Comments Off on What can we learn from David Swensen?
Robin writes:
When I first heard about the growth of index investing in the United States 12 years ago,I decided there were five key people I need to go to America to interview. They were Jack Bogle, David Booth, William Sharpe, Charley Ellis and David Swensen. I managed the first four, but to this day I regret failing to persuade Swensen I was worth his time. Sadly I won’t have the chance again. Swensen died two years ago at the age of 67.
Over the last 100 years, some of the sharpest financial minds have been unable to help prestigious university endowments beat the broader market. An exception was John Maynard Keynes, who despite failing to anticipate the Wall Street crash of 1929, enjoyed much greater success after taking a more long-term approach to investing the wealth of King’s College Cambridge in the 1930s.
The other exception was David Swensen, who achieved outstanding returns as the endowment manager at Yale for more than 30 years. Many endowments have attempted to replicate the Yale Model, but none has succeeded to anything like the same extent.
I can highly recommend the latest episode of the Capital Allocators podcast with Ted Seides, which examines Swensen’s philosophy. If the name rings a bell, Seides was the man who bet with Warren Buffett that a portfolio of top hedge funds would beat the S&P 500 over ten years, and lost $1 million.
As Seides explains, “those following the Yale Model may presume David promoted active management for all. He did not. He believed that the chance of success is low and most who try will fail.”
David Swensen was also wary of private equity and venture capital. Swensen’s view, according to Seides, was that “in the absence of truly superior fund selection skills (or extraordinary luck) investors should stay far, far away.”
Thank you to the financial historian Mark Higgins for drawing my attention to this episode. As he explains in a post on LinkedIn, institutional investors in particular need to pay attention to David Swensen’s advice.
“Individuals can do as they please with their own money,” says Higgins, “even if it is counter to their best interest. But trustees have a fiduciary obligation to serve the interests of their beneficiaries.
“Seeking to replicate the Yale Model without possessing the exceptionally rare skills that permeate the Yale Investments Office is a losing proposition. Trustees that lack these skills — which is almost everybody — have a fiduciary obligation to heed Swensen’s advice and adopt the passive strategy.”
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Comments Off on Five better strategies than timing the market
It’s the great investor fantasy: quit the stock market at the top and buy back in at the bottom. While the lure of market timing sells millions of books and is standard fodder for financial television, the reality rarely lives up to the promise.
History is littered with the failed dreams of market timers. Less than five years after the nadir of the financial crisis, some pundits were saying US stocks were over-valued. Another five years on and the market had gained more than 60%.
Not even the gurus have much of a record. Back in 1996, Federal Reserve Chairman Alan Greenspan warned of “irrational exuberance” in the stock market, and yet the market climbed for another three years before the dot-com bubble finally burst.
Even if your logic about valuations is impeccable, there’s no guarantee the market will come around to your view. As someone once said — apparently it wasn’t John Maynard Keynes — markets can stay irrational longer than you can stay solvent.
But the most overlooked challenge with market timing is that it requires you to make two correct decisions: you must get out at the right time — and you need to know when to get back in.
Think back to the global financial crisis. Plenty of people were throwing in the towel by early 2009. But how many bought back into the market in time to enjoy the big bounce that followed in the second and third quarter of that year?
The fact is, market timing is tricky, because big gains and losses can come in relatively short periods. Not even the professionals have much of a track record in successfully negotiating these unpredictable twists and turns.
If market timing is a mirage, what can you do? Here are five alternatives that make more sense—and none requires a crystal ball:
1. Take the long view
“The historical data supports one conclusion with unusual force,” the index fund pioneer Jack Bogle once wrote. “To invest with success, you must be a long-term investor.”
Instead of trying to time the ups and down of the markets, why not simply change your time horizon? Over the very long term, patient stock investors holding diversified portfolios have almost always been rewarded. To be sure, not everyone can take the long view, such as those who need to access their money within the next two or three years — which is why these people shouldn’t have this money invested in stocks.
2. Construct a portfolio for all seasons
Everyone should have a balanced asset allocation — certainly a mix of stocks and high-quality bonds — that matches their capacity for risk. Defensively minded investors might have just 50% or less of their portfolio in stocks, with the rest in bonds.
The right mix also depends on your age, goals and circumstances. Whatever your risk capacity, diversification is key. Spreading your risk across different asset classes and geographies will reduce the impact of a steep decline in one particular market. Ultimately, it’s your asset allocation that’s going to be the most important driver of your investment returns.
