Swensen Transcript on Consuelo Mack Saturday

http://www.wealthtrack.com/transcript_05-22-2009.php





Consuelo Mack WealthTrack - May 22, 2009

CONSUELO MACK: This week on WealthTrack: in a television exclusive, Yale's legendary financial wizard David Swensen zaps the mutual fund industry and his endowment model critics and casts his magic spell on diversification, asset allocation, and contrarian investing, next on Consuelo Mack WealthTrack. Hello, and welcome to this edition of WealthTrack. I'm Consuelo Mack. We are breaking precedent on WealthTrack this week and devoting the entire program to one guest, and what a guest we have for you. It's a WealthTrack television exclusive with David Swensen, the truly legendary chief investment officer of Yale's endowment who, you will discover in a moment, pulls no punches in his approach to investment strategy, Wall Street, the mutual fund industry, and just about every other topic you engage him in. Swensen has literally transformed the way university endowments are managed all over the country. He has been so successful and influential that he has set a new standard for a wide array of institutional money managers from pension funds to foundations, and he was recently named to President Obama's new Economic Recovery Advisory Board. How did he do this? His track record tells the story. Under his leadership Yale's endowment generated 20 consecutive years of positive returns from 1988 until June of 2008, the end of its fiscal year. In the decade ended June of last year, the endowment had clocked an average annual return of 16.3%, versus 6.5% for the average college endowment and 2.9% for the S&P 500. That performance put Swensen in the top 1% of all institutional money managers and added an estimated $15 billion to Yale's endowment. Yale did not escape last year's market wrath. As of December, the portfolio lost about $6 billion or 26% of its value. But how did he generate those long-term results? Swensen radically altered what Yale's endowment invests in. From the traditional mix of domestic stocks, bonds, and cask, he and his team switched to alternative investments- their stake in private equity increased from under 4% to over 20%. Real assets like timber and real estate, the allocation increased from 8.5% to 29.3%; and in hedge funds from zero to 25.1%. Meanwhile, the investment in domestic stocks and bonds plunged from over 70% to under 15%. Swensen has literally written the book on university endowment management. His recently revised edition of Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment is considered the bible for institutional money managers. And luckily he has brought his message to individual investors with his book Unconventional Success: A Fundamental Approach to Personal Investment. What should our investment approach be? We're going to ask David Swensen next on Consuelo Mack WealthTrack. We are delighted to welcome in a WealthTrack television exclusive, the Chief Investment Officer of Yale's endowment, David Swensen. It's great to you have here on WealthTrack, thanks for joining us.

DAVID SWENSEN: It's my pleasure, thank you.

CONSUELO MACK: Let me ask you about what you've done at Yale. 24 years ago you arrived at Yale at the tender age of 31, and their endowment was then $1 billion. As I just said, it went up to $22.9 billion and is now down to around $17 billion. But you decided to make some really radical changes in the mix of the portfolio. What was wrong with the old mix? What was it when you got there, and why did you decide to make those changes?

DAVID SWENSEN: So when I arrived at Yale, it was April 1, 1985. There's an April Fool's joke there somewhere.

CONSUELO MACK: Perhaps, yeah.DAVID SWENSEN: I was totally unencumbered with formal investment management experience, and the first thing I did was to look around and see how it was that other institutions invested their funds.

CONSUELO MACK: Right.

DAVID SWENSEN: I saw colleges and universities had, on average, 50% of their portfolio in U.S. stocks, 40% in U.S. bonds and cash, and 10% in a smattering of alternatives. If you think about that, both from a common sense perspective and from a finance theoretical perspective, it doesn't make any sense. First of all, diversification is a great thing.

CONSUELO MACK: And it was even known back then in 1985 that diversification was a great thing.

DAVID SWENSEN: Even in 1985. Harry Markowitz, probably the father of modern portfolio theory, says diversification is a free lunch. We teach our students in introductory economics, there ain't no such thing as a free lunch, but diversification is, for a given level of risk, you can generate higher returns if you diversify.

CONSUELO MACK: And diversification means a lot of different things to a lot of different people. So in 1985 at Yale and a lot of other endowments, they thought they were diversified, right, or maybe they didn't?

