Consuelo Mack -- David Swensen Transcript Part II

Consuelo Mack WealthTrack - July 24, 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 Great Investors edition of WealthTrack. I'm Consuelo Mack. Back in May we devoted an entire program to David Swensen, the legendary chief investment officer of Yale's endowment. Now the response to that rare interview was impressive- traffic to WealthTrack's website doubled in the weeks thereafter. We've decided to broadcast a second part of the Swensen interview that has never aired. Yale's David Swensen is an important figure in the financial world. He has literally transformed the way big university endowments are managed all over the country and he was recently named to President Obama's new economic recovery advisory board. Swensen's track record is full of superlatives. Since joining Yale 24 years ago at the tender age of 31, Yale has led all university endowments in average annual returns, becoming the nation's second largest behind Harvard. 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 ending June of last year, the endowment had clocked average annual returns of 16.3% vs. 6.5% for the average college endowment and a mere 2.5% 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 the past year's market wrath. Yale has been projecting a decline of 25% for the fiscal year, which ended on June 30, 2009. How did Swensen generate such market-beating long-term results? He and his team radically altered what Yale's endowment invests in: from the traditional mix of stocks, bonds and cash, they switched heavily to alternative investments and dramatically reduced their positions in domestic stocks and bonds from over 70% to under 15% of the portfolio. 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 to be the bible for institutional money managers, and he has taken his message to individual investors with his book Unconventional Success: A Fundamental Approach to Personal Investment. In my interview, I asked Swensen whether he had seen the financial crash coming.

DAVID SWENSEN: In some ways, you could say that we saw this coming -- in the end of 2007, we took all of Yale's cash and put it into Treasuries. This was well before Bear Stearns failure and Lehman's failure.

CONSUELO MACK: Now where are we? What's your assessment of how far we've gone in repairing the financial system?

DAVID SWENSEN: Well, actually, you ask, I guess, first how it was that we got here, and I think that Jack Bogle gave a fascinating speech a few months ago where he talked about moving from the ownership society to an agency society, and about the need to move from the agency society to a fiduciary society. It really resonated with me. If you look at the investment banking world that I joined in 1979- I spent six years on Wall Street before I went to Yale, I spent three years at Lehman Brothers, three years at Salomon Brothers. They were private partnerships. The partners sat on the trading floor and knew what the exposures were because they owned the companies. So that was Jack Bogle's ownership society. And then you look at the absolutely insane capital structures that evolved in the intervening years; you saw way, way too much leverage in the financial system. Investment banks were the worst, but commercial banks were over-levered as well, and you looked at the character and quality of the assets, and the assets, I think, by and large were on their way to someplace else, but of course, when the music stops they don't get to go someplace else, so they're there.

CONSUELO MACK: Right.

DAVID SWENSEN: And it was other people's money because they were publicly traded entities, right? And so it was "heads I win, tails you lose" in terms of compensation for the individuals at these financial institutions. And the trick is getting away from this agency society - this set of financial institutions that are dealing with other people's money.

CONSUELO MACK: With no skin in the game.

DAVID SWENSEN: Yeah, or no skin or inadequate skin in the game, and then move to a fiduciary society.

CONSUELO MACK: How do we do that?

DAVID SWENSEN: I think it's a very, very difficult question, but if you think about commercial banking, for example, I think that it would be great if we ended up with a set of very simple, deposit-gathering balance-sheet lenders, and the deal would be that if you get government insurance on the deposits, you have to accept the high degree of regulation, and as part of the deal, it could be that when you generate loans, and these highly regulated deposit-gathering, balance-sheet-lending banks would only provide basic financial services.

CONSUELO MACK: Are these like the old S&L's?

DAVID SWENSEN: Actually, like the Bailey Brothers savings and loan of "it's a wonderful life," that's exactly what they're like, and you could require that they keep a large part of what it is that they originate on their balance sheet. Doesn't mean you can't have some securitization, you can't have some syndication, but you have to eat your own cooking. You have to live with the consequences of your actions.

CONSUELO MACK: What about regulation? Because you have some actually pretty big ideas about needing a much more-- broader, comprehensive regulation. So what is it?

DAVID SWENSEN: One of the pauses of the problems that we find ourselves facing is that there was this religion of deregulation, or this cultish belief that the market was always going to get you to the right solution. CONSUELO MACK: Right. Self-governing.

DAVID SWENSEN: Right, and Alan Greenspan was right at the top of the list of those who were advocating that position, that general attitude, and it turns out that that was an incredibly naive approach, because what the deregulation led to was this huge overleveraging and this incredible lack of quality control among our large financial institutions. We need to have much stronger regulation, much higher quality, we need to devote far more resources to the regulation of our financial system, broadly defined. I'm certainly not just talking about banks and securities firms. I think it's absolutely obvious that hedge funds need to be regulated. Long-term capital, 1998, $5 billion of equity, $150 billion of positions on the balance sheet, $1.2 trillion of derivative positions.

CONSUELO MACK: That was one institution.

DAVID SWENSEN: One institution.

CONSUELO MACK: That could have brought the system down.

