We've already talked about
our guest today.
This is David Swensen.
Remember, I said he was the
inventor of the swap, which is
a real claim to fame, because
swaps total in the hundreds of
billions --
PROFESSOR DAVID SWENSEN:
Trillions.
PROFESSOR ROBERT SHILLER:
It's amazing.
PROFESSOR DAVID SWENSEN: I
thought this was going to be a
polite introduction.
I used to be proud of the
swap thing, but that
was before the crisis.
PROFESSOR ROBERT SHILLER:
Well, that's financial
innovation.
I think, swaps are a very
important new technology.
We've been talking about that.
So anyway, just to
remind you --
David Swensen came to Yale in
1985, when the portfolio was
worth less than $1 billion.
And as of June, 2010,
it's $16.7 billion.
PROFESSOR DAVID SWENSEN:
And climbing.
PROFESSOR ROBERT SHILLER:
And climbing.
And this is a financial crisis,
but between 2009 and
2010, the portfolio went up $1.4
billion, so there's no
crisis around here.
Well, there was a little
hitch at one point.
But that kind of
thing happens.
I take pride in training young
people in finance.
David Swensen has done the same
with many young people.
Notably, Andrew Golden, who
heads the Princeton portfolio,
is one of your trainees.
And he's had an almost as
spectacular record as well.
Well, with that introduction,
I will turn it
over to David Swensen.
PROFESSOR DAVID SWENSEN:
Thank you.
[APPLAUSE]
PROFESSOR DAVID SWENSEN: So,
I've been at Yale for, I
guess, more than 25 years now.
And for most of the 25 years,
if there was any publicity,
the publicity was pretty good.
For the past couple of years,
it's been a little bit mixed.
And, I liked it better, before
the publicity was mixed.
I liked it, when every article
that you would read had
something great to say about
the Yale Approach or the
Swensen Model.
But after the collapse of Lehman
Brothers and the onset
of the financial crisis, it
didn't take very long for the
negative headlines to appear.
As a matter of fact, I carry
around this Barron's article
that appeared in November
2008, and the title was
''Crash Course.'' And it talked
about colleges cutting
budgets, freezing
hiring, scaling
back building projects.
And it blamed the Yale Model and
the Swensen Approach for
being too aggressive.
They said in Barron's that
university endowment should
own more stocks and bonds, less
in alternatives, because
the alternatives provided too
little diversification and too
little liquidity.
So, I thought what we could do
today as a jumping off point
is, talk about what it is that
Barron's meant when they were
talking about the Swensen
Approach or the
Yale Model and --
I think, when it was successful,
it was the Yale
Model, and when it failed, it
was the Swensen Approach,
which I really don't like.
There's an asymmetry there.
I keep thinking that I should
name it after one of the guys
in the office.
Maybe it should be the Takahashi
Approach instead of
the Swensen Approach.
It's time for him to have
some glory, right?
Talk about what it is that
Barron's meant by Swensen
Approach or the Yale Model, and
see, whether, indeed, the
criticisms that they levy,
that there's too little
diversification and two little
liquidity, whether those
criticisms are valid.
But to do that, let's go
back to 1985, when I
first arrived at Yale.
It was April 1, 1985, for those
of you who care about
April Fools' Day.
I came from a six-year stint on
Wall Street, and I had no
significant portfolio management
experience.
As Bob mentioned in his
introduction, I'd been
involved with structuring the
first swap transaction in
1981, when I worked for
Salomon Brothers.
It was a swap between IBM
and the World Bank.
And later, Lehman Brothers hired
me to set up their swap
operations.
So, generally what I was doing
on Wall Street was working
with new financial technologies
and being
involved with the early days
of swaps transactions.
It was a much smaller
market then, it
wasn't hundreds of trillions.
And it was a much less efficient
market then, so the
trades were incredibly
profitable.
Commodity swaps today trade on
razor thin margins, and tend
not to be anywhere near as
profitable as they were when
the markets were much
less efficient.
How did I end up at Yale?
Well, one of my dissertation
advisors called me and said
they needed somebody to
manage the portfolio.
And after coming to New Haven
and talking to them about the
job, I realized that my heart
wasn't in Wall Street.
My heart was in the world of
education, and at Yale in
particular.
So I came up here, amazed that
I was responsible, as Chief
Investment Officer, for
this portfolio.
It was less than $1 billion,
but close to $1 billion.
And the first thing I did was,
I looked around to see what
other people were doing.
That seemed like a sensible way
to approach the portfolio
management problem.
There must be some smart people
at Harvard or Princeton
or Stanford putting together
portfolios that make sense for
endowed institutions.
What I saw was that colleges
and universities had, on
average, 50% of their portfolio
in U.S. stocks, 40%
of their portfolio in U.S. bonds
and cash, and 10% in a
smattering of alternatives.
Even though I had no direct
portfolio management
experience, I had studied at
Yale and Jim Tobin and Bill
Brainard were my dissertation
advisors.
And I understood some of
the basic principles
of corporate finance.
And one of the first things that
you learn when you study
finance theory, is that
diversification is a great thing.
Jim Tobin won the Nobel Prize
in part for his work related
to the subject of
diversification.
In fact, when a New York Times
reporter asked Jim to explain,
in layman's terms, what it was
that he won the Nobel Prize
for, Jim said, well, I guess you
could say, don't put all
your eggs in one basket.
I didn't know you got a Nobel
Prize for that, but that's --
PROFESSOR ROBERT SHILLER: We
told our students that that
phrase goes back to 1802.
[correction: Lecture
4 mentions an
investment manual from 1874.
According to
ngrams.googlelabs.com, the
phrase can actually be
traced back to 1800.]
PROFESSOR DAVID SWENSEN: OK,
so if it goes back to 1802,
Jim was just picking up on the
vernacular and used it as a
way to describe what it is
that he did his work for.
