Excerpts from a presentation by David Swensen
Chief Investment Officer
Yale University Endowment
At the CMS New York Investment Seminar
November 25, 2002
October 5, 2004
Message from Gerard O. Haviland:
From time to time we come across interesting monographs and other materials whose messages are so compelling that we want to share them with our clients, associates and friends.
The following was presented almost two years ago by David Swensen, Chief Investment Officer for the Yale University Endowment. It’s content is thought provoking.
Excerpts from David Swensen..
I would like to start out with what might be a radical proposition. The investment management business is, at its heart, a very simple business. As a matter of fact, if you talk to people who are responsible for investing portfolios with a long time horizon, you would get almost universal agreement on two principles:
1. If you have a long time horizon, you ought to have an equity bias.
2. It’s important to diversify.
But the thing that’s striking is if you look at behavior, at least in the world of institutional investors, neither one of those principles on which more or less everybody would agree is followed in practice.
When I arrived at Yale on April 1, 1985, the average allocation for colleges and universities was 50% of the portfolio in U.S. stocks, 40% in U.S. bonds and cash and 10% in alternatives. Of course if you looked at that portfolio, it was neither equity oriented, nor diversified.
It wasn’t equity oriented because 40% of assets were in bonds and cash, which, over long periods of time, generate notoriously poor returns. It wasn’t diversified because 50% of the assets were in one asset class. No matter how attractive an asset class is, investing half of the portfolio in one asset type doesn’t meet the basic test of diversification.
Furthermore, under many circumstances U.S. bonds and U.S. equities are going to move in concert. Low interest rates are good for bonds – it’s a mathematical relationship – and low interest rates are generally pretty good for stocks. High interest rates are clearly bad for bonds and high interest rates are generally bad for stocks. Therefore, one of the most important economic variables – interest rates- will cause bonds and stocks to move in tandem much of the time. So it could be that 90% of your assets are being driven by one fundamental economic factor, which clearly fails the test of diversification.
Have we made any progress? If you look at a typical end-of-the-millennium portfolio, you would find colleges and universities have that same 50% allocation to U.S. stocks. Bonds and cash are now down to 30%, probably because of the comfort factor that people got from the wonderful bull market that we had for the past couple of decades, and 20% is in alternatives.
So colleges and universities, which I would hold out as among the best institutional investors, in the last 20 years or so have made very little progress in terms of creating a greater equity orientation for their portfolios on the one-hand, or diversifying their portfolios on the other hand.
What I would like to do today is discuss some asset allocation issues in the context of the framework for making investment decisions, a universal framework that relates to the three ways in which investors can generate returns:
1. The asset allocation decision. How much are you going to allocate to particular categories of assets in your long-term portfolio?
2. The security selection decision. Security selection involves taking those individual asset classes and managing them in an effort to do better than the market. So if you do better than the stock market, as measured by the S&P 500, that would be a positive return for your security selection. If you match the market, it’s zero. If you fail to meet the return for the S&P 500, then you’ve generated negative returns from security selection.
3. The market timing decision. The final way that you can generate returns would be through market timing, deciding that you want to make a short-term bet against your long-term policy targets. The extent to which the short term bet is rewarded or not would be the return attributable to market timing.
Let’s start with asset allocation. Asset allocation is the most important way in which you can express those fundamental investment principles that I talked about at the outset- equity orientation and diversification.
There is no more powerful argument for an equity bias than looking at the long history of capital markets returns. There are all sorts of different sources that you can look to, but for today’s discussion I’ll use Roger Ibbotson’s data, which began at the end of 1925. If you look at 75 years worth of capital markets returns, putting $1.00 into Treasury Bills at the end of 1925, by the year 2000 you would have ended up with 17 times your money, not a particularly impressive result, particularly in light of the fact that inflation would have consumed a multiple of ten. By accepting a little more risk, and owning longer-term bonds, you would have ended up with 49 times your money, so there would have been some after-inflation return, but still not a lot given that this was a 75-year period.
Stocks, on the other hand, would have given you nearly 2,600 times your money, a staggering difference between lending money to the government and owning shares in corporate America. Small stocks would have given you 6,400 times your money – huge, huge returns for the long run investor.
Worried that it all seemed too simple, I went back and took a closer look at the Ibbotson data. I looked at what happened to small stocks around the crash in October 1929. For every dollar that you had in small stocks at the peak, by December 1929 you would have lost 54% of your money. By December 1930 you would have lost another 38% of your money. By December 1931 you would have lost another 50% of your money, and just for good measure by June of 1932 you would have lost another 32% of your money. So for every dollar that you had at the peak in small stocks, by June of 1932 you would have had ten cents left.
At some point during that period, whether you were an institutional investor or an individual investor with a strong stomach, you would have given up completely. You would have sold all your small stocks, put the proceeds in Treasury Bills or Treasury Bonds. You would have said, “I’m never going to go back to the stock market again. My money is going to go to a safe haven and I’m going to behave sensibly.” And, that’s what people did in the Thirties, in the Forties, in the Fifties and even into the Sixties.
Of course, that was exactly the wrong attitude to have in the Thirties and Forties and Fifties and Sixties because for every dollar that you had in small stocks in June of 1932, by the end of 2000 you could have multiplied it 6,400 times. So, obviously the data support maintaining an equity bias, but it’s also important to have diversification in your portfolio so you can stick with what otherwise would be an apparently risky proposition.
Let’s turn to the second source of returns, which is security selection. I think the sensible thing to do is to pursue those markets that offer us the greatest opportunities – those that are most inefficiently priced. One of the ways that I like to look at market efficiency is through the revealed behavior of those individuals and institutions that manage assets actively. If you find a market that’s efficient, managers survive by mimicking the market.
Maybe they pretend that they are making active security bets, but in reality what the survivors are doing is creating portfolios that stay very close to the market. Because when a manager makes a series of bad bets, when the bet fails, they’ll be fired and they’ll be out of business. In an efficient market, that series of bad bets is inevitable because they can’t be well informed. The market is too efficient to allow positions to be underpinned by good, solid, fundamental analysis.
At the opposite end of the spectrum, those markets that are at least efficient ought to provide huge opportunities to make big bets and be rewarded. Therefore, you would find that the dispersion of active manager returns in an inefficient market would be wide.
One way to measure the opportunity is to look at the difference between a first quartile manager and a third quartile manager. First quartile managers beat 75% of the players out there. Third quartile managers beat 25% of the other active participants.
So, what’s the most efficient market? Bonds! The first to third quartile differential over 10 years amounts to only 1% per annum – it almost doesn’t pay for you to find that first quartile manager because it turns out that first quartile returns (net of fees) are quite close to index returns so you might as well just say, “Forget the active management game for bonds.” Buy the index and let bonds do whatever it is that you expect them to do in your portfolio, namely provide a deflation hedge or protection against financial accidents.
U.S. equities show a first to third quartile differential of 4.2% per annum. It’s a game that’s more interesting than the bond game, but still relatively efficiently priced and not a huge opportunity for active management.
Real estate enjoys a much bigger differential, 7.4% per annum first to third quartile. Now we are getting to the area where if you are going to play, you have to be active. It doesn’t make any sense to try and index the real estate market even if you could.
Leveraged buyouts show a staggering 24.6% per annum first to third quartile differential, while venture capital displays a 26.4 per annum spread. Compound that over ten years and the top quartile manager differs enormously from the bottom quartile manager.
So the bottom line is that you should focus your efforts on inefficient asset classes – private equity, real estate, perhaps smaller cap equities that are less efficiently priced than large cap equities. Avoid those marketable securities that are traded in markets where prices are extraordinarily efficient.
