Yale Endowment Manager: Index

Among individual investors, David Swensen isn’t a household name. But he is an icon in the world of big institutional money managers such as endowments and pension funds.

Mr. Swensen’s fame comes from his oversight of Yale University’s $15 billion endowment fund, which, since he was hired 20 years ago, has returned an average of 16% a year, far outpacing the market and other funds run for universities. Before arriving, Mr. Swensen had never overseen an institutional portfolio, and he brought to the job an unconventional approach for dividing up the portfolio among different asset classes. He is now Yale’s chief investment officer.

Five years ago, Mr. Swensen set out to write a book that would bring the lessons he learned to individual investors. Instead, he says he found that the option most accessible to individuals — mutual funds — often makes it impossible to beat the market. And even when they do find good managers, individuals end up shooting themselves in the foot, he says.

So while Yale relies on actively managed portfolios, Mr. Swensen says individuals should just stick to index funds, especially those run by not-for-profit companies. He also likes exchange-traded funds, which trade on exchanges like stocks, but says "buyer beware."

Excerpts from an interview with Mr. Swensen follow:

WSJ: You had hoped to give small investors a road map for beating the market based on Yale’s approach to investing. What happened?

Mr. Swensen: I found when I started down that path that individuals just don’t have the same set of investment opportunities available to them that we do here at Yale. In fact, the evidence showed me that the mutual-fund industry has completely failed to provide reasonable active-management returns to individuals.

WSJ: To say that it completely failed — that’s a pretty harsh statement to make.

Mr. Swensen: I think the evidence is there. The crux of the failure is with the for-profit management of funds for individuals. Mutual-fund managers have a fiduciary responsibility to investors. Obviously, if they are operating in a for-profit mode, they have a profit motive. When you put the profit motive up against fiduciary responsibility, that fiduciary responsibility loses and profits win.

continued below . . .

Yale Manager Blasts Industry
THE WALL STREET JOURNAL, September 6, 2005


WSJ: But the investment managers that Yale hires — or any other institutional investor hires — are out to make money.

Mr. Swensen: But there it’s a fair fight. In the context of Yale,
you’ve got a sophisticated institutional investor on the one hand and a
for-profit provider of investment services on the other hand. And we
can go toe-to-toe and end up with a fair result. If you look at Yale’s
history over the last 20 years, we have excellent results in terms of
active-management returns.

problem in the mutual-fund industry is that you’ve got a sophisticated
provider of investment services on the one hand and, on the other, you
have an unsophisticated consumer. That imbalance leads to behaviors
that line the pockets of mutual-fund managers and at the expense of the
individual investor.

WSJ: What is some of the evidence that you believe shows that mutual funds have failed small investors?

Mr. Swensen: The data I cite in the book was put together and
analyzed by Rob Arnott (chairman of manager Research Affiliates LLC).
He adjusts for survivorship bias, an incredibly important phenomenon.
If you don’t do that, you are going to get a false picture of what the
world looks like.

WSJ: So if you look at the regular data on fund performance, you’re not seeing the whole story?

Mr. Swensen: You’re not seeing the losers that disappear. They could
disappear because they go out of business or because cynical managers
of mutual funds will take poorly performing funds and merge them into
better-performing funds, and so the record of the poor performer
disappears. The picture that you get if you just look at the survivors
is dominated by the winners — but of course investor dollars were
invested with the losers that disappeared.

And if you look at the aggregate results of the mutual-fund industry
on an after-fee, after-tax basis and adjust it for survivorship bias,
the probability that you are going to end up with market-beating
returns is de minimus. According to (Mr. Arnott’s data), the 10-year
after-tax shortfall for mutual funds is 4.5% per year relative to what
you would have gotten if you had put your money in an index fund.

That doesn’t even take into account the fees for advice … which
takes you from a de minimus probability to a virtual certainty that you
will end up losing relative to the market.

WSJ: What keeps funds from living up to their promise?

