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The Art and Science of Investing Successful investing is one part "art"�
The term "art" conjures images of brilliant creativity punctuated by long periods of disorganized rambling. While the art of investing relies on creativity and judgment, the process itself is much more ordered than may be the case in the fine arts. Making successful venture capital investments is a classic application of art in investments. Properly selected venture capital investments offer the potential for returns well beyond any other asset category. But selection is critical since investments made today will not pay off for four to seven years. Deciding which technologies and management teams to back involves the highest form of investment art backed up by a tremendous amount of detailed analysis. A recent investment by UTIMCO in a biosciences venture fund is a great case in point. The University of Texas System institutions spend more than $1.1 billion annually on scientific research with about 75% of that amount committed to life sciences research. However, in relative terms, the state of Texas lags other states with significant biotechnology research in having sufficient local capital to commercialize the fruits of life science research. There is a significant imbalance between the supply of scientific research and the supply of early-stage venture capital in Texas. Realizing this imbalance, UTIMCO staff members considered several alternatives that would meet return criteria while also stimulating the development of a more extensive biosciences venture capital infrastructure in the state of Texas. The creative solution to this investment problem was to select the right external team to exploit the biosciences market opportunity in Texas. Evaluating several potential management teams, UTIMCO staff relied on experience and judgment to select just the right team, and then used the art of striking an attractive deal to make our investment on favorable terms. The result was an investment in the PTV Sciences Venture Fund. Our investment will allow the PTV Sciences Fund (Fund) to work with UT System and other Texas-based institutions to target the most promising life and physical science research and develop companies around those technologies. The Fund will invest in seed and early-stage life science and materials companies sourced primarily through the offices of technology transfer of Texas-based academic and medical institutions. In the life sciences sector, the Fund expects to invest in medical devices, biopharma (drug development involving biotechnology) and diagnostic device companies. On the materials side, portfolio companies will focus on biomaterials, chemistry, semiconductors, and energy-related technologies. Investments made by the Fund in research stemming from the UT System should highlight the System's research capabilities. If the Fund syndicates a portion of its investments to investors outside Texas, that will create awareness of UT System's research strengths to the broader venture capital community. The Fund will benefit from being positioned as the "local lead" in Texas research opportunities. Importantly, additional funding successes can create a "virtuous circle" by attracting researchers to join the UT System and drive future investment opportunities. In addition, the Fund's investments in UT System research and technology may help attract additional government R&D funding to support research teams at component institutions. Last, but certainly not least, the UT System research institutions will benefit along with the endowment funds from equity interests retained in the companies created by the mix of great technology and venture funding. Our PTV Sciences investment is a good example of the art of investing. But complementary quantitative tools, the science of investing, are every bit as important. and one part "science".
An important first decision was to choose PMPT as the risk and return framework for the asset allocation review and decision. PMPT is a relatively new capital market framework that is actually an extension of the more well known Modern Portfolio Theory (MPT). PMPT offers two critical advantages over MPT: one, a more realistic view of what "risk" really means to an investor, and two, a more precise method of measuring the newly defined investor risk metric. PMPT is significantly more mathematically complex, but with the mathematical and computing resources available to UTIMCO today, that complexity can be turned to an investment advantage. In its simplest form, risk is a measure of the possibility that some future desired result will not be achieved. MPT was based on the assumption that risk was simply the variability in future returns around a mean expected return. In the MPT world, a pleasant future surprise was just as "risky" as a future disappointment. But, we know that is not a realistic view of risk. What risk means to investors is the possibility that future returns will fall below the return level needed to meet future needs such as a target payout level from an endowment. Falling below an expected future value in an investment is a lot more important than exceeding the expected value. PMPT differentiates between risk, the possibility of not reaching a goal, and uncertainty, the possibility of exceeding a goal. PMPT does this by looking only at so-called "Downside Risk", the probability of failing to meet a future goal, and therefore has a more solid risk foundation than does MPT. MPT also makes some significant simplifying assumptions about how future returns might occur that were necessary when expensive computing power demanded lower computational complexity. But those days are gone. UTIMCO has access today to almost unlimited computational resources, and those simplifying assumptions are no longer necessary. PMPT provides much more precise quantitative models of risk allowing us to make much more accurate assessments of the likelihood that future goals can be achieved. The cost of this advance is greater complexity, but the increased complexity can be handled by UTIMCO's enhanced risk management tools and staff. Even with better measures of risk, asset allocation decisions ultimately require decision makers to make tradeoffs between risk and expected return. How much risk is appropriate? Is the reward for assuming higher risk acceptable? To help the UTIMCO Board address these issues, we adopted the Decision Factor process in our asset allocation review this year. Decision Factors link goals, objectives and limitations to decisions. Generally, decision factors are any set of measures used to translate facts regarding a potential decision or choice to the criteria for making that decision. Decision factors are usually quantitative in nature, and are, therefore, best applied in situations where criteria for the decision can be stated explicitly through precise statements of goals, objectives, resources, and limitations as is clearly the case in asset allocation decisions. Decision factors were used to select the most appropriate asset allocation policy portfolio from a candidate group of equally "efficient" policy alternatives derived by PMPT procedures. In this case, we were able to apply more scientific procedures to what is typically a highly unstructured decision making process. The final innovation in our asset allocation decision process was the use of Potential Value Added (PVA) as a fourth dimensional attribute for the asset categories, along with the more typical risk, return, and correlation in returns statistics. PVA is a measure of the opportunity for returns from active management in a particular asset category. PVA stems from two primary sources: first, from decisions our internal and external portfolio managers make in selecting individual investments for our portfolios, and second, from decisions made by UTIMCO staff in selecting and monitoring external managers, as well as from structuring favorable contractual terms with those external managers. An organization capable of producing value-added from a higher PVA asset allocation plan can have a distinctive return advantage over a less capable organization incapable of capitalizing on PVA opportunities. By incorporating PVA directly into the quantitative analyses of each asset category, the UTIMCO Board was able to make more fully informed decisions regarding the most effective asset allocation policy. As these examples indicate, successful investing is based on both art and science. Investing art requires creativity, experience, and judgment. Investment science requires quantitative skills, precision, and judgment. Both art and science require attention to detail and hard work. Our goal at UTIMCO is to maintain the skills and resources necessary to apply both art and science to future investment decisions. |
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We have all heard that the secret of successful investing is to "buy low and sell high." If only it were that simple! Anyone who has actually tried investing knows that such simplistic approaches face an uphill, if not impossible, challenge. Investment returns stem from three primary sources: strategic asset allocation, tactical changes in asset allocation to capture temporary imbalances in markets, and successful selection of particular investments in each asset category. Successful investing results from careful analysis and hard work; there is no simple solution. In order to provide a bit of insight into how we make investment decisions at UTIMCO, we offer examples of how good intuitive judgment and quantitative tools complement each other to produce successful investments. We call this approach the Art and Science of Investing.
Throughout the recently completed fiscal year, both the UTIMCO Board and staff focused intently on structuring a new asset allocation policy for the endowment funds. Our process incorporated four important advances in the science of investing:
