On 4 Feb, Seth Alexander, President of MIT Investment Management Company and his Global Investment team member, Joel Cohen delivered a wonderful lecture to my students and ex-students at MDI. It was a privilege to host them at MDI.

A few days before the lecture, I had asked my students to read:

  1. This excellent interview of Seth, Joel and their colleague Nate Chesley conducted by the Manual of Ideas in December 2014; and
  2. MITIMCO’s investment brochure.

If you haven’t read these documents, I urge you to read them carefully.

The presentation delivered be Seth and Joel at MDI can be downloaded from here which I have uploaded with permission.

While the entire presentation was quite instructive, I got the maximum out of slide 8 on top down risk framework. While Seth and Joel were talking about top-down risk framework in the context of managing an endowment, in my view, there’s an important lesson which is equally applicable for building much smaller portfolios using the principles of value investing.

Essentially, Seth stated that at MITIMCO, they buy “bottoms up” but worry “top down” while constructing portfolios.

Most value investors are bottom-up stock pickers anyway. But having a top-down risk management framework while constructing portfolios is a different skill which is worth acquiring.

What are the type of things one should worry about while constructing portfolios? Well, to my mind, there are many things and just one of them is to do with the type of value investing one is following. In risk arbitrage, for example, you need lots of diversification while investing in high quality businesses with long runways you need a lot less diversification. But you still need diversification. How much is sufficient diversification? There’s is no right answer to this question in my view, and many other questions related to top down risk framework. Any constraints imposed by the portfolio manager will be necessarily arbitrary. The key point Seth made on this was that having an arbitrary constraint is better than having no constraint.

What are the other things one must worry about while constructing portfolios? An excellent answer to that question lies buried deep inside Warren Buffett’s 2001 letter, in which he wrote a wonderful essay titled “Principles of Insurance Underwriting.”  Here’s that essay in which I have bolded the relevant part for our purposes.

Principles of Insurance Underwriting

When property/casualty companies are judged by their cost of float, very few stack up as satisfactory businesses. And interestingly unlike the situation prevailing in many other industries  neither size nor brand name determines an insurer’s profitability. Indeed, many of the biggest and best-known companies regularly deliver mediocre results. What counts in this business is underwriting discipline. The winners are those that unfailingly stick to three key principles:

  1. They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.
  2. They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.
  3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn’t work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

* * * * * *

Good insurance underwriters as well as value investors must worry top down about risk aggregation and they must “ceaselessly search for possible correlation among seemingly-unrelated risks.”

Seth’s remarks on MITIMCO’s top down risk framework should be read with Buffett’s principles of insurance underwriting. There is a very important lesson for value investors in there and that important lesson is this: Buy bottoms up, worry top down.

7 thoughts on “MITIMCO @ MDI

  1. Thanks a lot for the wonderful post again.

    What I learn from it is that the “worry top down” framework is very important in the following circumstances:

    1. Insurance companies: Where there can be huge outflows if an unfortunate event occurs.

    2. Endowment and retirement funds: Where there is a constant stream of payout the funds need to make through out their investing life.

    3. Open-ended Funds/ Mutual Funds: They can face redemption pressure due to seemingly-unrelated risks, just like the insurance companies

    4. Value investor doing risk arbitrage: Since their investment horizon is very short, they are exposed to the same seemingly-unrelated risks as any calamity can hit and effect the market in the short term.

    What I have learned by following you all these years is that in this one case, one should avoid the “worry top down” framework to make investment operation simplistic and much more effective in the long run:

    If you are an individual investor and satisfies the following four conditions:
    a) You invest in high quality business for the long run
    b) You have put patient capital into investment, which you do not need for any emergency.
    c) You avoid leverage at both portfolio level and at company level
    d) You are essentially a buy and hold investor

    By avoiding the “worry top down” framework in this single unique case, your portfolio may be volatile in the short-term, but in the long run, if you do the right things, you are more likely to achieve better results.


    • student241 says:

      Hi Ankit,
      I beg to differ with you. I really liked that “worry top-down” theme.
      I think a lot of risks are same for companies belonging to same sector.
      For ex- Lets say, I like Microfin sector. But if some black swan (like it happened in 2011) comes & hits the sector, all your stocks will get the hit.
      If you have not limited your exposure to the sector (by worrying top-down), your portfolio will get a big hit.
      Similar is the case of pharma sector & risk of FDA.

      • Suresh Vr says:

        Dear student241, may be we can not generalise it. for eg. even in current banking npa recognition phase, all PSUs and vivid lenders during 2005-2008 period are getting hurt. Doesnt mean the entire sector is getting hurt. On the contrary, as it hits one section so bad, the un-hit section (say 2-3 private bankers) will only reap benefit out of sickness prevailing in that sector.

  2. Ankit – Well put. I would add a 5th condition which is that you have provided for a good Margin of Safety based on your estimate of the Intrinsic Value and the current market price.

  3. […] of f MIT Investment Management Company delivered a lecture to Prof. Bakshi’s students at MDI. A note on the same by Prof. […]

  4. Prof. Bakshi,

    Thanks for sharing MITIMCO’s presentation and link to their brochure and the interview. It provides some excellent food for thought for emerging investment managers and also a perspective of what a long term value oriented institutional investor will look for in an investment manager.

    The MOI interview with MITIMCO team consists of many nuggets of wisdom like ” The most common mistake we see is when an investor makes small compromises in the early days of the partnership in ways that limit future success” and “We’ve observed that almost all the very successful and established firms we work with turn away large amounts of capital – they even did so when they were small, by the way – because they understand the
    need to apply the same high bar to their choice of partners as they do their
    choice of investments”. These are very powerful and rewarding ideas in long term,I realize that considering the difficulty in raising early stage capital, these may be very difficult choices to make. It will be very helpful if you can share your views/experience on these aspects and any suggestions on how maintain a fine balance between scaling up in early stage and being choosy.

    As always, I appreciate the wonderful posts that you have been writing/sharing and helping us learn vicariously

    Best Regards
    Dhwanil Desai

  5. You must have surely read this but thought others might benefit “a balanced investment position, that is, a portfolio exposed to a variety of risks in spite of individual holdings being large, and if possible, opposed risks. ” Keynes Source:

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