I figured this would be a good time to share a lecture I have enjoyed by David Swensen.
Swensen is the chief investment officer of the Yale Endowment, which has outperformed other large institutions over a long period of time. He helped pioneer the “Yale Model” which has been copied by other institutions. His full list of qualifications can be found on his wikipedia article.
To a certain extent, his Yale model was criticized when it experienced its first year of major loss in 2009, a year of systematic failure, but all things considered, his rather defensive position buffered Yale’s portfolio against what could have been an even worse impact (as measured by standard indexes). It was criticized because an institution like Yale needs to draw from its endowment annually to pay expenses. Yale’s long-term performance has outperformed the S&P 500 over the 25 years that Swensen has led it (since 1985), and has done so with less volatility (Yale only had 3 years of endowment reduction out of the 25, and two of them were very mild).
So what’s his secret for long-term risk-adjusted success? Asset allocation and attention to liquidity.
For those that don’t want to watch the hour-long lecture (I’d propose that a free lecture by Yale’s chief investment officer is worth an hour, but perhaps I’m unusual), or for those that wish to watch it but want some background, I’ll provide a quick summary of what his technique is and what his main arguments are.
I’ve mentioned it a few times here on Dividend Monk, but I suppose I don’t mention it enough considering I focus on a specific niche rather than portfolio theory in general: asset allocation is the most important decision for a portfolio. Choosing where to invest your money and what your broad strategy is, is far more important than which specific investments you pick. Everyone has their preferred investment class (some prefer indexes, some prefer dividend stocks, some prefer other niches; I prefer both dividends and indexes), but what’s most important is how those investment types come together.
The main points from Swensen’s lecture are:
-Actively managed stock funds, in aggregate, underperform the market over the long term.
-Asset allocation is key, because it’s the closest thing to a “free lunch” around. With asset allocation, you can get better returns for the same level of total risk, or you can lower risk for the same level of portfolio returns. It’s an efficient way to maximize risk-adjusted returns, which modern portfolio theory assumes that any rational investor would want to do.
-There are some areas in which active management makes a difference, and it’s rather intuitive. The more efficient a market is, the less active management matters. In other words, the best bond traders are only slightly better than mediocre bond traders, but the best venture capitalists and leveraged buyout investors are significantly better than mediocre venture capitalists and leveraged buyout investors. The general progression of active management relevance is: bonds, stocks, real estate, buyouts, venture capital.
-Liquidity plays a big role in why some markets are more efficient than others. Less liquid investments, for the same level of risk, can often offer better returns. So, real estate and private equity, if invested in, can potentially provide outsize returns for a similar level of risk (assuming the fund is large enough to diversify even among these illiquid and large investments). If you want an example, look at a few of your favorite REITs, and imagine what your returns would be if you owned them personally at book value rather than paying a multiple of book value that the market has agreed is a good price to pay for what is on their part a passive and liquid real estate investment.
Obviously, some of this is more important for some managing an institution’s portfolio to know than for an individual investor to know. So what’s the takeaway for readers? The first takeaway is that, asset allocation really matters. The second is that, as an investor ascends in wealth, she may find it worthwhile to pursue some less liquid investments, including real estate and private equity (which to a certain degree are indeed accessible to individuals).
The third takeaway is, he also offers his portfolio advice for individual investors, which is not included in this lecture. The summary of his recommended asset allocation for a liquid individual portfolio is:
30% Domestic Equity
15% Foreign Equity
5% Emerging Markets
There are many similar portfolio allocations that will work approximately as well; the specifics are less important. There are ways to diversify effectively with only 3 asset classes rather than 6, and the various allocations could be either purely indexed (such as through Vanguard ETFs), or through individual stock selection. The benefits of this particular portfolio are that you get a ton of protection against inflation (REITs respond well to inflation, and TIPS (Treasury Inflation Protected Securities) are bonds that are indexed to inflation), and you get 70% of your portfolio allocated towards equity, which is typically the area that provides good returns.
The key to using a portfolio like this one is to realize the importance of rebalancing. The bond components aren’t necessarily a huge drag on returns; by rebalancing your portfolio with fresh capital or with annual selling/buying, you profit from both growth and volatility while being protected from some downside risk.
So, for those interested, here is his lecture, which I find to be worthwhile: