[0:04]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 is a Wealthtrack Television exclusive with David Swenson, 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. Swenson 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. Well, 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 in average annual returns of 16.3% versus 6.5% for the average college Endowment and 2.9% for the S&P 500. That performance put Swenson in the top 1% of all institutional money managers and added an estimated 15 billion dollars 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? Well, Swenson radically altered what Yale's endowment invest in. From the traditional mix of domestic stocks, bonds and cash, he and his team switched to alternative investments. Their stake in private equity increased from under 4% to over 20%. In 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%. Now Swenson 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 Swenson next on Consuelo Mack Wealthtrack.
[2:55]Well, we are delighted to welcome in a Wealthtrack Television exclusive the Chief Investment Officer of Yale's Endowment, David Swenson. David, it's great to have you here in Wealthtrack. Thanks for joining us. Oh, it's my pleasure. Thank you. So, so let me ask you about, uh, about what you've done at Yale because 24 years ago, you arrived at Yale. You were at the tender age of 31. And there endowment was then a billion dollars. It as I just said, it it went up to 22.9 billion and it's now down to around 17 billion, but you decided to make some really radical changes in in the the mix of the portfolio. What was wrong with the old mix? What was it when you got there and and why did you decide to make those changes? So when I arrived at Yale, it was April 1st, 1985. Uh-huh. You think there's an April Fool's joke there somewhere. Perhaps. Yeah. I was totally unencumbered with formal investment management experience. And so the first thing I did was look around and see how it was that other institutions invested their funds. I saw colleges and universities had on average 50% of their portfolio in US stocks, 40% in US bonds and cash, and 10% in the smattering of alternatives. And if you think about that, both from a common sense perspective, and from a finance theoretical perspective, it doesn't make any sense. I mean, first of all, diversification is a great thing. And it was even known back then in 1985, that diversification was a great thing. Even in 1985. Right. Harry Markowitz, who's probably the father of modern portfolio theory, says diversification is a free lunch. Right, 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. 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 not. Or maybe they didn't. Well, 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 bonds. But there's no way that you can argue having 50% of your assets in a single asset class, US stocks, or having 90% of your assets in US marketable securities represents diversification. The portfolios simply failed that test. But but so how did you get from what you just described to what I just described in my opening remarks, which is a radically different portfolio. And and why did you go the direction that you went in? Were you're really vastly underweighting the domestic stocks and bonds that that you just talked about. Well, I mean, there there's one other other important element that underpins the strategy. And that's that if you have a long investment horizon, which an endowment does. Which an endowment does. And which we do when we start our careers. Uh, and it becomes increasingly shorter as we, 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. And be an equity orientation because Because over longer periods of time, equities are going to deliver better results. Right. If they don't, then capitalism isn't working. Um, and and and we could well be at a at a point where investments in equities are going to produce returns going forward that are, uh, higher than, uh, what we've seen in the past five or 10 years. And we could well be in a position where bonds are priced to produce lower returns. Uh, when you when you see Treasuries with, uh, coupons of two or two and a half or 3%, um, that doesn't really bode well for prospective returns. So so a lot of people listening out there are going to say, so what does David Swenson think the returns we're going to get are going to be from equities? So so what do you think? Do do you think that that what do you think equity returns? What should we expect in returns from equities? Next 5, 10, 20 years. Those are the the questions that are really impossible to answer. And one of the one of the difficulties of this current crisis is that we have to think about securities markets more from a top-down basis or macro basis than is the case when we're not facing the the type of crisis that we've, you know, lived through in the past six or nine months or or or a year. And I I I have to move beyond the time, the immediate time of the crisis to see the benefits of of diversification.
[11:23]So, so were there any lessons that you learned in in the the financial crisis that that we've just come through and we're we're still kind of climbing our way out of investment lessons. That anything that you would now do differently in the future than you did in the past? 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 of of liquidity. Now, one of the things that I 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. So, hedge funds, private equity funds. That's exactly it. Right. And even if you look in the government bond market, they're illiquid treasury securities where you get a substantial premium relative to Treasuries that are uh liquid or or on the run. Um and then beyond that, there are full faith in credit instruments of the US government that aren't standard Treasury securities that that pay you even more and it's solely a function of of liquidity. So almost everywhere in the investment world, you can find illiquid alternatives that 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 and you've got to be in a position to generate the liquidity that you need to support your portfolio management activities. I want to bring this back to the individual as well because I know you're very interested in in helping the rest of us. And in unconventional success, which is, which is your book for, uh, for individuals.
[13:16]You know, you're used to stress asset allocation, diversification, how important that is. Um, a couple of major, my major principles. So tell us a little bit about, you know, give us kind of your a thumbnail sketch of of how why diversification for individuals is so important and and how how we can figure out the appropriate asset allocation as well, which strikes me as difficult. Well, so so I think that the the the same basic principles apply to institutions and individuals, uh, in terms of the importance of asset allocation and having a diversified and an equity-oriented portfolio. When I started writing unconventional success, what I wanted to do was take pioneering portfolio management and essentially translated into a book for individuals that would follow the the the same type of strategy that we, uh, pursued at Yale. Um, but I knew that there would have to be different investment tools that would be available to individuals because much of what we do at at Yale is in 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, uh, directly to the portfolios that that that individuals hold. And and because you couldn't find the kind of active management available to individuals that you can find, obviously, at Yale. That's exactly it. We we couldn't find high quality active management for all the various asset classes that that that we've got at Yale. Um for the individual investor. And so I 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. And that's where I, that's where most of us, including myself, you think I belong. But why can't I hire 20 terrific, uh, you know, mutual fund managers? I mean, just, you know, buy different mutual funds and and allocate them among the different asset allocation classes. Why doesn't that work for me, but it works for you. Well, the the problem is that the 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. Uh, I cite a study by Rob Arnot in my book and he looks at 20 years worth of mutual fund returns and and comes to the conclusion that you've got 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. Uh, there's a Center for Research and Security Prices survivorship-free database that has 30,000 mutual funds in it.
[17:11]Well, 20,000 of them are alive and kicking and 10,000 of them are dead. Why is it that, that in the investment world, because, you know, I I we try on Wealthtrack try to, uh, interview the top investment managers and and many of them are mutual fund managers, the kind of the cream de la cream. So, you know, why is it that that I I can't as an individual, you know, pick kind of the, the best mutual fund manager. Just like I would pick the best doctor or the best lawyer in, in the financial world. So, So it's So it's So it's Well, it's there are a number of ways that that you can answer the the question.
[17:52]So we say after fees, after taxes. Right. Well, fees are too high, right? So so that's something that you see throughout the entire industry. And of course, we're not talking about the index funds because the index funds are the where you think we should be low cost way of getting exposure to the market. But why why are the tax bills so high? Because turnover is too high. Right? Um, the mutual fund managers are are are trading the portfolios as if taxes don't matter, and taxes do matter. And they're trading the portfolios as if transactions cost and market impact, don't matter and they do matter and and as they trade the portfolios, uh, basically what's what's happening is that Wall Street is, you know, siphoning off its uh, slice of the pie. And I guess that's a mixed metaphor. Sorry about that. And and you know, that's at the expense of the the the investor. But even if you end up finding that needle in a haystack, that that that mutual fund that's going to outperform over over a long period of time, you as an investor, and I'm not just talking about individuals. This this unfortunately is true of institutions as well. Are likely to be motivated not by kind of pure analytical rational calculus, but by fear and by greed. Morningstar did a study, which I 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 taken into account investor cash flows. In every one of those 17 categories, dollar-weighted returns were less than the time-weighted returns. All right. Which meant that individuals got in after good performance and got out after bad performance. And so they were buying high and selling low. So they they 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. Right? No, absolutely.
[20:29]It it, you know, it's definitely a problem with individuals. So so so your recommendation for individuals basically is to is to invest in, uh, in index funds. And and and the your your recommended asset allocation at this point would be for an equity-oriented investor would be what? So, uh, 30% in US stocks, 15% in Treasury bonds, 15% in Treasury inflation-protected securities (TIPS). And then in in my book I I I talk about 20% in REITs. I've got a 15% allocation to foreign developed equities and a and a 5% allocation to emerging markets. Which I think you've up to 10%, right? And emerging markets at this point, but So so I think I probably would put some more in emerging markets. Um, maybe move that from 5 to 10 and and take the REITs and move it from 20 to to to 15. But that would be a basic kind of equity-oriented, growth-oriented portfolio that that you think would provide the kind of diversification that you need. And you know, and I I guess another question is for for a lot of our viewers are are older. They're either in retirement or they're nearing retirement. So how does that change the equation? How defensive should we get as we get closer to retirement? Well, so so so I think that, uh, the best way to deal with getting older and moving from, let's say, the accumulation phase to the consumption phase, is simply to to keep that risky portfolio intact, but have a portfolio that's a blend of the risky portfolio and a riskless asset.
[22:16]Like cash or treasury, protected securities or 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.
[22:33]But then is as you grow older and get, uh, to the point where you're going to be actually consuming what it is that that you've accumulated, to move out of the risky portfolio gradually into a combination of the risky portfolio and cash or Treasuries. All right. That's very helpful. So David Swenson, I'm going to have to ask you now for the one investment. So the one thing that we should all own some of in a long-term diversified portfolio, what would it be? So we talked earlier about the notion that this current crisis is causing us to think more top down. Yes. And this is a an investment that addresses some of the concerns that I have coming out of this 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 a pretty substantial risk of inflation. Down the road, at some point. Down the road, at some point. Uh, so Treasury inflation-protected securities would be the one investment that I would put on the table that should be in every investor's portfolio. And another portfolio diverter as well, which is what what they do kind of double duty. Absolutely. And it and it does double duty in in another way. If you own new issue Treasury inflation protected securities, they can actually protect you against deflation as well, right? Because you're guaranteed that you'll get your principal back. So new issue Treasury inflation protected securities can do double duty in the portfolio.
