Who Is This Man?

Cover Story from aiCIO Magazine: Warren Buffett chooses an heir. Kip McDaniel & Paula Vasan report.

To see this article in digital magazine format, click here.

On a brisk day in late October, in the hedge fund office that he frequents on New York City’s Fifth Avenue, Adam Smith sat at a conference table and told of how he first created Warren Buffett.

Not the real Adam Smith, of course, and not a creation in the formal sense of the word. Instead, it was George “Jerry” Goodman, the man who has used this pseudonym for half a century to famously write on finance; his creation—a phrase the humble Goodman eschews—came in the form of a request by Benjamin Graham that Goodman go to Nebraska and ask Graham’s former student if together they would update the legendary investment tome The Intelligent Investor.

“We turned Graham down, of course,” said Goodman, now a spry octogenarian splitting his time among Manhattan, Princeton, and Florida, “but I did go meet Buffett—and we had a wonderful time. We met for dinner, and liked each other enough to meet for breakfast the next day. He’s a great storyteller, a real teacher, even back then, and, please pardon my language, we were like two drunks trying to top each other with grander stories. He was better.” Smith turned the encounter into a chapter in his second bestseller, Supermoney, and the legend of Warren Buffett commenced.

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Buffett is now pulling a Smith, so to speak. Three days before Goodman expounded upon their original meeting, Buffett had stunned the investment world when he announced that Todd Combs, an anonymous Connecticut hedge fund manager, would be taking the reins of a $2 to $3 billion portion of the $113 billion Berkshire Hathaway investment portfolio—and one day potentially would serve as chief investment officer (CIO). Just as Goodman had done four decades before, Buffett, with a stroke of a pen, had created a legend. The announcement, however, prompted a nearly ubiquitous question: Who is Todd Combs?

Todd Combs certainly won’t tell you who Todd Combs is. Before the announcement that he would cease investing at his hedge fund, the $400 million Castle Point Capital Management, and move onto Berkshire Hathaway’s portfolio, no one cared much about who he was. After the announcement, everyone cared—but still could find nothing of substance about the man. Even discerning what he looked like was near to impossible: It took nearly a week for the financial press to find a picture of him and, when they did, it was from his high school yearbook. Only when a Bloomberg photographer confronted him at his child’s hockey game did the world get to see what he looked like in adulthood.

Even before the most basic of details emerged about Combs, markets and critics had an opinion. Berkshire Hathaway A Class stock fell 4.5% in the days following the news, perhaps reflecting the idea that Buffett was mortal more than any negative insight about his successor. Headlines such as “Todd Combs May Be A Fine Stockpicker, But He Was A Bad Choice For Warren Buffett” permeated the frenzied online investing media. While few have made money betting against Buffett over the years, Mister Market, by and large, was not entirely happy with the announcement.

Here is what is known: Combs is 39 years old. He lives in Darien, Connecticut, with his wife and three children in a modest white clapboard house. He is a Sarasota, Florida native. His undergraduate degree, awarded in 1993, is from Florida State University. Upon graduation, he worked at the state’s financial regulator before joining Progressive as a risk analyst. In 2000, he enrolled at the prestigious Columbia Business School and, in his second year, was accepted into the even more exclusive Value Investment Program. Upon graduation, he moved to Buffett-inspired Copper Arch Capital. In 2005, with funding from Stone Point Capital, Combs started Castle Point. While there, he focused almost exclusively on public shares of financial firms, and, similar to the myriad hedge fund characters of note in recent years—John Paulson, Steve Eisman, Michael Burry—apparently was prescient regarding the financial system’s near-collapse. Consequently, his 2007 and 2008 returns were a good, if not exceptional, +19% and -6% net of fees. His 2009 returns were significantly below most hedge fund indices at +6%. According to The Wall Street Journal, when it became known that Buffett was looking for an eventual replacement, Combs applied for the job, met Buffett’s partner Charlie Munger, and then met the man himself. In the last week of October, Buffett revealed his choice to the world, and Todd Combs, whom no one knew anything about, became the most sought-out interview in the financial world. As of yet, no one has gotten that scoop. (Combs declined an interview request for this article.)

Indeed, Combs has been making an active effort to convince others to stay silent on who he is. In a time when keeping information clear of Google’s servers is seemingly as hard as inventing the next Google, Combs has succeeded in preventing personal information of any consequence from leaking into the public sphere. Additionally, he has reached out actively to people in his past to ask for their silence. “Unfortunately, Todd is keeping a low profile and has asked me not to speak to the press about this,” said Bruce Greenwald, Columbia professor and Director of the Heilbrunn Center for Graham & Dodd Investing, when contacted. “We are trying to keep the program as low profile as possible since we are limited to forty places and want to accept at least half of the applicants. Being identified in The Wall Street Journal as an elite program is a potential disaster for us.”