3. Occasionally rebalance
In general, the less you tinker with your portfolio, the better. That’s not to stay you shouldn’t touch it at all, but any changes you make should be done in a strategic, structured and disciplined way that reflects your needs and circumstances.
A good discipline is to rebalance your investment mix periodically, so you bring its asset allocation back into line with your target portfolio weights. This means, every year or so, lightening up on some of the winners and adding more money to the losers. This effectively forces you to sell high and buy low, which is what you should be doing.
4. Drip money into the market
If you’re worried about the stock market and want to reduce your risk, try dollar-cost averaging. Say you have a sizeable sum—perhaps an inheritance or a year-end bonus — that you want to invest. Instead of going all in and investing the full amount in one go, you can drip small amounts into the market over a period of time. Economists don’t think this approach makes much difference from an investment perspective. You might end up with slightly lower returns. But it’s a useful way of helping you sleep at night and minimising regret.
5. Carry more cash
Everyone should hold enough cash to cover three to six months of living expenses, in case of, say, unexpected medical bills or you lose your job. But nervous investors may want to hold more than that. The advantage: your portfolio will hold up better in a market downturn, plus — if you’re feeling courageous — you’ll have extra cash to put to work when share prices are lower.
SUMMARY
In summary, timing the market — while superficially an attractive idea — is fraught with danger. If you get lucky, great, but there’s no method to it. We’ve seen that not even the gurus are much good at it.
The good news is that second-guessing the market just isn’t necessary. With the right outlook and a methodical process, you can achieve better results — and enjoy a smoother ride along your investment journey.
Investing Fundamentals is a series in which we look at the basic principles underpinning successful investing. Here are some other recent articles in the series you may have missed:
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Whatever your views on the merits of the UK leaving the EU, there’s one thing no one can take away from the Leave campaign: its victory in the 2016 referendum was one of the most remarkable achievements in modern political history.
The Director of Vote Leave was Dominic Cummings, now a special adviser to Boris Johnson’s new government. In an article published in The Spectator, six months after the referendum, he explained how it happened.
One of the biggest challenges, he said, was persuading the various disparate groups in favour of leaving — Eurosceptic Conservative MPs, lobby groups and so on — that victory was possible and they should pull out all the stops to achieve it.
Most of them, he recalls, wanted to win, but didn’t want it enough to give up their free time and holidays to knock on doors and win voters over.
“This lack of motivation,” he wrote, “is connected to (an) important psychology — the willingness to fail conventionally. Most people in politics are, whether they know it or not, much more comfortable with failing conventionally than risking the social stigma of behaving unconventionally. They did not mind losing so much as being embarrassed, as standing out from the crowd.”
He then said this: “The same phenomenon explains why the vast majority of active fund management destroys wealth and nobody learns from this fact repeated every year.”
Worldly wisdom
It was John Maynard Keynes who first articulated what I suppose you could call Conventional Failure Syndrome. In Chapter 12 of The General Theory, which incidentally Warren Buffett describes as required reading, he wrote: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Keynes, when he wrote those words, was specifically referring to the investment management. He was an experienced investor himself, mainly on behalf of King’s College, Cambridge, of which he was the Bursar.
As an investor, Keynes was anything but conventional. For example, he favoured equities for long-term investing when most college endowments and other institutions favoured bonds. He believed in international exposure at a time when home bias was even more prevalent than it is today. Ignoring accusations of aesthetic indulgence, he also invested in paintings by the likes of Matisse, Seurat and Picasso.
Keynes learned from his failures
Keynes the investor certainly had his failures. He was all but wiped out twice — most famously in the market crashes in London and on Wall Street in 1929. But he learned from those setbacks. A study by David Chambers and Elroy Dimson from Cambridge Judge Business School shows, for instance, how he gradually gave up on trying to time the market, focussing instead on long-term investing and bottom-up stock selection.
It’s very difficult you say how Keynes would invest if he were alive today. I’m a committed indexer, but I’m not going to pretend that he didn’t believe in active management (he did), or that he considered markets to be efficient (he didn’t).
What I do feel certain of, however, is that Keynes would have had very little sympathy with today’s investing industry.
Unconventional success is risky
Asset management, in particular, is a classic example of conventional failure. Unconventional success brings a fund manager fame and riches; you only need to look at those who’ve built an entire career on one big, contrarian bet. But it’s also very risky. Get it wrong and you can be made to look a fool; you can lose your bonus and ultimately your job.
Most fund managers simply have too much to lose to be truly contrarian. So they prefer to fail conventionally and keep their well-paid jobs than assume the risks required to succeed unconventionally.
