David Swensen

David Frederick Swensen (January 26, 1954 – May 5, 2021) was an American endowment fund manager, who was chief investment officer at Yale University from 1985 until his death in May 2021. Quotes Pioneering Portfolio Management (second edition, 2009) Introduction When I wrote my second book, Unconventional Success, I characterized its message as “a sensible investment framework for individuals,” in contrast to the institutional focus of Pioneering Portfolio Management. I erred in describing my target audiences. In fact, I have come to believe that the most important distinction in the investment world does not separate individuals and institutions; the most important distinction divides those investors with the ability to make high quality active management decisions from those investors without active management expertise. Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong decision-making process can investors sell mania-induced excess and buy despair-driven value. Most asset classes contain investment vehicles exhibiting some degree of agency risk, with corporate bonds representing an extreme case. Structural issues render corporate bonds hopelessly flawed as a portfolio alternative. Shareholder interests, with which company management generally identifies, diverge so dramatically from the goals of bondholders that lenders to companies must expect to end up on the wrong side of nearly every conflict. active management strategies demand uninstitutional behavior from institutions Investment and Spending Goals Harvard articulated a goal of accumulating sufficient new capital gifts to offset the difference between the general inflation rate and university expense growth. In so doing, the university explicitly employed new gifts to replenish inflationary losses. Unfortunately, the excess of university inflation over general price inflation may well consume any incremental returns from TIPS, providing almost no real return to the institution... Lack of productivity gains in education accounts for the greater inflation in academic costs. the distinction between current income and capital appreciation proves too easily manipulated to provide a sound foundation for spending policy. In desiring to supply a stable flow of operating income, hoping to exist forever and wishing to comply with minimum IRS distribution requirements, foundation fiduciaries face a fundamentally conflicting set of goals. Simulations show that in 1970, if a traditional portfolio followed a stable spending policy, more than 60 percent of the purchasing power of a fund evaporated by the end of the decade... By spending at unsustainably high rates, purchasing power of assets declined dramatically, dropping more than 40 percent during the 1970s. Successful investors articulate coherent investment philosophies, consistently applied to all aspects of the portfolio management process. Investment Philosophy Investment returns stem from decisions regarding three tools of portfolio management: asset allocation, market timing, and security selection. Typical institutional asset classes include domestic equities, foreign equities, fixed income, absolute return, real assets, and private equities. Market timing consists of short-run deviation from the long-term policy targets. The authors note that “[o]n average, policy accounted for a little more than all of total return,” implying that security selection and market timing make no material contribution to returns. By choosing to place asset allocation at the center of the investment process, investors ground the decision-making framework on the stable foundation of long-term policy actions. Because such activity lowers anticipated returns, market timers must succeed substantially more than 50 percent of the time to post a winning record. The wind in the speculator’s face, combined with transactions costs and market impact, provide a high hurdle for those who would beat the market by holding abnormally high cash positions. In less efficient markets, active management produces potentially sizable rewards. In fact, passive replication of benchmark returns proves impossible in private markets, such as venture capital, leveraged buyouts, real estate, timber, and oil and gas. Even were the market return obtainable, investors would almost certainly prefer to pursue more selective approaches. When examined over reasonably long periods of time, in aggregate, illiquid asset classes generally produce mediocre returns relative to less risky marketable security alternatives. Intelligent acceptance of illiquidity, and a value orientation, constitutes a sensible, conservative approach to portfolio management. Security selection decisions, while extremely difficult to execute with consistent success, contain the potential to add value to portfolio returns. Investors enhance opportunity for beating the market by pursuing excess returns where the degree of opportunity appears largest, by accepting reasonable degrees of illiquidity, and by maintaining a value orientation. Sensible investors approach markets with a strong equity bias, since accepting the risk of owning equities rewards long-term investors with higher returns... the tension between the conflicting goals of preserving assets and spending for operations can be relaxed only by increasing investment returns. The low return of Treasury bills should not come as a surprise. On at least two measures Treasury bills have been close to risk free. Investors face virtually no credit exposure, as the U.S. government represents, perhaps, the most creditworthy entity in the world. In addition, Treasury bills have provided a hedge against inflation, with returns that closely track price increases. The price of these attractive characteristics has been an extremely low real return. Thus, at least with twenty-twenty hindsight, Treasury bills would not have been an appropriate investment for an institution investing to earn substantial after-inflation returns. gold “bugs” will be disappointed to learn that their favorite precious metal returned a multiple of only 27 [from 1925 to 2005], trailing by a large margin the returns of low risk Treasury bills and only modestly exceeding the 16-fold impact of inflation. One study suggests that “…the 5 percent real capital appreciation return on U.S. stocks is exceptional, as other markets have typically returned 3 percent less than U.S. equities.” Were this conclusion to influence expectations for long-run equity returns, the case for stock investments becomes considerably less compelling. Even though market return studies indicate that high levels of equity market exposure benefit long-term investors, the associated risks come through less clearly. Significant concentration in a single asset class poses extraordinary risk to portfolio assets. Fortunately, diversification provides investors with a powerful risk management tool. By combining assets that vary in response to forces that drive markets, investors create more efficient portfolios. At a given risk level, properly diversified portfolios provide higher returns than less well diversified portfolios. Conversely, through appropriate diversification, a given level of returns can be achieved at lower risk. Harry Markowitz, pioneer of modern portfolio theory, maintains that portfolio diversification provides investors with a “free lunch,” since risk can be reduced without sacrificing expected return. Of the fifteen largest foundations in the United States, two (the Lilly Endowment and the Starr Foundation) hold nearly all assets in a single stock, another (the Robert Wood Johnson Foundation) holds well over half of assets in a single stock, and yet another (the Annie E. Casey Foundation) holds over a quarter of assets in a single stock. Oblivious to the measure of good fortune that contributed to the undiversified portfolio’s rise to the top of the charts, trustees use past success to justify continuing to concentrate assets in one security. True diversification requires owning assets that respond differently to fundamental forces that drive markets. If these asset classes provide high equity-like returns in a pattern that differs from the return pattern of the core asset (U.S. domestic equities), investors create portfolios that offer both high returns and diversification. Although on an asset-specific basis, higher expected returns apparently come with the price of higher expected volatility, the lack of correlation between individually risky asset classes actually reduces overall portfolio risk. Diversification represents “a free lunch” that allows investors to reduce risk without sacrificing expected returns. Market timing, defined as a short-term bet against long-term policy targets, requires being right in the short run about factors that are impossible to predict in the short run. Yet investors can reasonably deal with the important drivers of returns in the long run as short-term anomalies disappear into predictable long-term patterns. Sensible investors avoid concentrated bets against the institution’s adopted asset allocation, thereby eliminating the risk of inflicting serious damage by holding a portfolio inconsistent with long-term objectives. This valuation-based technique worked well until 1958, when stock yields last exceeded bond yields. After the October 1987 crash, portfolio stability disappeared as market forces drove down allocations to stocks and pushed up allocations to bonds. Responding to the collapse in stock prices with fear, the average endowment manager exacerbated the market-induced dislocation by selling stocks. Reacting to the rally in high quality bond prices with greed, the average endowment manager enhanced the market-induced increases by purchasing more bonds. From June 1987 to June 1988, equity holdings declined from 55.3 percent to 49.1 percent, more than can be explained by the market drop during the year. Roughly offsetting the equity decline, fixed income increased from 36.7 percent to 41.9 percent, more than can be explained by the market rally. In retrospect, educational institutions bought high and sold low, following a poor recipe for investment success. price volatility creates opportunity only when prices change more than necessary to reflect changes in underlying fundamentals. real-time [daily] rebalancing tends to cost less, as trades generally prove accommodating to the market. Frequent rebalancers buy in the face of immediate declines and sell in the face of immediate increases, in both cases supplying liquidity for traders pursuing the opposite, predominant tack... The university’s endowment enjoys tax-exempt status, allowing frequent trading without adverse tax consequences associated with realization of gains... As a matter of course, at the beginning of every trading day Yale estimates the value of each of the components of the endowment. When marketable securities asset classes (domestic equity, foreign developed equity, emerging market equity, and fixed income) deviate from target allocation levels, the university’s investments office takes steps to restore allocations to target levels. In fiscal year 2003, Yale executed approximately $3.8 billion in domestic equity rebalancing trades, roughly evenly split between purchases and sales. Net profits from rebalancing amounted to approximately $26 million, representing a 1.6 percent incremental return on the $1.6 billion domestic equity portfolio. Even though rebalancing profits produce a nice bonus for investors, the fundamental motivation for rebalancing concerns adherence to long-term policy targets. The fundamental purpose of rebalancing lies in controlling risk, not enhancing return. In a sustained bull market, rebalancing appears to be a losing strategy, as investors constantly sell assets showing relative price strength. Years go by without reward, other than the knowledge that the portfolio embodies the desired risk/reward characteristics. The alternative of not rebalancing to policy targets causes portfolio managers to engage in a peculiar trend-following market timing strategy. Like many contrarian pursuits, rebalancing frequently appears foolish as momentum players reap short-term rewards from going with the flow. Regardless of potentially negative reputational consequences, serious investors maintain portfolio risk profiles through disciplined rebalancing policies, avoiding the sometimes expedient appeal of moving with market forces. Market timing explicitly moves the portfolio away from long-term policy