Contemplating his meeting with Warren Buffett and their ensuing interactions, George Goodman voiced concerns over whether Todd Combs will emulate what he sees as the man’s most essential quality. “There have been other great investors,” he said, leaning back in his chair. “What makes Buffett Buffett is that he is a great teacher. He toils over his letters to investors—and he loves it. Even 40 years ago, he was a master of metaphor, baseball in particular, and loved explaining complicated issues in a simple way.” (Buffett even wrote one for the back cover of later editions of Goodman’s Supermoney: “In this book, Adam Smith says I like baseball metaphors. He’s right. So I will just describe this book as the equivalent of the performance of Don Larsen on October 8,1956. For the uninitiated, that was the day he pitched the only perfect game in World Series history.”) From the limited history previously reported in the press regarding Combs, Goodman’s concerns would be far from assuaged. However, by looking at how Todd Combs went from regulator and analyst to professional investor, it is possible to infer that this essential legacy of Buffett—the ability to pass on knowledge to other investors—will not wane when the torch is passed.

By all accounts, a defining period of Combs’ investing life— and, it must be said, of many people’s, including Warren Buffett himself—occurred just northwest of Manhattan’s Central Park, on the campus of Columbia University. Within this bastion of the Ivy League, itself ironically without much ivy to speak of, sits the famed Value Investing Program. A subset of the graduate school of business and its Heilbrunn Center, the program annually accepts forty-odd second-year students to be taught the principles first espoused by Buffett’s mentor, the aforementioned Benjamin Graham. Surprisingly, considering the seal of silence Combs has surrounded himself with, many people at and associated with the program are more than willing to speak openly about their recently famous graduate, one who has continued to associate with the school in the decade since he left.

“We have a great relationship with Todd,” said Louisa Serene Schneider, the administrative Director of the Heilbrunn Center, during an interview on campus. “He speaks in one of our classes.” Other people who know him from his Columbia involvement referred to him as “down to earth,” “very warm,” and a “good person to be around.” Almost all, including Schneider, mentioned his involvement in the school’s mentor program. “Todd has been a mentor for as long as the mentor program has existed—a couple of years,” she said.

The lucky current mentee: Jake Shelton, a shy 27-year-old who came to Columbia because “no one was hiring in the public markets” in 2008 and decided that a shot at the Value Investing Program was worth the two years in New York City. “I felt I had a decent shot,” he said one Monday this fall after the announcement of his mentor’s new position. “Not a slam dunk but, if I were going to spend two years at school, I wanted to choose the best.” In September, before he became a quasi-household name, Combs became known to Shelton as the Connecticut hedge fund manager who would be his mentor. “The first time we met, he swung by to meet me while he was on a business trip,” he said. “We went to a Starbucks in Midtown for a cup of coffee. At that time, I wasn’t aware that he would be Buffett’s pick. With good investors, you can tell they really enjoy doing it. They have a passion. I could tell that with Todd. I got the sense he really enjoys investing.” A few weeks after that coffee outing, Shelton saw an article announcing that Warren Buffett had picked his mentor to manage a major part of Berkshire Hathaway’s investments. “So, I sent him an e-mail— just a sentence or two—letting him know that I saw the news, and I congratulated him. He replied with a quick ‘Thanks, I appreciate it.’ It’s cool to be able to say I’m the mentee of the person Warren Buffett picked to help run his fund.”

TO be sure, investment differences exist between Buffett and his heir apparent, the most prominent and noted being that Combs is an avid short-seller, an idea anathema to his new boss. According to a portfolio analysis by Buffett biographer Alice Schroeder, the vast majority of Combs’s historical returns have emanated from the short side of his portfolio—something not unexpected considering the abrupt drop in financial stock prices since Castle Point’s inception, yet still a different source of returns from the traditionally long-only Buffett. Also, according to his 13F institutional investment regulatory filings, Combs moves in and out of positions much more quickly than Buffett, who often holds positions for years, even decades.

Yet, as with many media stories, the widespread hype surrounding Buffett’s seemingly odd choice obstructs the myriad similarities between the two men. While their actions differ marginally with regard to investing, the underlying principles remain constant. Short selling, after all, can be seen as simply value investing in reverse: Finding the intrinsic value of a company well below its market price, those investors with the ability to endure market fluctuations and margin calls could go short without violating their value principles. Additionally, while his short selling has been successful, Combs still clearly thinks along Buffettesque lines in one sense: “At Castle Point, we like to think of ourselves as owners of businesses,” he wrote in a July letter to shareholders that was obtained by Reuters, echoing a frequent Buffett refrain. Their motives for investing are seemingly also similar. Buffett reportedly takes home compensation of $500,000 each year (although, admittedly, his vast ownership in Berkshire Hathaway makes him one of the richest men on earth). He, thus, is unlikely to pay his heir much more than this. Combs, it seems, will be remunerated more like a successful pension fund chief investment officer than a hotshot hedge fund manager.