And Harry Markowitz, who
actually did a fair amount of
his work on modern portfolio
theory at Yale's Cowles
Foundation, has said that
diversification is a free lunch.
I mean, didn't you learn in
introductory economics and
intermediate [clarification:
intermediate economics]
that there ain't no such
thing as a free lunch?
Economists are always talking
about trade-offs.
If you want more of this,
you have less of that.
Well, with diversification,
that's not true, right?
If you diversify your portfolio
for a given level of
return, you can generate that
return at lower risk.
If you diversify for a given
level of risk, you can
generate higher returns.
So, diversification is this
great thing, it's a free
lunch, it's something that
everybody should embrace.
Well, if you look at the
portfolios that I saw in the
world of endowment investing in
the mid-1980s, they weren't
diversified.
If you've got half of your
assets in a single asset
class, U.S. stocks, and you
have 90% of your assets in
U.S. marketable securities,
you're not diversified.
Half your assets in a single
asset class is way too much.
And the 90% that are in stocks
and bonds under many
circumstances will respond to
the same driver of returns,
interest rates, in
the same way.
Lower interest rates,
mathematically, are good for
bonds, and lower interest rates
lower the discount rate
that you use to discount future
earning streams, so
they're probably going to
be good for stocks too.
And vice versa.
And the second thing I thought
about was the notion that
endowments have a longer
time horizon than any
investor that I know.
And if you've got a long time
horizon, you should be
rewarded by accepting
equity risks.
Because those equity risks,
even though they might not
reward you in the short
run, will reward
you in the long run.
So, with a mission, as a manager
of an endowment, to
preserve the purchasing power
of the portfolio in
perpetuity, I expected that
other endowments would have
substantial equity exposures, to
take advantage of the fact
that, in the long run, that's
where you're going to generate
the greatest returns.
But if you think about those
endowment allocations that I
saw in the mid-1980s, 40% of the
assets were in bonds and
cash, which are low expected
return assets.
So, the portfolios that I saw
when I got to Yale failed the
basic common sense test of
diversification and equity
orientation, and it prompted
me and my colleagues to go
down a different path, to put
together a portfolio that had
reasonable exposure to equities,
and put together a
portfolio that was sensibly
diversified.
So, I'd like to talk about how
it is that we got from where
we were in the mid-80s to
where we ended up in the
early- to mid-90s, and where
we remain today.
And to do that, I'd like to put
it in the context of the
basic tools that we have
available to us as investors.
And these tools are the tools
that you can employ if you're
managing your portfolio as an
individual, or the tools that
I have to employ when I'm
managing Yale's portfolio as
an institutional investor.
And there are basically three
things that you can do to
affect your returns.
First of all, you can decide
what assets you're going to
have in the portfolio and in
which proportions you'll hold
those assets.
So, that's the asset allocation
decision.
How much in domestic stocks,
how much in foreign stocks,
how much in real estate.
If you're an institutional
investor, how much in timber,
how much in leveraged buyouts,
how much in venture capital.
The fundamental decision of how
it is that the portfolio
assets are allocated.
The second thing that
you can do is make a
market timing decision.
So, if you establish targets
for your portfolio --
targets with respect to how much
in domestic socks, how
much in domestic bonds, how
much in foreign stocks.
And then, because in the short
run, you think that --
let's say domestic stocks are
expensive and foreign stocks
are cheap --
you decide to hold more foreign
stocks and less in
domestic stocks.
That bet, that short-term bet
against your long-term
targets, is a market
timing decision.
And the returns that are
attributable to that deviation
from your long-term targets are
the returns that would be
attributable to market timing.
And the third source of
returns has to do with
security selection.
So, you've got your allocation
to domestic equities.
If you buy the market -- and
the way that you buy the
market is to buy an index fund
that holds all the securities
in the market in the proportions
that they exist in
the market -- if you buy the
market, then your returns to
security selection are zero,
because your portfolio is
going to perform in line
with the market.
But if you make security
selection bets, if you decide
that you want to try and beat
the market, then that bet or
that series of bets will
define your returns
attributable to security
selection.
So, if you decide that you think
the prospects of Ford
are superior to the prospects
of GM, well, you want to
overweight Ford and
underweight GM.
And if that turns out to be a
good bet and you're rewarded,
because Ford outperforms and
GM underperforms, then you
have a positive return to
security selection.
If the converse is true, then
you have a negative return to
security selection.
But one of the really important
facts about security
selection is that, if
you play for free,
it's a zero sum game.
Because if you've overweighted
Ford and underweighted GM,
there has to be some other
investor or group of investors
that are underweight Ford and
overweight GM, because this is
all relative to the market.
And so, if you're overweight
Ford and underweight GM and
somebody else is underweight
Ford and overweight GM, well,
at the end of the day, the
amount by which the winner
wins equals the amount by
which the loser loses.
And so, it's a zero-sum game.
Of course, if you take into
account the fact that it costs
money to play the game,
it turns into a
negative-sum game.
And the negative-sum is the
amount that's siphoned off by
Wall Street.
And Wall Street takes its pound
of flesh in the form of
market impact, in the form of
commissions, in the form of
fees that are charged to manage
the portfolio actively,
and then sometimes there are
even fees to consultants to
choose the manager.
So, there's an enormous drain
from the system that causes
the active investment activity
to be a negative-sum game for
those investors that
decide to play.
So, let's take these in turn
and start out with asset
allocation.
Asset allocation is far and away
the most important tool
that we have available
to us as investors.
When I first started thinking
about this 25 years ago, I
thought, well, maybe there's
some financial law that says
that asset allocation is the
most important tool, because
it seems pretty obvious that
that was going to be the most
powerful determinant
of returns.
But it turns out, that it's not
really a law of finance
that asset allocation dominates
returns, it's a
behavioral result of how it
is that we as individual
investors, or we as
institutional investors,
manage our portfolios.
If I make it back to my office,
traversing these icy
sidewalks, I could take Yale's
$17 or $18 billion dollars and
put it all in Google stock.
If I did that, I am not sure
how long I'd keep my job.
It might be fun for a while,
but that would probably be
damaging to my employment
prospects.
But if I did that, asset
allocation would have almost
nothing to say about
Yale's returns.
It would be the idiosyncratic
return associated with Google
that would determine whether the
endowment went up or down
or stayed flat.
And so, security selection
would be the overwhelming
important determinant of returns
for Yale's endowment.
And if it wasn't exciting enough
to sell everything and
put it on Google stock, maybe
I could go back to my office
and start day trading
bond futures.
Well, if I took Yale's entire
$17 or $18 billion dollars and
started trading bond futures
with it, asset allocation
would have very little to
say about Yale's return.
Security selection would
probably have very little to
say about Yale's return, so it
would all be about market
timing ability.
And if I'm great at following
the trend -- the trend is your
friend -- of course, that's
true until it's not.
Or if I've got some sort of
marvelous scheme to outsmart
all the other smart people, who
are trading in the bond
market, I could generate
some nice returns.
But those returns would have
nothing to do with asset
allocation, nothing to do with
security selection, and
everything to do with
market timing.
Of course, these sound like
ridiculous things, right?
I mean, everybody in this room
knows, that I'm not going to
go back and put Yale's entire
endowment in one stock.
And we also know, that I'm not
going to go back and day trade
futures with the endowment.
I'm going to go back, and the
portfolio is going to look a
lot like it looked yesterday,
and the day before, and the
month before that, and the year
before that, because as
investors, whether we're
individual investors are
institutional investors, we
tend to have a sensible,
stable approach to
asset allocation.
And within the asset allocation
framework that we
employ, we tend to hold
well-diversified portfolios of
securities within each
of the asset classes.
So, that means that asset
allocation is going to be the
predominant determinant
of returns.
Bob Shiller and I have a
colleague at the School of
Management, Roger Ibbotson,
who's done a fair amount of
work looking at the
various sources
of returns for investors.
And a number of years ago, he
came out with a finding that
more than 90% of the variability
of returns in
institutional portfolios had
to do with the asset
allocation decision.
And that was a very widely
read, and widely accepted
conclusion.
In that same study, I thought
that there was a more
interesting conclusion, and that
was that asset allocation
actually determined more than
100% of investor returns.
How could that be, how could
asset allocation determine
more than 100% of returns?
Well, it goes back to the
discussion that we had about
security selection and the fact
that it's not free to
play the game, and the
same thing's true
about market timing.
If somebody is overweighting
a particular asset class
relative to the long-term
targets that they've got,
well, there's got to
be an offsetting
position in the markets.
Market timing is expensive in
the same way that security
selection is expensive.
And so, it, too, is a zero-sum
game, even though the analysis
that you'd apply to market
timing isn't quite as clear
and crisp as in the closed
system that you've got with
any individual securities
market.
So, if security selection
and market timing were
negative-sum games, then asset
allocation would explain more
than 100% of the returns.
And, on average, for the
community as a whole --
because investors do engage in
market timing, investors do
engage in security
selections --
those are going to be
negative-sum games, and you
have to subtract the leakages
occurring because of security
selection and market timing,
in order to get down to the
returns that you would get if
you just took your asset
allocation targets and
implemented them passively.
So, it turns out that asset
allocation is the most
important way that we express
our basic tenets of investment
philosophy.
I talked about the importance
of having an equity bias.
Well, these are some
of Ibbotson's data.
He's got this publication called
Stocks, Bonds, Bills,
and Inflation, although he
might have sold it to
Morningstar, so maybe it's
Morningstar's publication now.
And it actually is an outgrowth
of some academic
research that he did
decades ago.
And the basic drill was,
starting in 1925, looking at a
number of asset classes --
the ones that I've got here are
Treasury bills, Treasury
bonds, large stocks, small
stocks, and then, as a
benchmark, inflation --
starting the investment at the
end of 1925, taking whatever
income was generated from that
investment, reinvesting it and
seeing where you end up at
the end of the period.
I've got here the numbers
from 1925 to 2009.
And if you did that with
Treasury bills, which are
short-term loans to the U.S.
government, one of the least
risky assets imaginable, you
would have ended up with 21
times your money over
the period.
If you think about that, 21
times your money, that's
pretty good.
But if you think about the fact
that inflation consumed a
multiple of 12, well,
you didn't end up
with a lot after inflation.
And if you're an institution
like Yale and you only want to
consume after-inflation returns,
so you can maintain
the purchasing power the
portfolio, well, 21 times, but
taking off 12 times for
inflation, not so good.
One of the interesting things
about the Stocks, Bonds,
Bills, and Inflation numbers
over long periods is that they
correspond to our sense of the
relationship between the
riskiness of the asset, and the
notion that, if you except
more risk, you should
get higher returns.
And so, if you move up the risk
spectrum and, instead of
looking at Treasury bills, you
look at Treasury bonds, you
end up with a multiple
of 86 times.
That's pretty good, 86 times.
I mean, it's a lot better
than 21 times for bills.
It's still not a huge
return for decades
and decades of investing.
So, what happens if you move
away from lending money, in
this case lending money to the
government, to owning equities?
The multiple over this period --
and this includes the crash
in 1929, the market collapse in
1987, and the most recent
financial crisis.
In spite of those blips, you
would've ended up with 2,592
times your money.
That's stunning, that's way
more than 86 times and way
more than 21 times.
So, over long periods of time,
you do end up being rewarded
for accepting equity risk.
And what would've happened if
you would have put the money
in small stocks and
let her run?
12,226 times your money.
So, the conclusion is
pretty obvious.
This notion that, if you've got
a long time horizon, you
want to expose your portfolio
to equities, it makes an
enormous amount of sense.
As a matter of fact, the first
time I took a look at these
numbers was back in 1986,
when I was teaching --
probably a predecessor to the
class that Bob Shiller's
teaching, it was a lecture
class in finance --
and I was preparing the lecture
that had to do with
long-term investment
philosophy.
And that's when I first saw
these numbers, and I was
little bit disconcerted when
I put them together.
Because I thought, gee, 21 times
for bills, 86 times for
bonds, 12,226 times
for small stocks.
Maybe the right thing to do
is to just put the whole
portfolio into small stocks
and forget about it.
And my first problem was that,
if that were true, what was I
going to say for the next
ten weeks of lectures?
My longer-term problem was,
that, if the investment
committee figured out, that all
we needed to do is put the
whole portfolio in small stocks,
and that that was the
way to investment success,
I wouldn't have a job.
They wouldn't need
me to do that.
And I had a wife and young
children, and I like getting a
paycheck and being able to
feed and house them.
So, I took a look at the data
more carefully, and there are
a number of examples of
what it is that I'm
going to talk about.
But the most profound example
remains around the
great crash in 1929.
And if you had your whole
portfolio in small stocks at
the peak, by the end of 1929,
you would have lost 54% of
your money.
By the end of 1930, you would
have lost another 38% of your
money, by the end of 1931,
you would have
lost another 50% percent.
And by June of 1932, for good
measure, you would've lost
another 32%.
So, for every dollar that you
had at the peak, at the trough
you would have had $0.10 left.
And it doesn't matter, whether
you're an investor with the
strongest stomach known to
mankind, or you're an
institutional investor with the
longest investment horizon
imaginable, at some point, when
the dollars are turning
into dimes, you're going to
say, this is a completely
ridiculous thing to accept this
much risk in the portfolio.
I can't stand it.
I'm selling all my small stocks
and I'm going to buy
Treasury bonds or
Treasury bills.
And that's exactly
what people did.
And there was this sense in the
1930s, 1940s, even into
the '50s and '60s, that heavy
equity exposures weren't a
responsible thing
for a fiduciary.
When I was writing my book, I
was fooling around looking at
articles from the Saturday
Evening Post -- and I know
everybody here is too young to
have seen the Saturday Evening
Post when it was still
publishing, but you've all
seen Norman Rockwell
prints, right?
Well, he was famous for doing
covers for the Saturday
Evening Post. And there was this
article in the 1930s --
that's actually before my time,
so I was looking at
things in the library, not
things that actually had been
delivered to my doorstep --
and the commentator said that it
was ridiculous that stocks
were called securities.
That they were so risky that
we should call stocks
insecurities.
There was just this visceral
dislike for the risks that
were associated with the stock
market, because it had caused
so many investors
so much pain.
So yes, stocks are a great thing
for investors with long
time horizons, but you need to
diversify, because you've got
to be able to live through
those inevitable periods,
where risky assets produce
results that are sometimes so
bad as to be frightening.
Second source of return,
market timing.
A few years ago, a group of
former colleagues of mine gave
me a party at the Yale Club, and
they presented me with a
copy of Keynes's General
Theory --
because back, when I used to
teach a big finance class like
this, the last class always
involved reading from Keynes.
And I think Keynes is one of
the best authors about
investing and financial
markets, bar none.
I remember one of my students
telling me afterwards, that I
was reading from Keynes as if I
were reading from the Bible.
And I had this paperback copy
that was falling apart, and my
former students remembered this
and they gave me this
beautiful first edition
of Keynes.
And I was on the train back from
New York, where the party
had occurred, to New Haven
and I found this quote.
"The idea of wholesale shifts
is, for various reasons,
impracticable and indeed
undesirable.
Most of those who attempt to,
sell too late and buy too late
and do both too often, incurring
heavy expenses" --
there's that negative-sum game
thing -- "and developing too
unsettled and speculative a
state of mind." And as, in
most things, the data support
Keynes's conclusions.
Morningstar did a study of all
of the mutual funds in the
U.S. domestic equity market,
and there were 17
categories of funds.
And what they did with this
study is, they looked at 10
years of returns and compared
dollar-weighted returns to
time-weighted returns.
The time-weighted returns are
simply the returns that are
generated year in
and year out.
If you get an offering
memorandum or a prospectus,
they'll show you the
time-weighted return.
If you look at the
advertisements, where Fidelity
is touting its latest, greatest
funds, the returns
that you see are time-weighted
returns.
Dollar-weighted returns take
into account cash flow.
So, in a dollar-weighted return,
if investors put more
money into the fund in a
particular year, that year's
return will have a greater
weight in the calculation.
So, here we have all the mutual
funds in the U.S., 17
categories, time-weighted
versus dollar-weighted.
In every one of those
categories, the
dollar-weighted returns
were less than the
time-weighted returns.
What does that mean?
That means, that investors
systematically made perverse
decisions, as to when to invest
and when to disinvest
from mutual funds.
What investors were doing, they
were buying in after a
fund had showed strong relative
performance and
selling after a fund had shown
poor relative performance.
So, they were systematically
buying high and selling low,
and it doesn't matter whether
you do that with great
enthusiasm and in great volume,
it's a really, really
bad way to make money.
Very difficult.
So, the conclusion for these
individuals that operate in
the mutual fund market is that
their market timing decisions
were systematically perverse.
I also took a look at the top
10 internet funds during the
tech bubble, something I
published in my book for
individual investors.
And if you looked at the top 10
internet funds three years
before and three years after the
bubble, the time weighted
return was 1.5% per year.
You look at that and you say,
1.5% per year, well, the
market went way up and way
down, but 1.5% per year,
that's not so bad.
No harm, no foul.
Investors invested $13.7 billion
and lost $9.9 billion,
so they lost 72% of what
they invested.
How could it be that they lost
72% of the money that they
invested, when the time-weighted
return was 1.5%
per year for six years?
Well, they weren't invested in
the internet funds in '97, and
they weren't invested in
'98, and they weren't
invested in early '99.
It was in late '99 and early
2000, that all the money piled
in at the very top.
And then, in 2001 and
2002, bitterly
disappointed, they sold.
So, they lost 72% of what they
put in, even though the
time-weighted returns were
1.5% per year positive.
So, institutions don't get
a free pass either.
If you look at the crash in
October, 1987, which was an
extraordinary event --
I think, the calculation I did
put it at a 25 standard
deviation, which is essentially
an impossibility.
But however you measure it, it
was an extraordinary event.
And what happened on
October 19, 1987?
Well, stock markets the
world around went down
by more than 20%.
What people forget is, along
with the stock markets going
down, there was a huge
rally in government
bonds, flight to safety.
So, stocks were cheaper, bonds
were more expensive.
What did institutional
investors do?
Well, they got scared,
and they sold
stocks and bought bonds.
Same thing, buying high
and selling low.
As a matter of fact, endowments
took six years to
get their post-crash equity
allocations back up to where
they were before the crash,
arguably underweighted in
equities in the heart of one of
the greatest bull markets
of all time.
So, the teams of investors,
whether they're individual or
institutional, have this
perverse predilection to
chasing performance.
Buying something after it's
gone up, selling something
after it's gone down, and using
market timing to damage
portfolio returns.
The final tool that we have
available to us as investors
is security selection.
I cite a study in my book,
''Unconventional Success,''
conducted by Rob Arnott, that
does a very good job of
looking at 20 years worth
of mutual fund returns.
And he says that there's about
a 14% chance that -- or
historically there was a 14%
chance -- of beating the
market after adjusting
for fees and taxes.
So, you think a zero-sum game
would be a coin flip, 50-50.
But because of the leakages from
the system, and because
of taxes, the probability of
winning goes down to 14%.
But oh by the way, that
14% ignores two
very important things.
One is that a huge percentage
of mutual funds
have front-end loads.
If you call your friendly broker
to buy a mutual fund,
they'll extract a payment of
2% or 3% or 4% or 5% or 6%.
Those numbers aren't included,
so, if you included the loads,
that would make the likelihood
of winning
substantially less than 14%.
But even more important is the
concept of survivorship bias.
If you look at 20 years worth
of returns, the only returns
you can look at are the returns
of the funds that
survived for 20 years.
Well, which funds
didn't survive?
Almost always, the
funds that don't
survive are the failures.
So, you're only looking
at the winners.
If you look at the winners and
you only have a 14% chance, if
you take into account the
losers, that 14% chance has to
go to, essentially, zero.
And is survivorship bias an
important phenomenon?
It is.
The Center for Research in
Securities Prices has a
survivorship bias-free U.S.
mutual fund database, meaning
that it tracks the
funds that fail.
There were 30,361 funds
in the database.
19,129 were living.
11,232 were dead.
So, more than a third of the
funds in this survivorship
bias-free database were
ones that had died.
And they died mostly,
because they failed.
And that's kind of an honorable
way to die.
There are other ways to die.
If you're a big mutual fund
complex like Fidelity and
you've got an underperforming
fund, what you tend to do is
something like, oh, let's merge
that into this fund that
has good performance.
And guess what happens?
Fidelity loses a fund that has
bad performance, and one that
has good performance has more
assets, because they merge the
underperforming fund into it,
and makes them look like
they're a more successful
fund management firm.
There's one other aspect of
security selection that's
important, an aspect other
than the fact that it's a
negative-sum game that's
very tough for
practitioners to win.
And that has to do with the
degree of opportunity that
you've got in various
asset classes.
A number of years ago, I wanted
to come up with a way
of identifying, in an analytical
manner, where it is
that we could find the most
attractive investment
opportunities.
And, as far as I know, financial
economists haven't
determined a way to directly
measure, how efficient
individual markets are.
So, I took a look at
distributions of returns for
various asset classes.
And I had this notion that,
if a market priced assets
efficiently, the distribution
of returns around the market
return would be very tight.
Why would that be?
Well, if somebody makes a big
bet in an efficient market, by
definition, whether that
succeeds or fails has to do
with more luck than sense.
Because the premise is, that
these assets are efficiently
priced, and you don't make a big
win on a big bet, unless
there's an inefficiency that
you're exploiting.
So, if you're making big bets
in an efficiently priced
market, you might win one year
and gather more assets, and
you might win another year and
gather more assets, but,
ultimately, your luck is
going to run out and
you're going to fail.
And then, people will fire
you, and you'll lose your
assets, and lose your
income stream.
So, the right thing to do in an
efficiently priced market
is to hug the benchmark.
People call it Closet
Indexing, look
like everybody else.
And we're human beings, we don't
like firing people and
we don't like admitting
we're wrong.
And so, if somebody has
market-like performance, and
maybe it's not all that
outstanding, say, OK fine,
we'll just continue with this
particular investment
strategy, even though it's not
doing great things, at least
it's not doing terrible
things.
On the other end of the
spectrum, maybe there's not
even a market that you
can match with
your investment strategy.
I mean, think about
venture capital.
I mean, how is it that you could
index venture capital?
You can't, that's a bunch of
private partnerships and a
bunch of idiosyncratic
enterprises.
And even if you wanted to, you
couldn't match the market.
So, you're forced to go out and
forge your own path, and
live and die by the decisions
that you make.
So, how does this thought piece
translate into real numbers?
So again, we're looking at 10
years worth of returns for
various asset classes.
I look at the difference between
the top quartile
manager and the bottom
quartile --
the difference between first and
third [correction: fourth]
quartile, you can use
any measure of
distribution that you want.