targets, exposing the institution to avoidable risks. Because policy asset allocation provides the central means through which investors express return and risk preferences, serious investors attempt to minimize deviations from policy targets. To ensure that actual portfolios reflect desired risk and return characteristics, avoid market timing and embrace rebalancing activity to keep asset classes at targeted levels. While no market prices assets precisely at fair value all of the time, most markets price most assets with reasonable efficiency most of the time, providing few opportunities for easy gains. Moreover, active management costs increase the hurdle for success as active investors pay management fees, incur transactions costs, and create market impact. Intelligent investors approach active strategies with a healthy sense of skepticism. Sensible active managers favor markets with inefficiently priced assets and avoid those markets with efficiently priced assets. In those markets with limited opportunities for active management, managers deviate little from the market portfolio, leading to market-like returns... While overachievers may temporarily gain clients and gain assets (and gain public adulation), because efficient markets present no mispricings for active managers to exploit, good results stem from luck, not skill. Apparent success proves transitory for active managers in efficient markets. As a result, over time, managers in efficient markets gravitate toward “closet indexing,” structuring portfolios with only modest deviations from the market, ensuring both mediocrity and survival. In contrast, active managers in less efficient markets exhibit greater variability in returns. In fact, many private markets lack benchmarks for managers to “hug,” eliminating the problem of closet indexing. Inefficiencies in pricing allow managers with great skill to achieve great success, while unskilled managers post commensurately poor results. Hard work and intelligence reap rich rewards in an environment where superior information and deal flow provide an edge. High quality fixed income securities, arguably the most efficiently priced asset in the world, trade in markets dominated by savvy financial institutions... The spread between first and third quartile results for active fixed income managers measures an astonishingly small 0.5 percent per annum for the decade ending June 30, 2005. The radical break comes when moving from liquid public to illiquid private opportunities. Absolute return, real estate, leveraged buyouts, and venture capital exhibit dramatically broader dispersions of returns. For the ten-year period, absolute return shows a range of 7.1 percent between first and third quartiles, while real estate and leveraged buyouts exhibit even more extreme 9.2 percent and 13.7 percent per annum spreads. Venture capital captures the dispersion prize with a stunning 43.2 percent first-to-third quartile range. Selecting top quartile managers in private markets leads to much greater reward than in public markets... Ironically, identifying superior managers in the relatively inefficiently priced private markets proves less challenging than identifying skillful players in the efficiently priced marketable securities markets. With fee adjustments, the median active manager exceeds the benchmark by 0.5 percent per year. A first quartile manager adds real value, however, exceeding the benchmark by 1.4 percent per annum net of fees. The median small-capitalization manager beats the market by a scant 0.2 percent per annum. In contrast, a first quartile manager adds 2.3 percent per annum, reflecting the greater investment opportunity in less efficiently priced securities. Simple return numbers tend to overstate value added since early strong results, necessary to attract institutional interest, generally apply to relatively small amounts of money. As size is the enemy of performance, more established managers with greater funds under management tend to produce less eye-catching results... A dollar-weighted evaluation of active management would no doubt provide even less encouragement to those hoping to employ market-beating strategies. In the least efficient private markets, no passive alternative exists. Even were a passive alternative available, market-like results would likely disappoint. Serious managers who attempt to identify inefficiencies frequently gravitate toward relatively illiquid markets, since rewarding investments tend to reside in dark corners, not in the glare of floodlights. Such out-of-the-way, undiscovered opportunities receive little attention from Wall Street, which thrives on markets that generate large trading volumes. Examples of illiquid opportunities in marketable securities abound. In the realm of full faith and credit obligations of the U.S. government, otherwise identical bonds trade at different prices solely because market liquidity differs... Receiving a full percentage point in yield over Treasuries for simply bearing the illiquidity of a private placement raises serious questions about rationality of markets. Investors prize liquidity because it allows trading in and out of securities. Unfortunately, liquidity tends to evaporate when most needed. mindless contrarian investing poses dangers to portfolios. Sometimes popular companies deserve premium valuations. Sometimes out-of-favor companies deserve discounted valuations. Identifying out-of-favor assets serves as a starting point for serious investors, leading to further analysis. Only if careful analysis confirms expectations of superior future performance should investors purchase securities. Purchasing stocks with low price-to-earnings ratios or price-to-book ratios represents a naïve strategy. Value investors seek to purchase companies at a discount to fair value, not to purchase low growth or distressed assets 'per se''. When foolish clients of high quality managers destroy value by responding perversely to past performance, the already tough case for active management becomes tougher still. Asset Allocation The process of asset allocation illustrates the importance of combining art and science in investment decision making, as neither informed judgment nor quantitative analysis alone produces consistently