Mr. Swensen: So many of the behaviors that lead to high-quality
investment performance diminish (managers’) profits. For example, size
is the enemy of performance. If you limit assets under management, you
have a much better chance of beating the market. But asset gathering
improves profits. So what happens? Almost invariably, managers are out
there gathering assets, trying to increase profits, and it comes at the
expense of generating investment returns.

Concentration is another important factor in generating high levels
of incremental returns. We have managers in Yale’s portfolio that will
hold three or four or five stocks, or maybe eight or 10 stocks. You
have to have an enormous amount of conviction, and you have to really
believe that you have got an edge to make those kinds of concentrated
bets. But it’s not sensible for a mutual fund to do that from a
business perspective because the volatility of the results relative to
the market will be way too great, and the manager of the mutual fund
will likely not be able to amass the same level of assets they would if
they pursued a much more diversified strategy.

It also doesn’t scale. If you are trying to run a concentrated
portfolio and have a huge amount of assets under management, you just
can’t do it. One of the best managers out there has had as few as three
securities and never more than 10. If you’re Fidelity Magellan, with
$50 billion or $60 billion, there’s no way you can just put three
stocks in the portfolio.

As we’re going down the laundry list of reasons why mutual funds
fail, you have to talk about the turnover in the portfolios. A very
significant portion of assets in mutual funds are taxable, and the
overwhelming majority of mutual-fund assets appear to be managed with
complete indifference to the tax consequences. It’s probably not
criminal, but it should be.

WSJ: But there are portfolio managers who practice a very low-turnover, high-conviction style of managing mutual funds.

Mr. Swensen: Southeastern Asset Management (manager of Longleaf
Partners Funds) is one, and there are probably a handful of others. But
that brings us to the second set of problems, which has to do with the
way that individuals behave.

I looked at the results of three years before and three years after
the technology-stock bubble. If you looked at the stated investment
returns, they went up for three years and went down for three years. So
the results over the six-year period were basically zero — no harm, no

Then you look at the cash flows. Because people chased performance,
the overwhelming fund flows occurred in ’99 and 2000. So individuals
bought in right at the top and ended up suffering in the downturn.
There was massive wealth destruction.

Even though Southeastern does a wonderful job of managing … they
suffered substantial withdrawals in ’99 and 2000 because investors were
disenchanted with the low turnover, concentrated, steady-as-she-goes

WSJ: You have issue with fees charges by funds as well.

Mr. Swensen: Not only the investment-management fees but the 12b-1
fees, which are completely at odds with investor interests. You are out
there charging fees for marketing and distribution, and so you are
charging the investor for adding assets under management — which
ultimately hurts the investor’s prospective returns. It’s a very sweet
deal for the mutual-fund industry, and it’s terrible for the investor.

WSJ: The fund industry says without these fees, it couldn’t attract investors.

Mr. Swensen: That was the argument when the SEC allowed them quite a
number of years ago. I thought it was a specious argument and viewed it
without merit then, and it certainly doesn’t have merit now.

WSJ: Some of these fees go to compensate financial advisers. Those folks are providing a service, so don’t they need to be paid?

Mr. Swensen: The amount that people pay for financial advice relative to the quality of what they get is totally out of whack.

WSJ: For individuals, given the way the fund industry operates, you
argue that they should be focusing on the not-for-profit companies and
index funds such as Vanguard Group and TIAA-CREF. (Mr. Swensen is on
the board of TIAA, but isn’t directly responsible for mutual funds,
which fall under CREF.) What does that get you?

Mr. Swensen: Well it doesn’t give you much to talk about at cocktail
parties! It gets you a well-diversified equity-oriented portfolio that
ought to be good for all seasons.

WSJ: When it comes to diversifying a portfolio, you have somewhat unconventional asset-allocation recommendations.

