-if scenarios and get a broad, actionable look at where they stand versus predetermined risk limits. If risk exceeds their target, Bill’s firm will hedge out the excess risk. In a nutshell, “Managing” the portfolio risks is about controlling the downside and allocating to the best sources of risk-adjusted returns”

For more detail see Bill Ferrell “Pension & Investments” May 4, 2009. Link:
http://www.ferrellcapital.com/pdfs/P&I%20Transparency%20Editorial%2004MAY2009.pdf

Bill has been successful in marketing to banks, and he tells me he’s now seeing increasing interest from the foundation and endowment world.

All thoughts, comments, and career moves are welcome.