successful results. Institutional portfolios require assets likely to generate equity-like returns, such as domestic and foreign equities, absolute return strategies, real assets, and private equities. To mitigate asset-class-specific risks, investors diversify aggressively, holding assets in proportions that allow the asset class to matter, but not matter too much. Committing less than 5 percent or 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Committing more than 25 percent or 30 percent to an asset class poses the danger of overconcentration. Most portfolios work well with around a half a dozen asset classes. Functional attributes play the dominant role in defining asset classes, with structural and legal characteristics taking secondary positions. Asset class distinctions rest on broad sweeping differences in fundamental character: debt versus equity, domestic versus foreign, inflation sensitive versus deflation sensitive, private versus public, liquid versus illiquid. Ultimately investors attempt to group like with like, creating relatively homogeneous groups of investments that provide fundamental building blocks for the portfolio construction process. Fixed income represents an interesting case. If investors want fixed income assets to provide a hedge against financial accidents, then only high quality, long-term, noncallable bonds satisfy the requirement. Although from a legal and structural perspective below-investment-grade bonds (a.k.a. junk bonds or high-yield bonds) belong to the fixed income family, they lack important crisis-hedging attributes. Junk bonds contain equity-like risks, as payments depend mightily on the financial health of the issuer. Even if the high-yield obligor meets contractual obligations, holders may lose bonds through a mandatory call, as lower interest rates or improved corporate health allow issuers to redeem bonds at a fixed price prior to maturity. Ironically, junk bondholders may lose if corporate prospects deteriorate or if they improve! In any case, below-investment-grade bonds provide little protection against a period of severe financial distress, since at a time of economic disruption high-yield bondholders might suffer from a corporate default. Treasury Inflation-Protected Securities have no place in a properly defined fixed income portfolio. Traditional fixed income assets respond to unanticipated inflation by declining in price, as the future stream of fixed payments becomes worth less. In contrast, inflation-indexed bonds respond to unexpected price increases by providing a higher return. When two assets respond in opposite fashion to the same critically important variable, those assets belong in different asset classes. Many investors include foreign bonds in portfolios as part of a broadly defined fixed income asset class or as a separate asset class. Neither choice makes fundamental sense. First, foreign bonds have no role in a fixed income portfolio designed to protect against deflation or financial trauma. Investors cannot know how foreign bonds might respond to a domestic financial crisis, since conditions overseas may differ from the environment at home. Moreover, foreign exchange translations influence returns in a substantial, unpredictable manner. Second, as a separate asset class, high quality foreign bonds hold little interest. The combination of low, bond-like expected returns and foreign exchange exposure negates any positive attributes associated with nondomestic fixed income. Careful investors define asset classes in terms of function, relating security characteristics to the role expected from a particular group of investments. In the case of fixed income, introduction of credit risk, call risk, and currency risk diminish disaster-hedging attributes. Yet in reaching for return or seeking an easy way to beat the benchmark, most institutional portfolios contain disproportionate allocations to bonds lacking the purity of U.S. Treasury obligations. The net result leads to a portfolio that meets neither the goal of producing equity-like returns nor the goal of protecting against market trauma. Judgment plays a critical role in defining and shaping asset classes. Unless the statistical analysis employed in the asset allocation process rests on reasonable asset class definitions, the resulting portfolio stands little chance of meeting institutional needs. Although using normal distributions facilitates implementation of mean-variance analysis, real-world security returns include significant nonnormal characteristics, limiting the value of the conclusions... Richard Bookstaber... states that a “general rule of thumb is that every financial market experiences one or more daily price moves of four standard deviations or more each year. And in any year, there is usually at least one market that has a daily move that is greater than ten standard deviations.” Mean-variance optimization defines return distributions completely in terms of expected return and risk. The framework fails to consider other important attributes, such as liquidity and marketability... Clearly, less marketable assets, such as private equity and real estate, cannot be rebalanced in a low cost, efficient manner... Another problem with mean-variance optimization relates to investor time horizon. In many cases, investors care about multiple objectives that span different time horizons. For instance, endowment managers seek intermediate-term spending stability even as they pursue long-term purchasing power preservation. A mean-variance time period of three to five years might serve the spending stability criterion, while a time period spanning decades might serve the purchasing power criterion. The almost universally employed one-year time period serves neither... Because the process involves materially simplifying assumptions, unconstrained asset allocation point estimates produced by mean-variance optimization represent simply a starting point for further work. Care must be taken, however, to avoid using asset class constraints simply to fashion a reasonable-looking portfolio. Taken to an extreme, placing too many constraints on the optimization process causes the model to do nothing other than to reflect the investor’s original biases... Alternatively, investors