If, for example, they have a good first half of the year, they often lock in their gains by reducing their risk in the second half. Worse still, they will claim to be active managers, and charge accordingly, while quietly hugging the benchmark. For those who run them, closet trackers can’t lose; they won’t trail the index by much, but they bring in fees regardless. After costs, investors almost invariably do lose, relative to investing in a low-cost index fund.
Consultants and advisers
Nor is it just fund managers who are prone to Conventional Failure Syndrome. Investment consultants have it big time too. They’re perceived as experts by their clients, so why risk tarnishing that expertise by standing out and being made to look silly? Better, surely, to keep on recommending what you’ve always done, and everyone else does, even if you have your private doubts as to the quality of the advice you’re giving?
Most (yes, most) financial advisers are conventional failure addicts as well. In an extraordinary new book, STANDUP to the Financial Services industry, John De Goey, a portfolio manager from Toronto, claims that the majority of advisers in Canada actually cause their clients harm. They don’t mean to, he says; they just do. For example, they trade too much, pick funds based on past performance and try to time the market, and there’s academic evidence to prove it.
“It is just human nature,” De Goey says, “to go along with the crowd when virtually everyone has a consistent perspective. Independent viewpoints are hard to come by when they are met with ostracisation by peers and colleagues. This unwitting lack of independent thought gives way to ‘groupthink’. Pressure to conform means the problem never gets solved.”
Journalists aren’t immune either
Financial journalists are the same. I’m sure, deep down, that most of my colleagues realise that constantly writing about the latest investment products and focussing on short-term market movements does more to help the advertisers than the readers. But why make a fuss? That’s what the financial media does and people want to read about, isn’t it? Journalists, too, havecareers and salaries to think about.
But John De Goey is dead right. Being a lemming is the easy option. But if everyone conforms, problems never get solved.
There is huge inertia and resistance to change in the UK investing industry. Yet, as the FCA’s report on its Asset Management Market Study made abundantly clear, it is riddled with problems from top to bottom. Unless more people start to challenge the status quo, and risk falling on their faces in the process, nothing much will change at all.
Extraordinary things happen
Organisations like The True and Fair Campaign and the Transparency Task Force have made a huge contribution. So too have principled politicians like Frank Field and Tom Tugendhat who’ve spoken out on the need for better consumer outcomes.
But, ultimately, we need to move on from arguing and lobbying. We need to start changing the investing industry, beginning with its culture. We need, in short, to be the change we wish to see.
Of course, we might fail. But as Vote Leave showed, extraordinary things happen when people really put their minds to it.
Comments Off on Even Keynes couldn’t time the market
Financial academics have consistently shown that beating the stock market is very hard to do and that very few investment professionals manage to achieve it, on a cost- and risk-adjusted basis, over the long term.
But what if academics themselves turned their hand to active money management? Are economists, for example, with all the intelligence, academic insights, and other resources they have at their disposal, any better at outperforming the market than anyone else?
Unfortunately, the evidence is not very encouraging. Long-Term Capital Management, or LTCM, the hedge fund led which boasted Nobel Prize-winning expertise but flopped spectacularly in 1998, is often cited as an example, but there are several others.
DAVID CHAMBERS, Reader in Finance at Cambridge Judge Business School, is an expert in this area, having studied in detail the investment performance of John Maynard Keynes, the most famous economist of all, and of the world-renowned Yale University endowment.
In Part 1 of this three-part interview, David discusses what lessons we can learn from the experience of Keynes and the Yale Model.
David, thank you for your time. Together with the market historian Elroy Dimson, you have studied John Maynard Keynes’ performance record as an investor. What did Keynes learn from his experience of investing? And what are the wider lessons for investors today?
John Maynard Keynes was the bursar of King’s College Cambridge from the early 1920s up until his death in 1946. That was one of the many investment roles that Keynes fulfilled in his very busy life. He also managed money for himself and he was also involved as chairman of the board of a large-sized investment insurance company, as well as the investment director for another insurance company. But it’s fair to say that the endowment fund that he ran for King’s College — after his own money, of course — was the thing that was closest to his own heart.
Keynes wrote an awful lot about investments and a lot of that material exists in the archives, and some of that material has been covered by other historians, most notably, Robert Skidelsky, who wrote an excellent three-volume biography of Keynes. Skidelsky does touch upon some aspects of Keynes’ investment life and he does talk about the change in the investment approach that Keynes underwent during the quarter-century or so that he was running money.
