6. Guest Speaker David Swensen

published on July 13, 2020

I already talked about our guests today but this is a David Swensen who remember I said he was the inventor of the swap which is a real claim to fame because swaps total in the hundreds of million trillion it's amazing I thought this was gonna be a polite introduction prodded

The swap thing but that was before the crisis well that's financial innovation I think swaps are 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 a billion less than 1 billion and as of June 2010 it's sixteen point seven billion uh and climbing and climbing okay and this is a financial crisis but between 2009 and 2010 the

Portfolio went up 14 billion so there's no crisis right here well there was a little hitch at one point but that kind of thing happens uh and David Swensen also I take pride in training young people in finance David

Swensen has done the same with many young people uh notably Andrew golden who heads the Princeton portfolio is one of your trainees and he's had a similarly almost as spectacular record as well but with that introduction I

Will turn it over to 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 that when you know 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 matter fact I I carry around this Barron's article that appeared in November 2008 and 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 lessen alternatives because the alternatives provided too little diversification and too little liquidity so I thought what we could do today is 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 amat or the Yale model and I think when it was successful it was the OU 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

Swanson approach or the Yale model and see whether indeed the criticisms that they levy that there's too little diversification and too 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 1st 1985 for those of you who care about April Fool's 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've been involved with structuring the first swap transaction in 1981 when I 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 there swap operations

And so generally what I was doing on on Wall Street was working with new financial technologies and being involved with the early days of swatched 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 the trades were incredibly profitable commodity swaps today traded 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 him about the the job I realized that my

Heart wasn't in Wall Street my heart was in the 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 a billion but close to a

Million 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 and what I saw was that colleges and universities had on average 50% of their portfolio in US stocks 40% of their portfolio in US bonds in 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 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 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 okay so if it goes back 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 Cole's Foundation has said that diversification is a free lunch right I mean didn't you learn in introductory economics and intermediate that there ain't no such thing as a free lunch that 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 return so diversification is this is this great thing it's a free lunch it's something that everybody should embrace well if

You look at the portfolio's that I saw in the world of endowment investing in the mid-1980s they weren't diversified right if you've got half of your assets in a single asset class US stocks and you have 90

Percent of your assets in us marketable securities you're not you're not diversified after your assets in a single asset class is way too much and the 90 percent that are in stocks and bonds under many circumstances will

Respond to the same driver of returns interest rates in the same way right lower interest rates mathematically are good for bonds and lower interest rates lowered the discount rate that you use to discount

Future earnings 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 in the short run will reward you in the in the long run so with a mission as a

Manager of an endowment to preserve the purchasing power of the portfolio and perpetuity I expected that other endowments would have substantial equity exposures to take advantage of the fact that in the 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 portfolio's that I saw when I got to Yale failed the basic common-sense tests 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 the tools that I have

To employ when I'm managing Yale's portfolio is an institutional investor and they're basically three things that you can do to effect your returns first of all you can decide what assets you're going to have in the portfolio and in

Which proportions you will 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 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 stocks 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 bat at 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 have to do with 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 of 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 bat's if you decide that you want to try and beat the market then that bad or that series of

Bets will define your returns attributable to security selection so if you decide that you think the the prospects are afford are superior to the prospects of GM well you want to overweight forward and underweight GM

And if that turns out to be a good bet and you're rewarded because Ford outperforms in 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 right because if you've over weighted Ford and under weighted GM there has to be some other investor or

Group of investors that are underweight forward and overweight GM because this is all relative to the market and so if you're overweight forward and underweight GM and somebody else is under weight forward and overweight GM

At the end of the day the amount by which the winner wins equal the amount by which the loser loses and so it's a zero-sum game but of course if you take into account the fact that it costs money to play the game it turns

Into a negative sum gain and the negative sum is the amount that siphoned off by Wall Street right and Wall Street takes its pound of flesh in the form of market impact and in the form of commissions in the form of fees that are

Charged to manage the portfolio actively and then sometimes they're even fees to consultants to choose the managers 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 that decide to play let's take these in turn and start out with asset allocation the state allocation is far and away the most important tool that we have available to us as investors and 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 is the most important tool because it seemed 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 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 go back I could take Yale's 17 or 18 billion dollars and put it all in Google stock now if I did that I'm not sure how long

I'd keep my job it might be fun for a while but but they 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

Right 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 like sell everything and put it all in 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 returns security selection would probably have very little to say about Yale's returns it would all be about market timing ability

And if I'm graded yeah following the trend the trend is your friend of course that's true until it's not or I've got some sort of you know marvelous scheme to outsmart all the other smart people who are trading in

The bond market that could generate some nice returns but those returns would have nothing to do with asset allocation nothing to do with security selection everything to do with market timing of course these sound like ridiculous

Things right I mean everybody in this room knows and I'm not going to go back and put Yale's entire endowment in one stock and they also know that I'm not going to go back and day trade futures with the 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 in the month before that and the year before that because as investors whether we're individual investors or 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 you know 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 percent of the variability of returns and institutional portfolios had to do with the asset allocation decision and that 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 a hundred percent of investor

Returns now how could how could that be how could asset allocation determine more than a hundred percent 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 is true of market timing right if somebody is over weighting 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 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 are negative some games then asset allocation would explain more than a hundred percent of the returns and on

Average for the community as a whole because investors do engage in market I mean investors do engage in security selection those are going to be negative some 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 Roberts ins data he's got this publication called stocks bonds bills and inflation although I think he

Might have sold it to Morningstar so maybe it's morning stars 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

Investment reinvesting it and seeing where you end up at the end of the period and we've got here are the numbers from 1925 to 2009 if you did that with Treasury bills which are short-term loans to the US government

One of the least risky assets imaginable you would have ended up with 21 times your money over the period anything 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 of the portfolio well 21 times but taking

Off 12 times for inflation and that's 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 accept more risk you should get higher returns and so if you move out 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 whatever 21 times four bills it's still not a huge return for decades and decades of investing so what happens if you move away from lending money and 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 have ended up with

Two thousand five hundred and ninety two times your money that's stunning I mean that's like way more than eighty six times and way more than 21 times so over long periods of time you do being rewarded for accepting equity risk

And what would have happened if you would have put the money in small stocks and let her run twelve thousand two hundred and twenty six times your money so the conclusion is pretty obvious this is this notion that if you've got a long

Time horizon you want to expose your portfolio to equities 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 and in finance and I was preparing the the the lecture that had to do with and long-term investment philosophy and that's when I first saw these numbers and I was a little bit

Disconcerted when I put them together because I thought gee twenty-one times four bills eighty-six times four bonds twelve thousand two hundred and twenty six 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 if that were true what was I going to say for the next ten weeks of lectures my longer-term problem was if the

Investment committee figured out that all we needed to do was 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'd had your whole portfolio in small stocks at the peak by the end of 1929 you would have lost 54 percent of your money by the end of 1930 you would have lost

38% of your money another 38% that is by the end of 1931 you would have lost another 50% and by June of 1932 for good measure you would have lost another 32% so for every dollar that you had at the peak at the

Trough you would have had 10 cents 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 they'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 going to buy Treasury bonds or

Treasury bills right 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 seen The Saturday Evening Post when it was 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 and the commentator said that it was ridiculous that stocks were called securities that they were so risky that we should call stocks in securities I did there was just this visceral dislike

For the risks that were associated with the with the stock market because it had caused so many investors so much pain so yes stocks are a great thing for investors with 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 as to be frightening second source of return Marton 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 when I used to teach a big finance class like this the last class always involved reading from

Keynes and I think Keynes one of the best authors about investing in 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 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 in Korean 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 morning started a study of all of the mutual funds in the us domestic equity

Market and there were 17 categories of and what they did with this study is they looked at 10 years of returns and compared dollar-weighted returns the time-weighted returns the time-weighted returns are simply the returns that are

Generated urine and you're out if you get an offering memorandum or 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

Our time-weighted returns dollar-weighted returns take into account cash flows alright so in a dollar weighted return if investors put more money into the fund in a particular year that yours return will have a

Greater weight in the calculation so here we have all the mutual funds in the us 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 a 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 that's something I published in my book for individual investors and if you looked at the top 10 internet funds 3 years before in 3 years after the bubble the I'm weighted return was one-and-a-half

Percent per year look at that you say one half percent per year well the market went way up and way down but I wouldn't have percent per year that's not so bad no harm no foul investors invested 137 billion and lost

Nine point nine billions so they lost 72 percent of what they invested how could it be that they lost 72 percent of the money that they invested when the time-weighted return was one and a half percent 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 percent of what they put in even though the time-weighted returns were one-and-a-half percent 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 you know I think the calculation I did put it at a 25 standard deviation event which isn't essentially an impossibility but however you measure it was an extraordinary event and what

Happened on October 19th 1987 both stock markets the world around went down by more than 20 percent when people forget is along with the stock market's 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 that got scared and they sold stocks and bought bonds same thing buying high 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 inequities in the heart of one of the greatest bull markets of of all time so it seems that

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 looking at 20 years worth of mutual fund

Returns and he says that there's about a 14 percent chance that or there historically there was a 14 percent chance of beating the market after adjusting for fees and taxes so you'd think is 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 percent but oh by the way that 14 percent 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 two or three or four or five or six percent those numbers aren't included so if you included the loads that would

Make the likelihood of winning substantially less than 14 percent but even more important is a concept of survivorship bias if you look at twenty years worth of returns the only returns that you can look at are the returns of

The funds that survive for twenty 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 if you look at the winners and you only have a 14 percent

Chance if you take into account the the losers that 14% chance has to go to essentially zero and as survivorship bias an important phenomenon it is the Center for Research on securities prices has a survivorship bias free us mutual

Fund database meaning that it tracks the the funds that fail there were thirty thousand three hundred and sixty one funds in the database nineteen thousand one hundred and twenty nine were living eleven thousand two

Hundred and thirty two were dead it's almost a or more 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 big mutual fund complex like fidelity you've got an underperforming fund what you tend to do is something like well 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 very tough for practitioners to 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

Asset sufficiently the distribution of returns around the market return would be very tight now why would that be well if somebody makes a big bet in an efficient market by definition whether that bet succeeds or fails has to do

With more more luck than sense right 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's going to run out and you're going to fail and then people will fire

You and you 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 you know we're human beings we don't

Like firing people and we don't like admitting we're wrong and so if somebody has kind of market like performance and maybe it's not all that outstanding say okay fine we'll just continue with this particular investment strategy even

Though it's not 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 right I

Mean how is it that you could index venture capital you can't it's a bunch of private partnerships and a bunch of idiots and kradic 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 kind of thought piece translate into real numbers so again we're looking at ten years worth of returns for various asset classes I look

At the difference between the top quartile manager in the bottom quartile you know difference between first and third quartile you could 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 got coupons you've got principal you've got probabilities that default it's the most easily analyzed of all the assets

In which we invest the difference between top quartile and bottom quartile is a half a percent per annum almost nothing all bond managers are jammed together right in the heart of the distribution because you know 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 yeah 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 the third quartile over ten years foreign stocks less efficiently priced than those in the domestic markets four

Points per year then you move into the hedge fund world a part of the hedge fund world that we call absolute return at Yale seven point one percentage points first the third quartile real estate much less efficiently priced than

Marketable securities nine point three percentage points top to bottom quartile leveraged buyouts thirteen point seven percent difference top quartile the bottom quartile in the venture capital forty three point-two percentage points

Difference top to bottom quartiles 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 leverage buyout managers and spending far less of our time and energy trying to be the bond market or beat the stock market because even if you win there and 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 Swanson approach

First of all they talked 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 so 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 US 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 US Treasuries but if you owned a substantial amount of US Treasury bonds and what's a substantial amount 25 30 35 percent 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 percent in US Treasuries and you're in and

You're out you would pay this opportunity cost and then when the crisis comes you can happy 4 6 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 US Treasuries is the best strategy for a long-term investor and there are those who say that well if

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 a local Japanese investor 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 seventy three percent so diversification makes an enormous amount of sense in the long run even if there are occasional occasional panics where you're disappointed that the diversified approach that you had to managing the

Portfolio didn't didn't produce results the second criticism over emphasis on alternatives let's just look at the last decade when the Yale's portfolio over the 10 years ended June 30th 2010 domestic equities produced returns of

Negative zero point seven percent per year bonds produced returns of five point nine percent per year let's look at the alternatives as opposed to domestic marketable securities private equity six point two percent per year

Real estate six point nine percent per year absolute return 111% per year timber twelve point one percent per year oil-and-gas 247% per year I think the the numbers speak to 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 it was less than a billion

Dollars the amount that we distributed to support yells operations that year was forty five million dollars for the year ended June 30th 2010 be endowment stood at a little bit above sixteen billion dollars the amount that we

Distributed to Yale's operations was 11 billion dollars so an enormous change over normos positive change over 25 years if you look at Yale's performance over the last ten years it's still better than that of any other

Institutional investor eight point nine percent per annum and that compares to an average for colleges and universities of about four point zero percent per annum and that translates into seven point nine billion dollars of added

Value relative to where we would have been had we had average returns over the past ten years and the comparable numbers for twenty years are Yale at thirteen point one percent per annum again the best record of any

Institutional investor in the United States relative to an average for colleges and of Union universities of eight point eight percent per annum and twelve point 1 billion dollars of value added so the slings and arrows of