DAVID SWENSEN: Could have brought the system down. Why is it that we are more than 10 years later, we haven't come to the conclusion that we need to regulate entities that could pose a threat to the system? I think it's absolutely obvious that any institution that could pose a threat to the system should be under the regulatory umbrella.

CONSUELO MACK: You have talked about the new reality -- PIMCO refers to it as the new normal. So what is the new reality that we're living in now as far as the investment climate, the economic climate, looking at the big picture? What do you think the new reality is that we should expect?

DAVID SWENSEN: I think that at least for the near term, we have to have more modest expectations about what it is that our investment portfolios are going to generate for us.

CONSUELO MACK: For instance, what is more modest -- Yale delivered 16.3% returns in the Yale endowment over a 10-year period.

DAVID SWENSEN: That was a pretty good run.

CONSUELO MACK: That was a terrific run.

DAVID SWENSEN: And I think stocks over that period were up a little bit more than 3% per annum and bonds somewhere between 4 and 5% per annum, so there was just a huge gap between what the portfolio produced and what you could have generated from marketable securities. If we think that equities over long periods of time--

CONSUELO MACK: 11% --

DAVID SWENSEN: 11, 12% returns, that's exactly the number I was going to come up with. I think we have just gone through a period where the economy took a more substantial hit than I think any of us--

CONSUELO MACK: Anticipated. And I guess than we have in, like, 50 years.

DAVID SWENSEN: Right. And we're still in a position where the financial markets, which were broken a few months ago, have yet to heal completely, and so I would say that at least for the intermediate term, you have to have lower expectations with respect to equities and maybe all other financial assets. Bonds- starting out with 3, 3.5, 4% coupon on Treasuries. That's a very, very, very low starting point.

CONSUELO MACK: Corporate bonds. We've had several guests on who were investing in corporate bonds, and they just said the returns are pretty exceptional. Are you at all attracted to the distressed bond market? Are you at all attracted to the corporate bonds or high-yield junk bonds, those kinds of securities?

DAVID SWENSEN: It depends on what hat I'm wearing. If I'm wearing my Yale hat, I think there are some extraordinary opportunities in the credit markets. If I'm wearing my individual investor hat, I don't think that there are high quality vehicles that individuals can tap into.

CONSUELO MACK: Because you don't want individuals to lose money, in other words -- you don't think individuals should take the kind of risks that you can take at Yale or -

DAVID SWENSEN: Well, I think if the right investment vehicle were there then I could recommend that an individual take those kinds of risks because one of the things that has come out of these broken credit markets are some very attractive risk-adjusted opportunities. But the corporate bond market is very, very tough. You need to have the same kind of analytical capabilities that you have to analyze equities, and on top of that you have to understand call provisions. It's incredibly complicated, and the mutual funds that specialize in this area generally are high cost and do a poor job of dealing with these incredibly complicated issues.

CONSUELO MACK: There are some hedge-fund managers who have come out with mutual funds, and we've had a couple on our show -- Cliff Asness from AQR and Andrew Lo, who you probably know from MIT, and again, it's in the spirit of portfolio diversification, they're giving an individual an opportunity to invest in arbitrage or to replicate some hedge-fund returns. What do you think about those kind of options for individuals that I'm sure we're going to see more of in the years ahead?

DAVID SWENSEN: I believe that there are a handful of high quality managers and -- I think Cliff Asness and Andy Lo are really impressive guys, and there are also some impressive guys on the equity side and in the mutual-fund world, but it's a handful among the thousands of mutual funds, and individuals, by and large, aren't well equipped to separate the wheat from the chaff.

CONSUELO MACK: Right.

DAVID SWENSEN: And when the probabilities are overwhelming that they'll end up with the not-so-good managers or the bad managers or the terrible managers as opposed to this tiny handful of high-quality managers. I think the only reasonable advice that I can give is to stay on the passive end of the spectrum. Put together a portfolio that you can implement using index funds.

CONSUELO MACK: It seems so unfair. So you think that individuals are always going to be, essentially, at a disadvantage, so the best that we can hope for is to have market returns and to have a portfolio that has some noncorrelated assets? Is that --

DAVID SWENSEN: Yeah, it seems unfair in a sense, but most everybody has something that they do with their lives other than studying financial markets.

CONSUELO MACK: Right.

DAVID SWENSEN: And I know how hard it is to beat the markets. They're actually quite efficient. And so I've got an incredibly highly qualified, wonderfully motivated group of colleagues at Yale, and we work really, really hard to put together these market-beating portfolios.

CONSUELO MACK: And the market-beating portfolios, our viewers should know -- you're not investing the money yourself.

DAVID SWENSEN: No.

CONSUELO MACK: You outsource.

DAVID SWENSEN: With outside stock managers.

CONSUELO MACK: Right. So is there one or two things that you insist upon in choosing a manager? I mean, what are the things that you look for in choosing a good investment manager? Criteria.

DAVID SWENSEN: If we talked about this 20 years ago, I probably would have come up with a list of objective criteria.

CONSUELO MACK: And now?

DAVID SWENSEN: And now, I just say it's all about the people. You want to have really high quality people, great integrity, very intelligent, hard-working, people that have found an edge that they can exploit.

CONSUELO MACK: In their particular niche.

DAVID SWENSEN: In their particular niche. And I would say it's people first, people second, people third. You just want to be partners with great people.

CONSUELO MACK: But size counts too, right? You don't like to invest with funds that get too big?

DAVID SWENSEN: Size is the enemy of performance. So the people that we invest with -- I like to say have a screw loose because they don't define winning by amassing as large a pool of assets as they possibly can, because if they did that, they would invariably make more money because it's asset-based fees, and they sometimes get a carry on the performance so the bigger the pile of money, the more money they're going to make and that's one of the big problems with the mutual-fund industry. It's not about creating great investment returns, it's about amassing these huge piles of assets because that's the way that the fund companies generate greater profits. But the managers that we're with are actually being good fiduciaries to the university because almost invariably they'll limit the size of assets under management so they can produce great investment returns, and they define winning by having a great investment record as opposed to the greatest degree of fee income that they can possibly generate.

CONSUELO MACK: Assets under management. Haven't you been tempted to leave Yale and the not-for-profit sector and make more than a paltry couple million a year?

DAVID SWENSEN: I get paid incredibly well for what I do, and I love being part of an academic community. I love being part of the economics department at Yale. I have been teaching since 1980, even longer than I have been working at Yale. I love the students. I like the idea that I'm supporting one of the world's great institutions.

CONSUELO MACK: So this is something you want to continue to do.

DAVID SWENSEN: As long as they'll have me.

CONSUELO MACK: I'm sure they'll have you for a long time. I should end it there but I'm not going to. What about your kids' portfolios? How do you invest -- I've got a 21-year-old son and you have got three children. So how are you investing their portfolios?

DAVID SWENSEN: I've got a combination of index funds and some closed-end funds trading at a discount. I guess that's kind of the one asterisk that I would put by the purely passive approach. I love what Jack Bogle has written. I love what Charley Ellis has written. I love what Burton Malkiel has written. They're fans of index funds. But Burt Malkiel has also written about buying closed-end funds at a discount and I think that's an interesting strategy for individuals to pursue if they just can't stand having a purely indexed portfolio.

CONSUELO MACK: And at this point in the economy and in the markets, are there one or two areas that you would emphasize over others that you think are going to do extremely well over the next five years, let's say?

DAVID SWENSEN: TIPS are interesting, because if the fiscal stimulus and the monetary stimulus work, it's hard to see an environment where we're not dealing with substantial inflation. If they don't work, the fiscal stimulus and the monetary stimulus, then I think you have to worry about deflationary pressures, and if you buy new-issue TIPS, you have the protection of getting your principal back, and so new-issue TIPS- not the ones that have accredited to above par because of the passive inflationary adjustments- new-issue TIPS are actually instruments that could help you in an inflationary environment and in a deflationary environment.

CONSUELO MACK: And not TIPS funds. You buy the new-issue TIPS because then you hold them to maturity and you get the principal back at maturity.

DAVID SWENSEN: Yeah. And to get the deflation protection, you have to keep in the new issues, because if you are in an inflationary period, the value of the principal goes up along with inflation, and then you've got something that you can lose before you get back to par. I guess the other thing that I think people should pay attention to in their portfolios that they probably by and large don't pay enough attention to would be emerging-markets exposure. I'm not sure where I come out on the decoupling issue, but you could certainly imagine a circumstance where China and India and Brazil, maybe some of the other big emerging-markets countries perform substantially better than some of the developed economies where you see the direct impact of the clots of the financial system.

CONSUELO MACK: What is it that we should know about your unconventional approach, that individuals should take to heart?

DAVID SWENSEN: I think that the sad fact is that the game is really stacked against the individual, that almost any provider of financial services to individuals, whether it's a stock broker or a mutual-fund manager, has a conflict between the fiduciary responsibility that's owed to the client and the profit motive. And when you see that conflict, the profit motive more often than not wins, and so the only way that an individual is going to end up with a reasonable outcome is to educate themselves, and I think the only reasonable way to do that is to read books, and you can read Charley Ellis's book or Jack Bogle's book -

CONSUELO MACK: Winning The Loser's Game, or Enough, Jack Bogle has written a lot of books. I might add your books, Unconventional Success.

DAVID SWENSEN: And you've just got to take control of your financial destiny, and not believe that you can pass responsibility off to a trained professional and that you'll end up with a good outcome, unfortunately, that just isn't the way that the world works.

CONSUELO MACK: I have a suggestion for you, David Swensen, and that is you should start a mutual fund, and take your fiduciary responsibility and make it accessible to the rest of us. At any rate, that's a dream, I'm sure, but thank you so much for being with us on WealthTrack and spending so much time with us.

DAVID SWENSEN: Thank you.

CONSUELO MACK: For those of you who would like to hear more from Yale's David Swensen, next week we'll be repeating part one of our wide-ranging interview with him as we continue our Great Investors series. If you would like to watch this program again, just go to our website, wealthtrack.com starting on Monday. You can see it as streaming video. Thanks for visiting with us and make the week ahead a profitable and a productive one.



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