DAVID SWENSEN: Maybe they were diversified when you looked at their holdings of domestic equities and maybe they were diversified if you took a look at their holdings of the bonds, but there's no way that you can argue, having 50% of your assets in a single asset class - U.S. stocks - or having 90% of your assets in U.S. marketable securities represent diversification. The portfolio's simply failed that test.

CONSUELO MACK: So how did you get from you just described to what I just described in my opening remarks, a radically different portfolio, and why did you go the direction that you went? You're really vastly under-weighting the domestic stocks and bonds that you just talked about.

DAVID SWENSEN: There's one other important element that underpins the strategy. And that's that if you have a long investment horizon...

CONSUELO MACK: Which an endowment does.

DAVID SWENSEN: Which an endowment does. And which we do when we when we start our careers, and it becomes increasingly shorter as we get older, but this principle applies to a great many individual investors as well, with a long time horizon you should have an equity orientation.

CONSUELO MACK: An equity orientation because?

DAVID SWENSEN: Because over longer period of time, equities are going to deliver better results. If they don't, then capitalism isn't working. And we could well be at a point where investments and equities are going to produce returns going forward that are higher than what we've seen in the past five or ten years, and we could well be in the position where bonds are priced to produce lower returns. When you see Treasuries with coupons of two, two and a half or three percent, that doesn't really bode well for prospective returns.

CONSUELO MACK: So a lot of people listening out there are going to say, "So what does David Swensen think the returns we are going to get are going to be from equities?" So what do you think, equity returns - what should we expect in returns from equities, in the next 5, 10, 20 years?

DAVID SWENSEN: Those are questions that are really impossible to answer.

CONSUELO MACK: Okay.

DAVID SWENSEN: And one of the difficulties of this current crisis is that we have to think about securities markets more from the top-down basis or a macro basis than is the case when we're not facing the type of crisis that we've lived through in the past six or nine months or a year.

CONSUELO MACK: Right. Is that what you're doing now? Are you looking at the process through a macro screen, essentially? And if so, take us - take us through that process.

DAVID SWENSEN: I'm religiously bottom-up in everything that we do.

CONSUELO MACK: Bottom bottom-up, not top-down.

DAVID SWENSEN: Bottom-up, not top-down. But the crisis forces to you thinktop-down in ways that would, I think, be unproductive in normal circumstances, or absolutely necessary in the midst of a crisis. You have to think about the functioning of the credit system. You have to think about the potential impact of monetary policy on markets over the next 5 or 10 or 15 years. And I guess this is kind of a long way of cycling back to your question about what kind of returns do we expect from equities and perhaps other asset classes going forward, and, you know, I would say with today as a starting point, you could expect over reasonable periods of time to be rewarded for equity exposure. It's certainly a better time to put money in the stock market than a year ago, or three years ago or five years ago because you've got a much more attractive entry point.

CONSUELO MACK: Let me ask you about what we were talking about before as well. You looked at the endowment as it was invested in 1985 and you saw that it really wasn't well diversified, and all the studies, you are absolutely right, show that broad diversification pays off over long periods of time, so, and this is a question you've had many times, but a lot of people are saying now, diversification didn't pay off. And in fact the Yale endowment was down 25% from June to December of last year. You have an answer for that, and that answer is?

DAVID SWENSEN: Well, that I think in the first instance, diversification isn't going to help in the midst of a financial crisis, or at least the type of diversification that you see in institutional portfolios like Yale's. Diversification failed in 1987. It failed in 1998. And it failed again in this current crisis, because in these panics that we experienced in '87 and '98 and the one that we're experiencing currently, only two things matter - risk and safety. And people move away from risk, and they move toward the safety of holdings of Treasury securities. And that causes the price of all risky assets to go down simultaneously. And it also causes the price of Treasuries to go up dramatically. It happened in '87, it happened in '98, and it's happening today in a way that's far more pervasive and far more profound. And you have to move beyond the time, the immediate time of the crisis to see the benefits of diversification.

CONSUELO MACK: So were there any lessons that you learned in the financial crisis that we've just come through and we're still kind of clawing our way out of, investment lessons, anything that you would now do differently in the future than you did you in the past?

DAVID SWENSEN: I'm not sure that the crisis has caused us to conclude that we would do things differently, but it certainly highlighted the importance of liquidity. One of the things that I've said consistently, and I still continue to believe to be true, is that investors get paid unreasonable amounts for accepting illiquidity in their portfolios.

