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The Student Managed Investment Fund Annual Report: Fall 2011 & Spring 2012 Seth Borko Portfolio Manager: Fall 2011 & Spring 2012 A m e r i c a n U n i v e r s i t y K o g o d S c h o o l o f B u s i n e s s Dear Friends, Welcome to new friends and old supporters alike. Birthdays are a great chance to
celebrate but they also pose an opportunity to stop and reflect on the past year and set
goals for the future. As American University’s Student Managed Investment Fund
celebrates its second birthday it is fitting that we pause to look back on our progress. This
year has been an exciting one and has witnessed the fund grow and mature tremendously.
Fund management made significant strides in implementing resilient organizational
structures that will facilitate a higher quality learning experience and better performance.
Amongst many new changes, we began to look at our investment allocations in finer,
more sophisticated ways. We implemented a top down investment approach headed by
our chief economist. We organized ourselves into industry and stock coverage groups
which fostered deeper and broader analysis of our holdings and the broader market. We
also set up new safeguards to address problematic securities and much more.
The Student Managed Investment Fund has seen promising returns this past year. Since
our first trades in December 2010 the SMIF has returned 4.8%.1 Year to date, the SMIF
has seen a 7.03% gain leaving us well positioned to finish out the rest of the year. The
fund is careful in the risks we take onto our balance sheet and are confident our returns
more than fairly compensate us for risks that we bear.
Fund Structure
The Student Managed Investment Fund has $281,503 in assets under management and
manages this money for the US equity portion of the American University endowment.
The fund has a three to five year investment outlook. The latest chapter in the funds
ongoing evolution has seen the implementation of a top down investment approach.
Fund management created allocation categories based on company size and industry that
let us take a targeted approach to stock selection. The fund has an official economist who
is responsible for shaping a long term macroeconomic outlook. This view feeds into
industry coverage groups, which produce an industry outlook. Target weightings are then
created for each industry based upon this outlook. The groups are also responsible for
maintaining coverage on all companies within their industry. This top down approach
presents students with a clear direction for stock selection. It also allows fund
management to guide analysts towards, say, mid-cap technology and away from largecap consumer staples, something we didn’t previously have the structure to do.
Allocation
The successful implementation of this top down approach is visible in how we have
aligned the fund’s investment allocation with our market outlook. The SMIF holds a
moderately bullish outlook on the US economy. Management found several internal
1 All data is current as of April 27, 2012 inconsistencies between our outlook and our holdings that we immediately sought to
address. For example, the fund had a large cash position and a defensive beta. In addition,
there was a bias towards large capitalization stocks and no clearly defined industry goals.
Each of these challenges was prioritized and addressed, first reducing cash and increasing
beta, then creating industry allocations, and lastly reducing average market capitalization.
The most striking part of the funds development is the dramatic reduction in cash. The
SMIF currently holds 10.79% of our portfolio in cash contrasting with a 56% stake last
year. To be so underinvested tied our hands behind our back as investment opportunities
passed us by. Cash was one of our largest challenges and it has been a top priority of
management both this semester and the last to become fully invested, something we are
proud to have achieved. In the fall semester cash was public enemy no. 1 and accordingly
we closed out the fall over 90% invested in equity securities. In the process of investing
our cash we managed to nearly double the portfolio’s beta from just below .5 to where it
currently stands at .94.
Figure 1. Changes in industry allocation
In the spring we remained aware of cash but focused on fine-tuning precisely where we
deployed our capital. This is how our new top down industry approach comes into play.
This spring, the fund created target industry weights relative to our benchmark, the S&P
500. Figure 2 shows where we would like to be in an ideal world. The fund hasn’t
reached its targets yet but we have made substantial progress towards realizing our goals.
Please see Figure 7 for our current weights.
Figure 2. Target industry weightings and the S&P 500’s weights
Notably, before we implemented a top down approach, the fund had significant exposure
to consumers with a 35% combined weight in discretionary and staples. Our economic
outlook favors a consumer recovery but we saw better opportunities in other sectors. We
therefore drew down our consumer exposure replacing much of it with a focus on the
technology sector. Technology is a key driver of the US economy and one of our
country’s competitive advantages. Figure 3 shows some of the more notable changes in
our industry allocations.
Figure 3. Selected changes in industry allocation Last spring, large cap stocks made up 50% of our portfolio while the fund had no small
cap holdings. As we reduced our cash, an increasing proportion has been invested in
medium and small capitalization stocks. Our top priority in the fall was cash management
over capitalization size. During the spring semester, with cash under control, the fund
became more aggressive about selling down large cap holdings in favor of mid and small.
Fund management believes that these allocation changes position us for the best possible
performance given our moderately bullish economic outlook.