And in the bond market, which
is probably the most
efficiently priced of all
markets -- and the reason it's
most efficiently priced
is, because bonds
are just math, right?
You've got coupons, you've
got principal, you've got
probabilities of default, it's
the most easily analyzed of
all the assets in
which we invest.
The difference between top
quartile and bottom quartile
is 0.50% per annum.
Almost nothing.
All bond managers are jammed
together right in the heart of
the distribution, because if
they were out there making
crazy bets and generating
returns that were
fundamentally different from the
market, they'd be in that
category of, yes, sure, it's
great, when it works, but when
it doesn't, you're dead.
Large cap stocks, less
efficiently priced than bonds,
but still pretty efficiently
priced, two percentage points
per annum difference first to
third [correction: fourth]
quartile over 10 years.
Foreign stocks, less efficiently
priced than those
in the domestic markets,
four points per year.
Then you move into the hedge
fund world, the part of the
hedge fund world that we call
absolute return at Yale, 7.1
percentage points, first to
third [correction: fourth]
quartile.
Real estate, much less
efficiently priced than
marketable securities, 9.3
percentage points, top to
bottom quartile.
Leveraged buyouts, 13.7%
difference, top quartile to
bottom quartile.
And the venture capital, 43.2
percentage points difference,
top to bottom quartile.
So, the measure that we have
here of market inefficiency
points us toward spending our
time and energy trying to find
the best venture capital
managers, trying to find the
best leveraged buyout managers,
and spending far
less of our time and energy
trying to beat the bond market
or beat the stock market.
Because, even if you win there,
even if you end up in
the top quartile, you're not
adding an enormous amount of
value relative to what you would
have had, if you just
would have bought the market.
So, with that background, let's
revisit the criticisms
that Barron's leveled
at the Yale Model
and the Swensen Approach.
First of all, they talk about
diversification failing.
And the fact is that, in a
panic, only two things matter:
risk and safety.
And I saw this in 1987, saw it
in 1998 with the collapse of
Long Term Capital, and saw it in
2008 in a way that was even
more profound than
in '87 and '98.
Investors sold everything that
had risk associated with it to
buy U.S. Treasuries.
Safety was all that mattered.
And of course, in that narrow
window of time,
diversification does fail.
The only diversification that
would matter in that instance
is owning U.S. Treasuries.
But if you owned a substantial
amount of U.S. Treasury bonds
-- and what's a substantial
amount?
25%, 30%, 35% of
your portfolio.
Then, under normal
circumstances, under the
circumstances, in which we live
most of our lives, you're
paying a huge opportunity
cost.
So, you could have a portfolio
with 30% in U.S. Treasuries,
and year in and year out you
would pay this opportunity
cost. And then, when the crisis
comes, you can be happy
for six or 12 or 18 months, and
then you go back to paying
the opportunity cost. And I
would argue that, if you
expand your time horizon to a
sensible length of time, that
the strategy, where you hold
relatively little in the high
opportunity cost U.S.
Treasuries, is the best
strategy for a long-term
investor.
And there are those, who say
that, well, diversification
doesn't protect you in
times of crisis.
What does it matter?
Why would you want
to diversify?
Well, think about Japan.
If you were local Japanese
investor and you wanted to
have an equity bias in your
portfolio -- so, you owned
lots of Japanese stocks --
in 1989, at the end of the year,
the Nikkei closed at
about 38,000.
At the end of 2009, 20
years later, the
Nikkei closed at 10,500.
So, with your long time horizon
and equity bias in
your portfolio over
two decades, you
would have lost 73%.
So, diversification makes an
enormous amount of sense in
the long run, even if there are
occasional panics, where
you're disappointed that the
diversified approach that you
had to managing the portfolio
didn't produce results.
The second criticism,
overemphasis on alternatives.
Let's just look at the last
decade in Yale's portfolio.
Over the 10 years ended June
30, 2010, domestic equities
produced returns of negative
0.7% per year, bonds produced
returns of 5.9% per year.
Let's look at the alternatives,
as opposed to
domestic marketable
securities.
Private equity, 6.2% per year,
real estate, 6.9% per year,
absolute return, 11.1% per year,
timber, 12.1% per year,
and oil and gas,
24.7% per year.
I think the numbers speak
for themselves.
If you have a sensibly long
time horizon, these basic
principles of equity
orientation and
diversification make an enormous
amount of sense.
And if you look at the bottom
line, which is performance,
when I began managing Yale's
endowment in 1985, it was less
than $1 billion.
The amount that we distributed
to support Yale's operations
that year was $45
million dollars.
For the year ended June 30,
2010, the endowment stood at a
little bit above $16
billion dollars.
The amount that we distributed
to Yale's
operations was $1.1 billion.
So, an enormous positive
change over 25 years.
If you look at Yale's
performance over the last 10
years, it's still better
than that of any other
institutional investor,
8.9% per annum.
And that compares to an average
for colleges and
universities of about
4.0% per annum.
And that translates into $7.9
billion of added value,
relative to where we would have
been had we had average
returns over the
past 10 years.
And the comparable numbers for
20 years are Yale at 13.1% per
annum, again, the best record of
any institutional investor
in the United States.
Relative to an average for
colleges and universities of
8.8% per annum, and $12.1
billion of value added.
So, the slings and arrows
of outrageous fortune.
I would suggest that the
Barron's articles really took
far too short a time horizon.
And looking at Yale's
performance and then looking
at the Yale Model, which
emphasizes a portfolio that's
well diversified and has
a strong equity bias.
And I think if we were back in
this room five years or 10
years from now, we'll see that
the portfolio will continue to
produce the same kind of strong
long-run results as it
has for the past 10, 20 years.
With that, I'd love to answer
any questions that you might
have.