What we set out to do (in our own research) was to try and document that in much, much greater detail and really bring some colour to that whole story. And what we were able to show was that, indeed, he seemed to have undergone this major shift in the way that Keynes approached running his portfolio.
Explain what that shift in approach was.
It’s fair to say that, in the 1920s, Keynes was running money in what we would call today a top-down or macro kind of style, where he believed it was possible to time entry and exit to the stock market and therefore to switch in and out of equities, bonds and cash according to what he believed the state of the business cycle (or what he called the trade cycle or credit cycle) was. And he pursued this strategy but with a fairly modest amount of success. Most particularly, he failed to spot the collapse that came in the London stock market in October 1929 which was coincident with the Wall Street crash at the same time.
We can see that he failed to spot it because his position, his allocation to equities, within the discretionary part of the portfolio where he had free rein as to how he chose to allocate his assets, was something like 90% of the total assets. So he had this big commitment to equities.
What then happened is that he underwent this sea change in the way that he approached investing. It’s very difficult to say when that move took place — it would’ve been some time in the early 1930s — but he moved towards a position which today we would characterise as a bottom-up stock-picking approach. There was a particular focus on smaller-cap, or smaller-sized, stocks and stocks that had a distinct value bias, where value is defined in terms of dividend yield, for example.
So this was a very significant change, and again, we can see that in his portfolios. We can see this tilt towards smaller-sized stocks, towards higher dividend yielding stocks, and we can also see that the turnover, the amount which he turned over his equity portfolio each year, declined over time. And that decline is consistent with someone moving to a more patient stock-picking approach where they’re trying to adopt a longer horizon in terms of holding the particular stocks that they like.
So as I say, we were able to document this in considerable detail and, I’m pleased to say, as a result of that change, his performance improved quite substantially. So having undergone a relatively disappointing (I’m sure disappointing for him) first decade or so, in the second decade and a half he was much more successful, both for himself as well as for his college.
People who run college endowments, like Keynes did, are often held up as the smartest investors of all. David Swensen at Yale is probably the best example. But what can investors usefully learn from the Yale model, and the investment model of other major universities?
One of the interesting things that came out of the research we did on John Maynard Keynes is that we made a connection between the investment writings of Keynes and his investment experiences, and the writings of David Swensen at Yale. David Swensen became the chief investment officer of the Yale endowment in 1985, and still today is running that fund extremely successfully.
As you say, Yale has become associated with the so-called “Yale model”. The major characteristics of the Yale model are that it has a very equity orientated approach. So it’s looking to invest in equity risk or equity-like risks and it has a tilt towards what we call illiquid assets — things like hedge funds, or private equity, or timber, oil and gas assets. These kinds of investments are not ordinarily as liquid as investing, say, in the stock market.
The Yale model model has, at the same time, this belief in a very active style of investing. David Swensen in fact wrote a very good book quite a few years ago now called Pioneering Portfolio Management, where he set out, in quite a lot of detail, his investment beliefs and how the Yale endowment went about fulfilling those beliefs in investing the portfolio. If you look in that book and if you look in the index of that book, it is sprinkled with references to Keynes and his writings. In another paper that I did with Elroy Dimson, we were able to look at those links and look at what Keynes was doing and how it was that Keynes developed his own beliefs and then draw the dotted line to Swensen’s beliefs.
But how easy is it, in practice, to replicate these sorts of ideas?
Well, one question that arises is: how relevant is the Yale model, or Swensen’s beliefs about investing, for the ordinary investor? And in fact, David Swensen, a few years later, wrote a second book, after Pioneering Portfolio Management, which was called Unconventional Success.
Unlike the earlier book, which was aimed at institutional investors, Unconventional Success was aimed at the ordinary, or retail, investor, if you like. The book was really trying to tell ordinary investors: don’t just pick up the Yale model and apply that to your investment portfolio. It’s something that requires an awful lot of resources and an awful lot of time in terms of sifting through investment opportunities, looking for the best managers, and so on. It also involves substantial amounts of risk and, more importantly, cost — an awful lot of money.
If you’re an ordinary investor, you’re much better off starting from the position of: how do I get equity exposure? You can do that, for example, through passive funds or through ETFs and look to try and keep your costs as low as possible. And be very careful about investing in illiquid kinds of assets. The amount of knowledge that is required to go investing in these areas is very substantial.
Look out for Part 2 of this interview in which David Chambers will discuss the findings of his research into IPOs, or initial public offerings, and how IPO stocks tend to perform after they float.