might identify superior, yet reasonable, portfolios by choosing from a set of portfolios that lay near (but perhaps not directly on) the efficient frontier. Mean-reverting behavior in security prices implies that periods of abnormally high returns follow periods of abnormally low returns, and vice versa. A global equity asset class fails to recognize the critical contribution that currency movements make to investment returns, while individual country asset classes create too many variables for reasonable analysis. Separating domestic equities from foreign allows investors to account for critical home country characteristics, particularly with respect to currency. A further distinction between developed and emerging markets groups assets with respect to important differentiating risk and return characteristics. absolute return managers attempt to produce equity-like returns uncorrelated to traditional marketable securities through investments in event-driven and value-driven strategies. Event-driven strategies, including merger arbitrage and distressed security investing, depend on the completion of a corporate finance transaction such as a merger or corporate restructuring. Value-driven strategies employ offsetting long and short positions to eliminate market exposure, relying on market recognition of mispricings to generate returns. Generally, absolute return investments involve transactions with relatively short time horizons, ranging from several months to a year or two. The real assets category includes real estate, oil and gas, and timberland, which share the common characteristics of sensitivity to inflationary forces, high and visible current cash flow, and opportunity to exploit inefficiencies. Real assets provide attractive return prospects, excellent portfolio diversification, and a hedge against unanticipated inflation. Despite important similarities, the three subasset classes differ from one another, showing only modest correlations, as supply of and demand for each depends on fundamentally different factors. For example, recent history indicates that oil and gas investments exhibit negative correlation to real estate and timber. Such diversification within real assets helps to produce steady returns through a variety of economic environments. Real estate provided extremely strong returns during the 1980s with relatively low volatility and relatively low correlation to traditional marketable securities. Not surprisingly, naïve application of mean-variance analysis led to recommendations of extraordinary allocations to real estate. Real estate contains characteristics of both debt and equity. The stream of contractual lease payments resembles fixed income, while the residual value shows equity-like characteristics. Hence, return and risk expectations logically flow from and fall between those for stocks and bonds. Similarities in factors driving valuations of real estate and traditional marketable securities lead to the conclusion that correlations might be expected to be positive, albeit less than one. When relying on historical data, after a bull market run, asset classes appear most attractive just when future prospects prove bleakest. Unfortunately, mean-variance optimization provides little useful guidance in choosing a particular point on the efficient frontier. Academics suggest specifying a utility function and choosing the portfolio at the point of tangency with the efficient frontier. Such advice proves useful only in the unlikely event that investors find it possible to articulate a utility function in which utility relates solely to the mean and variance of expected returns. Private assets, including venture capital, leveraged buyouts, real estate, timber, and oil and gas, which barely register among the broad group of educational institutions and account for less than 10 percent of assets, play an important role for the major endowments with an allocation of 40 percent. In spite of producing greater expected returns, large institution portfolio risk levels actually fall below risk estimates for the less well-diversified endowments. Employing rigorous quantitative portfolio analysis contributes to the construction of diversified, high-return portfolios. The use of simulations to test portfolios created through mean-variance optimization allows assessment of the effectiveness of investment and spending policies over appropriate time horizons. Employing the same capital markets assumptions used in mean-variance analysis, the simulations allow examination of longer time frames, consideration of interaction between spending and investment policies, and translation of statistical capital market and portfolio characteristics into relevant quantitative criteria for decision makers. Failure to achieve investment goals defines portfolio risk in the most fundamental way. Goals, and risks following therefrom, must be described in a manner allowing investment fiduciaries to understand trade-offs between various portfolios. By evaluating portfolios in terms of probabilities of maintaining purchasing power and providing stable spending streams, fiduciaries understand and choose among alternatives defined in the context of criteria directly relevant to institutional objectives. More serious problems stem from instability in the risk and covariance characteristics of asset classes. The tendency of markets for risky assets to move together in times of crisis reduces the value of diversification, at least in the short run. Lecture at Yale University (2011) 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. if you’ve got a long time horizon, you should be rewarded by accepting equity risks. So, if security selection and market timing are negative-sum games, then asset allocation would explain more than 100% of the returns. 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. 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. 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. 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. External links Category:Businesspeople from the United States Category:People from Iowa Category:Yale University alumni Category:Yale University faculty Category:Deaths from disease Category:1954 births Category:2021 deaths