Figure 4. Changes in size allocation Performance So what do we have to show for all of our hard work this year? Figure 5 shows performance since the fund’s very first trade on 12/15/2010. The Student Managed Investment Fund has a 4.8% return since inception. Frankly, this means that we have underperformed the S&P 500 but a deeper dive into the data reveals that we are being well compensated for the risks that we are taking. Looking at the Sharpe ratio as a measure of risk adjusted returns, we outperform our benchmark. As a university endowment looking for safety and stability we find the Sharpe to be a crucial metric. Figure 5 Performance since inception We believe underperformance comes from several factors. Historically, we see underperformance driven by large cash positions and losses over the summer. An examination of returns from when students retook active management in August of 2012 shows a 7.16% gain but this still underperforms the market. We attribute this to a low market beta and inefficient industry allocations. Management has aggressively moved to correct this and will close out this semester with an industry tilt we believe is most suited to capture gains moving forward. Figure 7 demonstrates the substantial progress we have made towards aligning the funds holdings with our internally recommended ideal allocations. Figure 6. Returns since fall semester Figure 7. Ideal weights and current weights Absolute performance is still the bottom line that we hold ourselves accountable for but management also values other performance measures. The SMIF’s other chief measure of performance is the Sharpe ratio. The Sharpe ratio measures return per unit of risk. One investment may have a large return but only after months of wild swings. Another investment may have a slow but steady return. By normalizing risk, the Sharpe allows a comparison between two investments with different risk profiles. The Student Managed Investment Fund has a Sharpe ratio of .024.2 Management considers this an outstanding result and is something that we are very proud of. The SMIF not only outperforms the S&P’s Sharpe ratio of -­‐.01 but also beats many other well-­‐respected benchmarks. Taken in context it becomes clear that despite the S&P’s larger return, the SMIF was paid significantly greater amounts for the level of risk that it took. 2 The SMIF maintains a three year investment horizon. As such, the Sharpe ratio was calculated using three year historical data and a three year risk free rate. The fund does not have enough of an invested history for these calculations. Instead the Sharpe ratio of the fund’s individual holdings was calculated and used in the aggregate to determine portfolio performance. If the fund is receiving a greater compensation for its risks but still underperforming its benchmark, it follows that we took on a lower level of risk than the general market. The fund’s low beta over the past several semesters corroborates this. Fund management has consciously tried to increase our beta through investment in cyclical industries poised to succeed from a US macro-­‐economic recovery. As the fruits of our investment strategy pay off over the next three to five years we expect to see not only risk adjusted but also absolute outperformance. Figure 8. Sharpe ratio of the SMIF compared to selected indices and equities Moving Forward In the past two years the Student Managed Investment Fund has developed into the premier finance course at American University. Enrollment is limited, and even though faculty maintains tough prerequisites, there is consistently a waitlist for the course. The Student Managed Investment Fund is well positioned to deliver educational and monetary returns. Our goals for the future are to increase assets under management, build relationships with financial professionals, and ultimately create new student directed classes with different fund management styles. As part of our growing emphasis on building relationships with financial professionals, the SMIF had several guest speakers over the past year. Dennis Gogarty, Bill Mann SIS ’92, Ira Jersey SPA/SOC ’93, Eric Green KSB ’92, and Chris Hill SOC ‘96 all shared their insights with the class. The class intrinsically has an emphasis on practice over theory. Regular speakers add practical depth as to the theoretical foundation we learn in other classes. Students not only find this interesting, but also regularly apply concepts from guest speakers to the SMIF’s management. Looking further down the road, management would like to see multiple funds with different styles. We envision a fixed income and a constrained optimization fund. Debt markets are some of the largest in the world yet very few universities have bond funds and such a class would present a unique opportunity for students. Constrained optimization is another rapidly growing field in asset management. American University is notable for its commitment to the environment. We see a sustainable fund as an idea that the school-­‐wide community could get behind while challenging students to be innovative investors. Both funds would expose students to unique educational experiences and prepare them for the job market. The Student Managed Investment Fund at American University has had an outstanding year of development and growth. The fund is well positioned to move forward with robust structures and a guiding investment philosophy. We have seen students gain hands-­‐on knowledge of the financial world and provide investment returns. The fund has built connections within both the Kogod School of Business and the broader American University community which continue to strengthen over time. I can’t think of a better birthday present. To touch briefly on a personal note, my involvement in the SMIF was the most rewarding of my college career. I know from speaking with classmates that many others share this thought. Professors, staff, alumni, parents, students, and many others made this class possible. I would like to personally thank each one of you for your contributions, both big and small. I can’t wait to see what our third birthday will bring. Sincerely, Seth Borko Portfolio Manager American University, Class of 2012