CONSUELO MACK: So hedge funds, private equity funds, right.

DAVID SWENSEN: And even if you look in the government bond market, there are illiquid Treasury securities where you get a substantial premium relative to Treasuries that are liquid or on the run. And then beyond that, there are full faith and credit instruments of the U.S. government that aren't standard Treasury securities that pay you even more. And it's solely a function of liquidity. So almost everywhere in the investment world, you can find illiquid alternatives that will pay a premium rate of return, but you've got to be able to manage the portfolio through a period of crisis, and make sure that you generate the liquidity that you need to support, in this case Yale University, and you've got to be in a position to generate the liquidity that you need to support your portfolio management activities.

CONSUELO MACK: I want to bring this back to the individual as well because I know you're very interested in helping the rest of us, and in Unconventional Success, which is your book for individuals, you stress asset allocation, diversification, how important that is, a couple of major principles. So tell us a little bit about - give us a thumbnail sketch of why diversification for individuals is so important and how we can figure out the appropriate asset allocation as well, which strikes me as difficult.

DAVID SWENSEN: So I think the same basic principles apply to institutions and individuals in terms of the importance of asset allocation and having a diversified and equity-oriented portfolio. When I started writing Unconventional Success what I wanted to do, was take Pioneering Portfolio Management and essentially translate it into a book for individuals that would follow the same type of strategy that we pursued at Yale. But I knew that there would have to be different investment tools.

CONSUELO MACK: Yes.

DAVID SWENSEN: That would be available to individuals because much of what we do at Yale was in vehicles that are only open to institutions. And I was really disappointed to find that I couldn't translate what we do at Yale directly to the portfolios that individuals hold.

CONSUELO MACK: And because you couldn't find the kind of active management available to individuals that you can find, obviously, at Yale.

DAVID SWENSEN: That's exactly it. You couldn't find high-quality active management for all the various asset classes that we've got at Yale for the individual investor. And so I came to the conclusion that the individual has to have a radically different portfolio. I actually came to the conclusion that in the investment world, you need to be on either one end of the continuum or the other end of the continuum. You either need to be very, very active and we are at Yale. I've got 20 investment professionals in the investments office who are devoting their careers to finding these high-quality active management opportunities. Or you should be on the other end of the spectrum, and you should be completely passive.

CONSUELO MACK: And that's where most of us, including myself, you think I belong. But why can't I hire 20 terrific, you know, mutual fund managers, just buy different mutual funds and allocate them among the different asset allocation classes. Why doesn't that work for me but it works for you?DAVID SWENSEN: The problem is the quality of the management in the mutual fund industry is not particularly high, and you pay an extraordinarily high price for that not-very-good management. I cited a study by Rob Arnott in my book and he looks at 20 years worth of mutual fund returns and comes to the conclusion that you have about a 15% chance, 15% chance of beating the market after fees and after taxes. And his study suffers from what all studies suffer from, something called survivor bias. You only get to look at the funds that have been in business for 20 years. But the mortality rate is stunning. There's a center for research and security prices survivorship-free database that has 30,000 mutual funds in it. Well, 20,000 of them are alive and kicking and10,000 of them are dead.

CONSUELO MACK: Why is it in the investment world - we try to, on WealthTrack, try to interview the top investment managers, and many of them are mutual fund managers, the kind of the crème de la crème. Why is it that I can't as an individual pick kind of the best mutual fund managers, just like I would pick the best doctor and best lawyer, in the financial world? Why doesn't it work?

DAVID SWENSEN: Well, there are a number of ways that you can answer the question. So we say after fees, after taxes. Well, fees are too high, right. So that's something that you see throughout the entire industry. And of course we're not talking about the index funds because index funds are--

CONSUELO MACK: Where you think we should be.