Mr. Swensen: When I arrived here 20 years ago, we had a pretty
typical institutional portfolio, maybe two-thirds in domestic stocks
and another big chunk in domestic bonds and a smattering of
alternatives. And if you apply the principle of diversification and the
notion of the equity orientation to these portfolios…they fail the
test of diversification because there is a huge chunk in domestic
equities, and they generally fail the test of equity orientation
because there is too much in fixed income and cash. Currently at Yale,
we’ve got a half a dozen asset classes with weights ranging between 5%
and 25%. And I identify a half dozen asset classes that individuals
ought to have in their portfolio. Traditional bonds, inflation-indexed
bonds, domestic equities, foreign-developed equities, emerging-market
equities and real-estate securities.

WSJ: You argue investors should have just 30% in domestic stocks.
But most people think ‘I’m a super-long-term investor, so I’m going to
be loaded to the gills with domestic stocks or just stocks.’

Mr. Swensen: There are lots of ways you can produce equity-like
returns without exposure to domestic stocks. So the foreign equities
and foreign emerging equities and the real-estate positions ought to
produce returns that are not dissimilar from those of U.S. stocks over
reasonably long periods of time. It’s important to point out that one
size doesn’t fit all and individual circumstance could lead an
individual to hold a portfolio that would differ from the one that
we’re talking about right here.

WSJ: If you like index funds, where do exchange-traded funds fit in?

Mr. Swensen: To the extent that ETFs are focused on index management
— with the provision that the indexes are well-structured indexes — I
think they are absolutely great. It’s another low-cost, even more
tax-sensitive investment that people can use to implement a sensible
asset allocation. But as they have grown in popularity, the waters have
been polluted by a variety of ETFs that have essentially
active-management components and poor fee structures. So it’s a
circumstance where buyers need to beware.

WSJ: Most average investors think an index is an index. What should they be on the lookout for?

Mr. Swensen: The S&P 500 is a well-structured index because it
has relative low turnover and the low turnover leads to reasonable tax
characteristics. But the Russell 2000, which consists of stocks ranked
by market capitalization…as defined once a year, has ridiculous
characteristics. The turnover is extraordinarily high. In a market that
you expect will rise over time, it will have very poor tax
consequences. It’s very widespread and used a lot but ridiculously,
poorly constructed.

Yale Manager Blasts Industry
THE WALL STREET JOURNAL, September 6, 2005

What's been said:

Discussions found on the web:
  1. CMG commented on Sep 25

    2 things–

    A. there is another great interview with Swenson in this months FORTUNE magazine.


    B. Rumor has it this guy (Swenson) will go to Harvard to manage their massive endowment fund once J. Meyer retires.

    Meyer — who is currently Harvard’s endowment manager — will be leaving soon to start a hedge fund, which would create an empty slot for the prestigious Harvard job.

  2. Idaho_Spud commented on Sep 26

    *Sigh* This is discouraging.

    There is literally *no place* for the average Joe to invest his money and expect a decent return. The game is rigged. He can:

    Bury it in the back yard or put it in a savings account or CD, and inflation will eat him alive.

    Invest in real estate (ha!) and watch as the bubble collapses.

    Put it into a mutual fund, where late trading and fees eat most of his profits.

    Try to be better than professional full-time stock pickers and find the next Wal-Mart in his spare time. That’s when he’s not working his day job to pay the bills.

    Looks like the best way to get ahead is still to pick good parents – something that I failed to do.

  3. I, Hans. commented on Sep 26

    Read it all before you invest.

    The Big Picture: Yale Endowment Manager: Index: You’re not seeing the losers that disappear. They could disappear because they go out of business or because cynical managers of mutual funds will take poorly performing funds and merge them into

  4. Barry Ritholtz commented on Sep 26

    its a matter of timing

    Investors need to recognize there are periods of over-performance and periods of under-performance;
    We just finished a long period of over-performance: 1982-2000
    The payment for that is a period of under-performance (think 1966-1982)

    see these chart for more details

    there are opportunities in these weak periods — they are more difficult to discern,
    see this graphic of 66-82 for more details

  5. Royale wit Cheese commented on Sep 26

    “Investors need to recognize there are periods of over-performance and periods of under-performance”

    Is a manager any more useful in a period of under-performance?