Furthermore, for all the hype about the end of an era and falling stock price, many of Berkshire Hathaway investors understood where Buffett’s decision originated. “It all makes sense. I’m not surprised in the least that Buffett chose someone not well-known,” said James Armstrong, a Pittsburgh-based investor who manages $400 million for high-net-worth individuals, family offices, and charities, and who has been invested with Berkshire for more than a quarter century. “He chose someone young enough to have a long life at Berkshire. In many respects, this seems perfectly unsurprising. It would be highly unlikely they’d pull someone out of a big bank. I can guarantee the best money managers don’t work at large institutions.” At such institutions, Armstrong believes, politics and corporate pressure can get in the way of the investment process—especially one that depends, as Buffett’s and Combs’s does, on the ability to value a company void of what the market currently thinks about it. Armstrong does see limitations to Combs’s immediate rise, however. “I don’t expect Todd to be the only manager. The company will hire two or three people to manage chunks of money for Berkshire and, from that group, they’ll pick a CIO. It’s likely identical to the arrangement Lou Simpson had for 25 years, [where] they carve off a chunk of assets for him to manage; at GEICO, Lou did a great job and earned good returns [for] Berkshire.” It even might be Simpson’s retirement, Armstrong believes, that has spurred Buffett’s announcement.

“What has been missed so far is that Combs is not the second in a line,” George Goodman said as he pushed back from the conference table. “It’s not Buffett to Combs. It’s Graham to Buffett to Combs, and all that comes with that.” What comes with that, Goodman noted, is a temperament aimed at logical thought, reasoned decisions, and humble education of others—traits that the first two possess and that many hope to see in the third. Indeed, in her behemothic biography, The Snowball: Warren Buffett and the Business of Life, Alice Schroeder, citing George Goodman, wrote that Buffett represents] the triumph of straight thinking and high standards over flapdoodle, folly, and flimflam.” Although no one has spoken directly to him about it, it is likely, based on available evidence, that this quote applies equally to Todd Combs. If the attention lavished on Buffett for these traits is any indication, Combs will have the ear of institutional investors for years to come, and the question of who he is and what he stands for will soon be answered.

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Home > News > Risk > CERN Revolutionizes Risk Management

Risk December 14, 2010

CERN Revolutionizes Risk Management

Strategy + Tactics from aiCIO Magazine: "We call it a capital preservation philosophy," notes Theodore Economou, the pension head at the European Organization for Nuclear Research (CERN), echoing Benjamin Graham's mantra that to win, the first thing you have to do is not lose. "Losing money is not okay."

To see this article in digital magazine format, click here.

DESPITE misguided and so far unfounded concerns, the European Organization for Nuclear Research’s (CERN) Large Hadron Collider has not created a black hole that, in turn, has swallowed earth and humanity. If it had, what the European scientific institute famous for smashing together sub-atomic particles did with its employee pension fund would be relatively meaningless. However, since we are all still here, the risk management and portfolio overall currently under way in Geneva matters—for the system’s thousands of pensioners, as well as for other capital pools willing to learn from CERN’s innovations.

First, an introduction to CERN’s team. Theodore Economou is the organization’s pension Chief Executive Officer and is potentially the nicest man in investment management. A close second for this title might be his Chief Investment Officer, Gregoire Haenni. They are the types that apologize profusely for even minor incidents of tardiness. They are exceedingly well mannered, as only two non-Americans can be. Together, they comprise the brain trust of the $4 billion pension system, and the work they are doing—focusing on portfolio reconstruction and proprietary risk modeling—is appropriately suited to an institution with multiple Nobel Prize recipients on staff.

“Essentially, what I found when I arrived in October 2009 was a very traditional portfolio that any pension CIO would recognize,” Economou says on a phone call with aiCIO following his October appearance at the aiCIO Summit in London, England. “It was 60% risk assets, including real estate, and 40% bonds. The fund did a strategic asset allocation study every three years, followed by tactical allocation moves, with the fund taking fairly large single bets, such as bets on currency.” Economou, who ran the ITT pension system in New York City before moving to Switzerland, thought it was time for a new approach. “We are in the process of changing it from this legacy, return-based approach, to a risk-based one,” he says. “It’s an absolute-return approach to the entire fund—with a key term being ‘liability-aware’.” This last term, Economou notes, means that the fund can be cognizant of its liabilities without being “slavishly tied” to liability-driven investing (LDI). “There is this religious discussion about LDI, but the reality is that it confuses actuarial losses with real cash losses,” he says. “I don’t think it’s acceptable. What this means is that, if you offset your liability with an asset, particularly a swap, if something happens to interest rates and your liability goes down, it’s great—but in an LDI world, your assets also go down the same amount.”

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Hand in hand with this allocation overhaul, Economou and Chief Investment Officer Haenni also are looking to retool the fund’s risk management procedures—and this is where the truly innovative work is being done. “We look at risk management as two processes,” Economou says. “One: the overall risk management process, showing us the acceptable risk constraints. This tells us what the size of the sandbox we can play in is, and this is a process where we involve an external risk manager.” The metric presently used to measure this risk is conditional value-at-risk-based (CVar), which Economou views as “not a perfect measure, but you need to start somewhere.” (Volatility is not risk, Economou stresses time and time again; the loss of capital is the risk). The result of this first process of risk management is that the fund’s board knows whether the risks being taken lie within previously agreed upon guidelines.

The reason Haenni was hired earlier this year was not so much to create this 30,000-foot view of potential problems, but to provide an expertise in portfolio-level risk management modeling. If the first risk management process is about the size of the sandbox, Haenni’s work is about how to maximize the fun in the sandbox. “I was asking around about what the best risk management system for portfolio construction was,” Economou says. “That’s how I got in touch with him.” Haenni, it turns out, has spent his academic and professional career working on risk modeling. An extension of his PhD thesis at the University of Geneva, this model first went with him to Swiss asset manager Pictit, where he spent a decade refining the system. He now finds himself and his model in Geneva.

The model itself is a sight to behold. Its entire goal is to “illustrate risk and make it actionable,” according to Economou, by answering two questions: how manager x should behave, and how, put together, all managers behave relative to each other. The system looks at 20 dimensions of correlation that, when presented visually, are distilled into three dimensions, making it both more intuitive and easier to act upon. Once this analysis has been done, Economou and Haenni have another process they apply. “The second part is top-down, a macro-view approach,” Economou says. “We don’t pretend that we can call the market— that’s borderline delusional. People spend hundreds of millions trying to do this, and we can’t argue that we can compete with these folks, but what we can do is identify different market regimes, different areas of risk that are excessive, and we can hedge.” In essence, this two-man team is attempting to identify market regimes and position their portfolio appropriately. It’s not forecasting. It’s identifying risk.

“We refer to it as a capital preservation philosophy,” Economou notes, echoing Benjamin Graham’s mantra that to win, the first thing you have to do is not lose. “Losing money is not okay. The traditional approach of running money—the 60/40 strategic asset allocation regime we had here at CERN—is focused on performance versus an index.” There is an assumption in this framework, Economou and Haenni believe, that the index, over time, will meet a fund’s needs. “We don’t view this assumption as appropriate,” Economou adds. “Market cycles can be very long—look at Japan. And boards don’t always understand volatility.” Put another way: They are not bullish on world markets, and they’ve designed a systematic approach to investing that (they hope) will allow them to act successfully upon this belief.

Of course, Economou and Haenni can’t go it alone. Their board, as at any other pension fund, must approve changes to asset allocation and risk controls. “Our board has been superb,” Economou says, noting that an institution that draws upon more than 10 countries for funding and houses some of the brightest minds in the world will naturally produce high-quality board members. Relying on Netherlands-based consultant Ortec Finance to confirm that the new asset allocation fits within the risk scope that the board finds comfortable, the fund has been “very receptive to the changes” Economou and Haenni are implementing. Alongside spending the summer “programming liability risk—our benchmark—into the model so that any incremental manager’s risk impact can be identified,” Economou and Haenni worked hard to educate their board on the new paradigm. “It was a success,” notes Economou. “They understand, and they are happy with the ideas underlying the changes. There is a difference between ‘conservative’ and ‘traditional.’ Most boards are ‘conservative’—as they should be—but that doesn’t mean 60/40 is ‘conservative.’ Investment boards and executives need to disassociate these two terms—and ours seems to be doing this.”

The inevitable stressful periods, the team knows, are yet to come. “The real test is when markets are up 20% and we’re below that,” Economou says. “We have told the board that we look at it as ‘how much have we left on the table on the upside to protect the downside.’ I think they’ll be with us in this scenario, due to the usual mantra: education, education, education.”

This could all be for naught, of course. Similar to its pre-2009 pension structure (which, Economou stresses, wasn’t wrong— it just needed to be updated) CERN’s particle collider is running at only half power due to an explosion in 2007. Yet, by 2013, it is expected to be firing sub-atomic fragments around its 17-mile loop at nearly their full speed—after which, if skeptics are to be believed, none of us will be here to see how either experiment turns out.

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