DAVID SWENSEN: They're a low-cost way of getting exposure to the market. Why are the tax bills so high? Because turnover's too high. The mutual fund managers are trading the portfolios as if taxes don't matter, and taxes do matter. And they're trading the portfolios as if transaction cost and market impact don't matter, and they do matter, and as they trade the portfolios, basically what's happening is that Wall Street is siphoning off its slice of the pie, and I guess that's a mixed metaphor. Sorry about that. And, you know, that's at the expense of the investor. But even if you end up finding that needle in a haystack, that mutual fund that is going to outperform over a long period of time, you as an investor- and I'm not just talking about individuals, this, unfortunately, is true of institutions as well- are likely to be motivated not by a pure, analytical, rational calculus, but by fear and by greed. Morningstar did a study which I think is absolutely fascinating, 10 years worth of returns for every one of the 17 categories of equity funds that they've got. And they compared dollar-weighted returns to time-weighted returns. Time-weighted returns are the returns you see in the prospectus. They're the returns you see in the advertisements. Dollar-weighted returns take into account investor cash flows. In every one of those 17 categories, dollar-weighted returns were less than the time-weighted returns, which meant that individuals got in after good performances and got out after bad performance. And so they were buying high and selling low. So they take this mutual fund industry, which produces a bunch of products that are not great to start with, and then they screw it up by chasing hot performance and selling after things turn cold.

CONSUELO MACK: It's definitely a problem with individuals.

DAVID SWENSEN: And institutions, too.

CONSUELO MACK: So your recommendation for individuals basically is to invest in index funds?

DAVID SWENSEN: Yup.

CONSUELO MACK: And your recommended asset allocation at this point would be for an equity-oriented investor, would be what?

DAVID SWENSEN: 30% in U.S. stocks. 15% in Treasury bonds. 15% in Treasury Inflation-Protected Securities. And then in my book, I talk about 20% in REITs. I've got a 15% allocation to foreign developed equities, and a 5% allocation to emerging markets.

CONSUELO MACK: Which I think you upped to 10%, right, in emerging markets?

DAVID SWENSEN: I think I would probably put some more in emerging markets. Maybe move that from 5 to10 and take the REITs and move it from 20 to 15.

CONSUELO MACK: But that would be a basic equity-oriented, growth-oriented portfolio that you think would provide the diversification you need. Another question, a lot of our viewers are older, either in retirement or nearing retirement. So how does that change the equation? How defensive should we get as we get closer to retirement?

DAVID SWENSEN: So I think that the best way to deal with getting older and moving from, let's say, the accumulation phase to the consumption phase, is simply to keep that risky portfolio intact but have a portfolio that's a blend of the risky portfolio and a riskless asset like cash or treasury inflation protected securities or something like that. And so, you know, when you're in your 30s or 40s or 50s, and you're saving for retirement, it should probably be 100% in the risky portfolio. But then as you grow older and get to the point where you're going to be actually consuming what it is that you've accumulated, to move out of the risky portfolio gradually into a combination of the risky portfolio and cash or Treasuries.

CONSUELO MACK: All right, that's very helpful. So David Swensen, I'm going to have to ask you now for the One Investment, the one thing we should all own some of in a long-term diversified portfolio. What would it be?

DAVID SWENSEN: So we talked earlier about the notion that this current crisis is causing up to think more top-down.

CONSUELO MACK: Yes.

DAVID SWENSEN: And this is an investment that addresses some of the concerns that I have coming out of this crisis. We've had this massive fiscal stimulus, massive monetary stimulus, and it's hard to see how that doesn't translate into pretty substantial inflation, or at least pretty substantial risk of inflation.

CONSUELO MACK: Down the road at some point.

DAVID SWENSEN: Down the road at some point. So Treasury Inflation-ProtectedSecurities would be the One Investment that I would put on the table that should be in every investor's portfolio.

CONSUELO MACK: And another portfolio diversifier as well. Double duty...

DAVID SWENSEN: Absolutely. It does double duty in another way. If you own new-issue Treasury Inflation-Protected Securities they can actually protect you against deflation as well because you're guaranteed that you'll get your principle back. So new issue, Treasury Inflation-Protected Securities can do double duty in the portfolio.

CONSUELO MACK: So David Swensen, Yale's Chief Investment Officer, thank you so much for joining us on WealthTrack.

DAVID SWENSEN: Thank you.

CONSUELO MACK: And we have to conclude this edition of WealthTrack. To watch this program again, just go to our website, wealthtrack.com. Starting on Monday you can see it as a podcast or as streaming video. And in addition, if you want to hear my extended interview with David Swensen, it will be available to our newsletter subscribers early next week. All you have to do is go to wealthtrack.com and sign up. It is all free. Thanks so much for visiting with us, and make the week ahead a profitable and a productive one.



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