The great bull market of the 1990s spawned almost as many investment books as IPOs. Some authors claim that stocks are still undervalued, others say the market is too high. Many of these books make diverting reading for a general audience. Sadly, most offer little of value to foundation trustees and other fiduciaries eager for insights that might help them better manage the funds in their charge.
Pioneering Portfolio Management by David F. Swensen is a splendid exception. Swensen has been Yale’s chief investment officer since 1985, during which time the university’s endowment has grown from $1 billion to over $7 billion. Even conceding the salutary impact of contributions, he has delivered extraordinary performance: Yale’s returns during his reign exceed those of 98 percent of institutional funds.
Swensen writes with a perspective rare in this era of Bloomberg screens and CNBC. He thinks about investing with a time horizon measured in centuries rather than seconds. He writes about process, not stock picking. Asset allocation and manager selection are his key tools, as Yale’s endowment is managed entirely by outsiders.
Three themes surface repeatedly, the first being the importance of “an analytically rigorous framework.” While few foundations are blessed with the analytical skills Yale can tap, all of us can benefit from his spade work.
The second theme concerns the prevalence of agency issues. These are the numerous conflicts between the interests of a fund and those of its agents, whether trustees impatient to make a mark during their brief tenures, investment managers following cautious, benchmark-hugging portfolio strategies in preference to longer-term contrarian plays, or issuers of corporate bonds who inevitably place shareholder interests ahead of those of their bondholders.
Swensen’s third theme relates to the obstacles to active management success. Swensen cautions that the market is a negative, not a zero, sum game, with active managers in the aggregate losing to the market by the amount it costs to play (management fees, trading commissions, and dealer spreads). He argues that institutions should only pursue active management in asset classes where the odds are stacked in their favor.
The book opens with a useful review of endowment purpose, arguing that it is to maintain independence, assure stability, and foment quality. This final point is argued by tables showing the correlation between academic excellence and endowment size among larger American universities.
On the matter of spending policies, Swensen makes it painfully clear that it is almost impossible to maintain real spending levels over long periods of time without a continuous infusion of gifts. This is not just because the investment gains of the past decade are an aberration. Equally important, broad inflation measures grossly understate the cost of nonprofit activities. His discussion is particularly timely today when foundations are facing pressure to increase payout rates. For better or worse, today’s foundations may be doomed to a continued decline in influence as investment gains, eroded by even a 5 percent payout, fail to keep pace with the escalating cost of maintaining programs.
Swensen next turns to investment philosophy, the central tenet of an investor’s approach to markets. He discusses asset allocation, market timing and security selection, the three sources of investment return. He argues convincingly for an equity-oriented bias and urges fund managers to focus on inefficient markets, as they present the greatest range of opportunities. He is dismissive of market timing, quoting Keynes’s comment that “most of those who attempt to [market time], sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind.” He is also critical of the general premium investors place on liquidity, noting that “rewarding investments tend to reside in dark corners, not in the glare of floodlights.”
It is apparent that much of Yale’s excess return has been due to his willingness to embrace investments that are not liquid. Swensen discusses illiquid strategies such as private equity, venture capital, and distressed securities at length, cautioning that careful manager selection is even more important here than in more liquid asset classes. This is a very important point for any investor new to alternative investments.
When discussing asset allocation, Swensen argues for “marrying the art of seasoned judgment with the science of numeric analysis.” He includes a provocative discussion of the limitations of mean-variance optimization, the quantitative tool at the heart of modern portfolio management. Among other weaknesses, this tool breaks down in periods of extreme price change such as the 1987 stock market crash, tends to shorten investor timeframes, fails to take into account important attributes such as the liquidity of an asset class, and unrealistically assumes continuation of past trends. Throughout the book Swensen includes illuminating discussions of quantitative issues such as survivorship bias, correlation, and mean reverting behavior. A close reader will become a more skeptical listener to investment manager presentations.
His chapter on portfolio management contains much useful discussion on risk control. He criticizes investment strategies “with poor payoff structures” such as securities lending, and many arbitrages, saying that “at best referring to risky strategies as arbitrages represents a Wall Street conceit, an attempt to create an aura of mystery and sophistication surrounding the investment process.”
Throughout the book he advocates unconventional approaches that others could fruitfully follow. For example, he makes a compelling case for long-term government bonds over other more popular fixed-income securities and for holding “only the amount necessary to protect portfolios against financial trauma.” His opinions can be scorching, as where he says that the “arrogance of technical analysts exceeds even that of the purest quantitative managers.”
Following excellent chapters on investment advisors and performance measurement he concludes with a discussion of investment process, describing Yale’s in detail and contrasting it with those followed by its peers. He advocates establishing a framework that “overcomes the handicap of group decision making, encourages well-considered risk taking, and increases the opportunity to add value to the portfolio management process.”
Sprinkled throughout the book are examples of past investment blunders. While these will make some readers squirm (he names names) they are fascinating lessons for the rest of us.
No book can transmit all of the skill and knowledge that a professional like David Swensen brings to his work. On the other hand, he has shared enough of his secrets here to make any reader a better manager of endowment funds. I expect that we will see the influence of his thinking reflected in the investment returns of foundations and other institutions for many years to come.
Russell Pennoyer is a partner of the investment bank Benedetto, Gartland & Company, Inc. where he raises capital for private equity partnerships. He is a trustee of the Achelis and Bodman Foundations.