STUDENT: How is your job similar
or different to what a
hedge fund manager would do?
And what are the concerns that
an institutional investor has
to have, versus a personal
investor, a wealthy
individual?
PROFESSOR DAVID SWENSEN: So,
the fundamental difference
between what we would be doing
at Yale, as opposed to a hedge
fund manager, or a domestic
stock manager, or a buyout
manager, is that we're
essentially one step removed
from the security selection
process.
So, our job is to find the best
hedge fund managers, find
the best domestic equity
managers, find the best buyout
managers, and put together
partnerships that work for
them and work for
the university.
And it's a tricky thing to
do, because, in the funds
management world, there are
all sorts of issues with
respect to what economists
call the
principal-agent problem.
And we're principals for the
university engaging agents,
the hedge fund managers or the
buyout managers, and trying to
find ways to get those agents
to act primarily in the
university's interests, to get
rid of those agency issues.
And it's a challenge, but a
fascinating challenge, because
in doing this, you end up
meeting an enormous number of
incredibly intelligent,
engaged, thoughtful
individuals that are
involved in the
funds management business.
And it's a fabulous career, at
least from my perspective,
because I get to do this and
do it to benefit one of the
world's great institutions,
Yale.
In terms of differences between
individuals and
institutions, there's some
structural differences.
We don't pay taxes.
And taxes are an enormously
important determinant of
investment outcomes
for individuals.
As an individual, you want to
avoid paying taxes or defer
paying taxes, because taxes
are just a huge drag on
investment returns.
We don't have to worry about
that, by and large, in
managing Yale's portfolio.
Another very fundamental
difference has to do with the
resources that we
can bring to the
investment management problem.
Most individuals, and many
institutions, just don't have
the wherewithal, either the
background or the time, to
make high quality active
management decisions.
Markets are incredibly tough.
Beating those markets is an
incredibly difficult challenge.
And doing it, by spending a
couple of hours on a weekend
once a month, isn't
going to cut it.
And so at Yale, we've got
20, 21, 22 investment
professionals, who are
dedicating their careers to
trying to make these high
quality active management
decisions, so we can go out
and have a decent shot at
beating the domestic stock
market and the foreign stock
market, and putting together a
superior portfolio of venture
capital partnerships and
hedge fund managers.
And over the past five, 10, 15,
20 years, we've produced
market-beating results.
In contrast, an individual has
almost no chance of beating
the market.
So I've written two books,
one, Pioneering Portfolio
Management that talks about
how it is that, I think,
institutions should manage
their portfolio.
And if they've got the resources
-- and it's not just
dollars, it's the human
resources --
to make those high quality
decisions.
They can follow what Barron's
referred to as the Yale Model
or the Swensen Approach.
But the book that I've written
ostensibly for individuals,
but it's really individuals and
institutions that don't
have the same resources that
Yale does to make these high
quality active decisions.
That book says, basically, what
you should do, is come up
with a sensible asset allocation
policy, and, then,
implement it using index funds,
which are low-cost ways
of mimicking the market.
And oh, by the way, because they
have very low turnover,
generate very little in terms
of tax consequences for the
holders of those funds.
So, it's kind of an interesting
world, where the
right solution is either one
extreme or the other extreme.
You're either completely
passive or you're
aggressively active.
But as in most things, most
people are kind of in the
middle, right?
They're neither aggressively
active nor completely passive,
but in the middle you lose.
Because you end up paying high
fees for mediocre active
results, and that's where most
people end up, and most
institutions.
STUDENT: Hi, so, my question
is about -- given you were
talking about your equity
orientation and bias, and
given what's going on right
now with the stock market,
just what your views are.
Whether or not the stock market
is currently expensive,
and whether or not you have any
money in tech stocks, with
all the valuations and
IPOs that have been
going in that space.
What do you think about that?
And also, what would you do in
terms of investing it in
response to what your view is?
Thank you.
PROFESSOR DAVID SWENSEN: So, one
of the great things about
having a diversified portfolio
is that you can worry less
about the relative level of
valuation of various assets in
which you invest. So, if you
go back to the mid-'80s and
you've got a portfolio that's
50% in domestic stocks, you
have to worry a lot about the
valuation of that portfolio,
because half of your
assets are in that
single asset class.
But if you've got a
well-diversified portfolio
with, let's say, minimum
allocation of 5% to 10%, and
now a maximum allocation of 25%
to 30% in an individual
asset class, the relative
valuation of each of those
asset classes matters less.
And there's another
nice aspect to
a rebalancing policy.
If you set up your targets and
you faithfully adhere to
those targets --
Suppose, the domestic equities
have poor relative
performance.
Well, then you're going to buy
domestic equities to get them
back up to target, selling
whatever it is that had
superior relative performance
to fund those purchases.
And vice versa.
If domestic equities have great
relative performance,
you'll be selling to get back
to your long-term target and
buying other assets that have
shown poor relative
performance.
So, if you're in a circumstance,
where domestic
stocks are expensive, where
you're selling into this
superior relative performance
that the domestic equities are
exhibiting, thereby maintaining
your risk exposure
at a level that's consistent
with what's implicit in your
policy asset allocation.
So, that's kind of a long way
of saying, that, if somebody
asked me whether stocks are
expensive or cheap, my first
line of defense, it doesn't
really matter all that much to
me, because we're
well-diversified and because
we do a great job
of rebalancing.
But the reality is that those
questions are just incredibly
tough to answer.
If they were easier to answer,
I guess I'd be much more
excited about market timing as
a way to generate returns.
In terms of the second question,
with respect to
technology, Yale's had a
long-standing commitment to
venture capital.
And over the decades, it's
produced extraordinary returns
for the university.
And we continue to have a
world-class group of venture
capitalists.
We've got exposure to companies
like LinkedIn and
Facebook and Groupon.
