The Commonfund model of investing adheres to three basic principles: an equity bias; diversification; and prudent use of illiquid investments. This approach has its basis in the endowment model of investing, which Commonfund helped to pioneer almost 50 years ago. Over the decades we have worked to refine and enhance the model, which now includes core elements that are unique to Commonfund.
When allocating to equities, we seek to separate the component pieces of investment returns (such as market beta) and factor exposures (such as size or style) from true manager skill, or alpha. A core step in Commonfund’s manager evaluation process is isolating these components of return using a range of quantitative tools. We aim to allocate to the most skilled managers, such that the resultant blend of components provides the desired risk and return profile to the portfolio, avoiding overlapping exposures and highly correlated sources of return. This analysis generally allows us to pay active management fees only for diversified alpha generation, not for concealed market beta.
Commonfund believes that effective diversification is no longer achieved by simply allocating to different geographic regions, investment styles or market capitalizations. With more efficient markets, correlations have increased. Hence, we focus on identifying returns uncorrelated to market movements as well as returns uncorrelated among managers (e.g., avoiding “crowded trades”). The firm’s bias for allocating to hedge funds, as an example, is to minimize market exposure – that is, to have little or no market beta in hedge fund strategies. In fixed income we seek bond alternatives that generate uncorrelated returns in different market cycles, but without equity market beta.
It is now possible to measure and track the existence of the liquidity premium earned over periods of time. This enables investors to take advantage of those periods when the market is willing to pay investors more for providing capital to illiquid investments. Commonfund’s bias is for investors to have policy allocations to illiquid strategies to the level that is practical, given an institution’s risk tolerance and appetite for liquidity.
In the context of this philosophy, we seek to add value to investors along three dimensions:
Strategic Asset Allocation: Strategic asset allocation is the most important investment decision impacting performance and risk. Our process is to work collaboratively with each client to develop this strategic allocation. The ultimate decision on strategic asset allocation is made by the client based on their return objectives, risk tolerances and a variety of inputs and potential constraints. We use a wide range of financial and operating metrics to help guide this decision. Further, we use extensive modeling tools to aid in decision making with a focus on optimizing portfolios to draw- down risk and recovery, in contrast to more traditional mean variance optimization models that we believe are more limiting for institutions with long-term investment horizons.
Portfolio Construction and Manager Search and Selection: Investment decisions on portfolio construction are team-based, and led by our Chief Investment Officer. The Investment Committee reviews client portfolios monthly, to determine and approve investment strategies, portfolios, products and the investment managers needed for use in the construction of client portfolios. This team will evaluate performance at the strategy, fund, manager and client portfolio level, while also monitoring client investment restrictions, as well as fund liquidity and leverage. Manager research, due diligence and selection is the broader responsibility of the 62-person investment team.
Tactical Asset Allocation: Commonfund uses tactical asset allocation selectively, when our investment conviction is high and supported by data. Decisions are subject to the following guidelines:
- Any tactical allocations away from strategic asset allocation require strong conviction based on data;
- Manager selection and allocation are not driven by tactical views;
- Tactical decisions are based on 6-18-month views, and are not short-term trades; and,
- We measure and control our risk from tactical decisions to ensure they do not override any potential manager alpha.