Market timing? I don’t have a neat story to tell about market timing the same way I do about asset allocation and security selection. There aren’t a lot of active practitioners of market timing. I think that one of the reasons that there aren’t is that the results tend to be more or less random. People that hang out a shingle and say they are “active market timers” tend to go out of business in relatively short order.
Market timing is generally driven by fear and greed. If you look at the asset allocation for colleges and universities in June of 1987, before the crash in October of that year, they had the highest allocation to stocks that they had in more than ten years (at 55% of the portfolio) and they had the lowest allocation that they had to bonds in more than ten years (at 37% of the portfolio). If you go forward one year to June of 1988, which includes the period when the market crashed, stocks were down to 49% of assets and bonds went up to 42%. The stock allocation declined more than the markets declined over that period and the bond allocation rose more than the bonds had appreciated over that period.
So the only explanation for those changes in allocations was that after the crash in October of 1987 institutions went out and sold stocks even though the only thing that was different in November and December of 1987, relative to June and July, was that stocks were cheaper.
The same institutions went out and took the proceeds from the sale of stocks and bought bonds when the only thing that was different about bonds in November and December of 1987, relative to June and July, was that they were more expensive. Selling low and buying high is a pretty crummy prescription for making money, even if you do it in great volume and with great enthusiasm.
The bottom line is that you ought to avoid market timing, pursue active management in those markets that are least efficient, and create an equity-oriented diversified portfolio.
So what does Yale’s portfolio look like today? Currently we have an allocation to U.S. equities of 15%, foreign equities of 12.5%, and bonds of 10%. So traditional marketable securities comprise 37.5% of the portfolio. Our absolute return allocation is 25%, private equity is 17.5%, and real assets is 20% of the portfolio. So 62.5% of the portfolio is in alternatives.
Last year, we made some pretty significant changes, maybe the most significant changes to policy asset allocation targets in a decade. We took our private equity allocation down from 25% to 17.5%. In many ways the reduction in the private equity target is merely a reflection of the reality that our private equity allocation had declined pretty dramatically from the June 30, 2000 level. On June 30, 2000, private equity represented 25% of assets and the target was 25%. If you look at the actual allocation today, it’s approximately 15% of assets. With an illiquid asset class, we don’t think it makes sense to have a target allocation that’s materially different from the actual allocation because it interferes with the rebalancing process. Establishing the target at 17.5% (above our current actual level of 15%) sends a signal to the investment community that we want to continue to pursue private equity opportunities since we are targeting an increase from our current allocation level. The 7 ½ points that we took out of private equity went 2 ½ points to foreign equities, 2 ½ points to absolute return and 2 ½ points to real assets.
Let me talk a little more about the role of alternatives in Yale’s portfolio and how they’ve performed in recent years. I’ll start with absolute return, probably because I have some paternal pride in the asset class. In 1989, Yale was the first institution to identify absolute return as a distinct investment strategy, articulate a policy target for it and implement a stand-alone program. We have close to thirteen years of data on absolute return investing.
The driving principle behind our absolute return investments is that returns ought to be fundamentally uncorrelated with those of traditional marketable securities. In addition, over a reasonable period of time absolute return investments should provide returns that are commensurate with those that you might find in marketable equities. Over the period that we’ve managed this as a stand-alone asset class we have achieved both of those goals.
The returns of our absolute return portfolio have come in at 12.2% per annum and the correlation with domestic equities has been approximately zero for the thirteen years that we have been investing in the asset class. The standard deviation of returns has been about 6 ½ %, which is really quite striking given that the standard deviation of returns for domestic equities over the last 75 years has been close to 20%. So, if domestic stocks had an 11% or 12% return with a 20% standard deviation, Yale’s experience with absolute return investing was to produce an equivalent return with a standard deviation that’s maybe a third of what you might have experienced in the domestic equity market.
Real assets include real estate, timber and oil and gas. Real assets played a significant diversifying role over the 23 years that Yale has been invested in this asset class. The returns have been 14.5% per annum, with a standard deviation of 15.5% per annum, which is right in between the risk level for bonds (which has been in the neighborhood of 10%) and stocks (which has been in the neighborhood of 20%). Real assets have created a fair degree of diversification since the correlation between real assets and domestic equities over that period came in at .4.
And finally, private equity. It has a role, not primarily as a diversifier, but as a source of high-powered equity returns. Although Yale has been invested in venture capital for close to three decades, we only have 24 years of what we consider reliable data. Over that period our venture capital has returned 38% per annum, with (Get This!) a standard deviation of 144%. It’s risky! The correlation with domestic stocks has been about 0.3.
Buyout returns have been 17.7% per year over the 24 years for which we have good data, and the standard deviation has been 49% per annum. Again, this is a very risky asset class with surprisingly low correlation to the stock market (.11 over that period).
What I’d like to do next is assess the performance of this diversified approach to investing, using the last three years of investment results. The year that ended June 30, 2000 was a spectacular year for the University. The endowment had a 41% return. Investment gains were in excess of $3 billion on a beginning base of around $7 billion. The average return for colleges and endowments that year was 17.7%, so there was spectacular relative performance.
The stock market that year was up only 9.5% and the bond market was up 5%. Private equities were up 168.5% and we got good contributions from almost everything else. Real assets were up close to 18%, domestic equities were up 30%, absolute return was up 15% or 16%, foreign equities produced low double-digit returns and fixed income came in at the bottom of the heap at 4.7%.
If you fast-forward to June 30, 2001, the market environment was really quite different. The stock market was off 15.4%, bonds were up 10%. Yale managed to generate a return of 9.2% compared to an average for colleges and universities of negative low single digits. Private equity went from a profit position to a loss position, but real assets continued to perform well (up 15%), absolute return provided spectacular results (up 21.6%), marketable equities made a middling contribution and fixed income produced low double-digit returns.
The year ending June 30, 2002 was a continuation of the tough environment that we had seen the year before. Domestic equities were off 16.6%, bonds were up 8.8% and the University managed to generate a positive investment return once again, albeit a small one (up 0.7%) while the average endowment was down 4% or 5%. Private equity had another significant negative return, as did marketable equities in general. But real assets showed a 9.5% return, absolute return strategies were up 7.3% and fixed income made another positive contribution.
I think if you take this picture as a whole, you can see this well diversified, equity-oriented portfolio managed to take advantage of the wonderful, speculative excess that we had at the end of the last decade. Then when reality hit, and the private equity positions, the domestic equity positions, and the foreign equity positions showed significant declines, the diversified nature of the portfolio kicked in with its absolute return strategies, real assets and bonds making enough of a contribution to offset the equity declines.
What do the results look like overall for the University? Well, when I started managing Yale’s endowment in 1985, the contribution to the operating budget was $45 million and amounted to about 10% of Yale’s revenue. This current fiscal year, the endowment is going to contribute $470 million to Yale’s operations, which is about 30% of the University’s revenues.
Over the last 20 years the University’s endowment generated 17% per annum returns versus a 12.7% return for the median college or university. As far as I can tell, the 17%, 20-year return represents a number that’s higher than any endowment, any foundation, any corporate pension plan, or any state pension plan.
But it’s not just Yale. If you look at Harvard, Princeton, and Stanford, you’ll see institutions that have asset allocations that are not dissimiliar to Yale’s. They are heavily equity oriented, and heavily diversified, and, like Yale, are in the top decile for 20 years. Those institutions have adopted investment strategies similar to Yale’s have managed to put together records of long-term success.
One of the things I like to do is move away from the relatively abstract percentages and translate relative results into dollar terms. Over the last 20 years, if Yale had generated average investment returns, the University would have $7 billion less in resources. So, when my friends at the development office call me and ask me if I would like to make a contribution to Yale, I tell them that I gave at the office.