And I hope that this wave of
IPOs that people are writing
about in the press actually
occurs, because that would be
very good for the university's
portfolio.
It's been a long time, right?
We benefited enormously in the
internet bubble in the late
90s, and the last decade
has been a bit fallow.
We also find, on the marketable
securities side,
that technology stocks tend to
be less efficiently priced
than many other securities.
And so, we have a manager that
is heavily focused on
information technology stocks
and another manager that's
very heavily focused on
biotechnology stocks.
And both those managers have
produced very handsome
absolute and relative returns.
And that's an important
part of our
domestic equity strategy.
STUDENT: Thanks for coming.
So, in recent years, the number
of hedge funds, private
equity firms, has gone up.
And I wasn't sure, how that's
changed the efficiencies of
these alternative asset
allocation markets.
And if it's changed the
efficiencies, how have you
changed your investment
philosophies?
And I was wondering, also,
what are the structural
patterns of these markets that
would prevent the market from
becoming very efficient, even if
there are a lot hedge funds
and a lot of funds of funds.
Thanks.
PROFESSOR DAVID SWENSEN: That's
a really good question.
I think, the most fundamental
issue with the explosion of
hedge funds and the explosion of
private equity funds has to
do with this negative-sum game
that we were talking about.
If you go back to the 1950s,
the most common way that
institutional assets were
managed would be for an
institution like Yale
to go to a bank like
Chemical Bank or JP Morgan.
And they would pay a small
fraction of 1% for a
reasonably diversified
portfolio, stocks, bonds, and
there'd probably be some foreign
stocks, and some
domestic stocks.
But the leakage from the
system was very small.
You look at hedge funds and
private equity funds, they're
essentially dealing with the
same set of securities that an
institution used to pay two
tenths of a percent a year, or
three tenths of a percent a
year for admittedly sleepy
bank management.
But it's the same set
of securities.
Now, those securities are traded
in a hedge fund format,
or taken in a private
equity fund format.
And the fees that you are paying
are a point, a point
and a half, two points.
The typical ''two and 20.''
And you're paying a
significant percentage
of the profits.
The 20 in the ''two and 20.''
Think about that.
The leakage from the system that
goes to Wall Street is
enormous, compared to what it
was 10 years ago, or 20 years
ago, or 30 years ago.
So, there's that much less
left for us as investors.
And I think that has huge
consequences for endowments,
foundations, pension plans,
institutions of all stripes.
And to the extent that
individuals get exposure to
these types of assets -- and
they're largely wealthy
individuals that end up getting
the exposure --
they're going to suffer the same
consequences of this huge
leakage of higher fees
and the profits
interest to Wall Street.
The question as to whether or
not the money flowing to hedge
funds is going to make the
markets more efficient and
take away opportunities --
I don't worry too
much about that.
I think, the best talent is
going to hedge funds, because
if they're in a long only
domestic equity environment,
maybe they can charge three
quarters of a percent or a
percent, or if they're in the
mutual fund world, maybe they
charge a percent and a half,
or something like that.
Well, you'd rather have ''two
and 20'' than 0.75, right?
That's easy.
So, there's a huge migration
of talent to
the hedge fund world.
But what I care about, when
I look at the degree of
investment opportunities, is
this dispersion we talked
about, and I haven't seen the
dispersion of results, top
quartile to bottom quartile,
compress at all.
So, I don't think, that we're
increasing the efficiency of
the pricing of assets.
I still need to go out there and
be able to identify people
in the top quartile or top
decile, so that we can win
relative to the markets, after
adjustment for the
risk that we take.
So, as long as we have plenty of
dispersion in the results,
it's still an interesting
activity for us to pursue.
STUDENT: Can I ask?
PROFESSOR DAVID SWENSEN:
It better be good,
it's the last question.
STUDENT: I'll try.
So, my question is about
performance of the Yale
portfolio, and we heard that
it grew from less than $1
billion -- but close to
it, apparently --
in 1985, to $16 billion, which
is very impressive.
And it's documented in
newspapers, it's online,
Wikipedia, Professor
Shiller introduced
you with these facts.
But what about the
Sharpe ratio?
And why do you think that people
talk more about total
returns than, say,
the Sharpe ratio?
PROFESSOR DAVID SWENSEN: So, I
think that one of the things
that needs to happen in the
funds management world is,
that we need to have better
measures of risk.
And so, one of the reasons,
why I don't talk about the
Sharpe ratio, is, that just
looking at standard deviation
of returns doesn't capture
risk in a way that is
meaningful.
I mean, I've seen other people
do an analysis of the Yale
portfolio, and show relative
Sharpe ratios.
And, obviously, because our
returns have been so good, if
you just look at the pattern
of those returns, we end up
scoring high when looking at
Sharpe ratios across different
institutional portfolios.
But the risks that exist in the
portfolio aren't really
captured by the standard
deviation of the returns.
Just a quick example: If you
look at real estate, or
timber, or even any of our
illiquid assets, they're
appraised relatively
infrequently.
There tends to be a huge
stability bias in the
appraisals.
If somebody looks at a piece of
real estate 12 months ago,
six months ago, and today,
they're likely to see pretty
much the same thing that they
saw over that period.
You can compare and contrast
that to the volatility they've
got in the stock market.
I think Bob Shiller deserves
credit for coining the term
"excess volatility." There's no
question that stock prices
are way more variable than they
need to be to adjust for
changes in the underlying
fundamentals.
So, if you've got a portfolio
that's largely marketable
securities, you're going to
see a lot more standard
deviation of returns than if
you've got one of illiquid
assets, where you've got this
stability built in because of
the appraisal nature of
the valuation process.
And if you end up comparing
those two portfolios, one
dominated by marketable
securities, one dominated by
private assets, you're going to
end up with measures that
are apples and oranges.
Thank you very much.
[APPLAUSE]