Outrageous fortune don't so I would suggest that the Barron's articles really took far too short a time horizon in looking at Yale's performance and in 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 ten years from now we'll see that the the portfolio will continue to produce the same kind of strong long-run results as

It has for the past ten and twenty years with that I'd love to answer any questions that you might have 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 for the university and it's a it is a tricky thing to do because in the 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 are the the bio managers and trying to find ways to get those agents to act primarily in the

University's interests to get to get rid of those those agency issues and it's a it's 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 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 and institutions there's some structural differences we don't pay taxes and taxes are an enormous ly important determinant of investment outcomes for individuals and you 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 are beating those markets is an incredibly difficult challenge and doing it by spending you know a couple hours on a weekend once a month isn't gonna isn't going to cut it and so so

Yeah we've got 20 21 22 investment professionals who are dedicating their careers to trying to make these high-quality active management decisions and so we can go out and have a decent shot at beating the domestic stock

Market in the foreign stock market and putting together superior portfolio of venture capital partnerships and hedge fund managers and you know over the past five 10 15 20 years we produce market beating results and contrast an

Individual has almost no chance of beating the 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 Behrens referred to as the Yale model or the Swensen approach but the

Book that I've written for ostensibly for individuals but it's really individuals and institutions that don't have the same resources that Yale does to to make these high-quality active decisions the 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 for the holders of those funds so it's it's kind of an interesting world where the right solution I think 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 that's that's where most people end up and most institutions 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 to the mid 80s and you've got a portfolio that's 50% in domestic stocks yeah you have to worry a lot about the 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 five to ten percent and now a maximum allocation of 25 to 30 percent in an individual asset

Class the relative valuation of each of those asset classes matters less and there's a another kind of nice aspect to a rebalancing policy if you 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 had 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 in your policy 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 those questions are 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 the second question with respect to technology he also had a long-standing commitment to venture capital and over the decades it's produced extraordinary returns for

The for the university and we continue to have a world-class group of venture capitalists we've got you know exposure to companies like LinkedIn and Facebook and Groupon and I hope that this wave of IPOs that people are writing about and

The press actually occurs because that would be very good for the for the university's portfolio it's been a long time right I mean we benefited enormously in the internet bubble in the in the late 90s and the last decades

Been a bit fallow we also find on the marketable security side the 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 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 so that's a that's a really good question I think the the most fundamental issue with the explosion of hedge funds and the explosion of private equity funds has to do with this

Negative sum gain 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 then probably be some foreign stocks and some domestic stocks but the leakage from the system was very small and 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 you know two-tenths of a percent a year or three tenths of a percent of your for you know admittedly sleepy bank management but it

Says it's the same set of securities now those securities are traded in the hedge fund format or taken private and a private equity fund format and the fees that your pain are a point a point and a half two points right the the typical

Two-and-twenty and your pain a significant percentage of the of the profits the twenty in the two and twenty think about that the leakage from the system that goes to Wall Street is enormous compared to what it was ten

Years ago or 20 years ago or 30 years ago so there's that much laughs but less left for us as investors and I think that has huge consequences for endowments foundations pension plans institutions of all stripes in to the

Extent that individuals get a exposure to these types of assets and they're largely wealthy individuals that end up getting the exposure that 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 markets more efficient take away opportunities I don't worry too much about that I mean I think that 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 percent and a half or

Something like that well you'd rather have two and twenty then 075 right that's easy so there's a huge migration of talent to the to the hedge fund world but what I care about when I look at the degree of investment opportunity is this

Dispersion that we talked about and I haven't seen the dispersion of results top quartile the bottom quartile compress it all so I don't 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 adjusted adjustment for the for the risks that we take so as long as we we have plenty of dispersion in the

Results it's still an interesting activity for us to pursue okay okay 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 the Sharpe ratio is that just looking at standard deviation of returns doesn't capture risk in a way that is 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 so good and if you just look at the the pattern of those returns we end up scoring high when looking at the Sharpe ratios across

Different institutional portfolios but but the risks that exist in the portfolio aren't really captured by their deviation of other 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 basis right by us in the in the appraisals if somebody looks at a piece of real estate you know 12 months ago six months ago and today

They're likely to see pretty much the same thing that they they saw for that period you know you compare and contrast that to the volatility that you've got in the stock market I think Bob Shiller deserves credit for the coining the term

Excess volatility there's no question that you know 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 kind of stability built in because of the appraisal nature of the valuation process and if you end

Up you know 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 so thank you very much

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