  6. Eddy commented on Sep 26

    I agree with Swensen about mutual funds, but I think he’s sending a dangerous message about individual investing. If anything, the institutions are the ones who are handicapped.

    Telling people that the game is fixed against them is one of most toxic messages in America today. The fact that many investors have lost to the market simply doesn’t mean they’ll continue to do so. It me, it simply means that there are too few disciplined investors out there.

    Here’s my take: http://www.crossingwallstreet.com/archives/2005/08/unconventional.html

  7. royce commented on Sep 26

    Doing well isn’t impossible for a talented individual investor even in a bad year. Keynes famously picked stocks from his bed with outsized returns, so we know it’s possible. The trouble for nearly all individual investors is that they’re not Keynes. Their ability to pick stocks is average, and to beat the return of the market, they have to find stocks that the pros on Wall Street have valued incorrectly. They have to do this day in, day out, for a couple of decades, while simultaneously maintaining another job and not spending all their spare time on managing money. The odds are way stacked against them, which is why accepting the average returns of the low-maintenance, low-expense index fund is seen as such a good idea.

  8. Catablast! Media Group commented on Sep 27

    One skeptic recently said:

    There is literally *no place* for the average Joe to invest his money and expect a decent return. The game is rigged.

    This statement reminds me of Gekko’s game theory monologue at the end of Wall Street.

    Anyways, I think individuals sometimes have an advantage over institutions, who can’t move in and out of stocks rapidly or without creating a big splash.

    There are a lot of day traders who were making $20,000 a day with Taser International (TASR, the stun gun maker that went to the moon and back in early 2004).

    By the time, the mutuals, pensions, and banks wanted a piece Taser’s volcanic run, there was no run.

    The stock was on its way down — way down where grown ups don’t play.

    Moral of the story: Don’t underestimate where you stand relative to the elephants.

    Run yonder, oh nimble one!

  9. TonytheTiger commented on Sep 28

    I agree with Barry as far as timing goes. As I have mentioned before, I trade for a living. I can tell you first hand that the markets are ruthless….no place for an investor. But!, these markets cannot exists without the investor. They are called “Dunb Money” among other names.

    It’s a psychological game, and it takes an average 10 years to learn to become a pro.

    I trade options on the ETF’s, there is an incredible amount of slippage. You buy at the bid and you lose 5 points. Then there are commission charges….$1.50 per option, then another charge when you sell. You lose 5 points when you sell at the ask because the option needs to be 5 points above the ask.

    That means I need to know where the market is going before hand. I have to predict direction.

    I trade 50, 100, and 200 lots, that”s a lot in commission charges, and not to mention slippage.

  10. SoCal Chris commented on Sep 28

    TonytheTiger: Do you have any long volatility positions? … I mean looooooong volatility.

    Leap-straddle ATM.

  11. Omega A commented on Jan 18

    Sure he has a great track record but to bash all mutual funds is crazy. One thing he fails to mention is the key to success is rebalancing. The average investor can buy all the index funds and EFT’s they want but if they are not discipline enough to have a buy and sell strategy then they will not be successful. Fund companies cannot control the average investor’s knee jerk reactions. Of course they sell when they shouldn’t and buy at the wrong time….they are human. Rather then point the finger at the fund managers he should blame the lack of education available to investors on keys of being successful such as having correct asset allocation and the importance of rebalancing….after all the majority of your long term returns come from having the right mix between stocks and bonds and not from the positions you own and when you bought and sold them.

  12. Bruce commented on Oct 30

    In the short run, timing does matter but in the long run we’re all dead.

    I ran a model based on Swenson’s portfolio mix (and adjusting every 6 months), starting from 2 different time frames. The first run I started it on June 30, 2000 and to date (10/27 closing prices) its up over 7% annually, not including any dividends that weren’t included in the prices (I estimate they’d add just under 1% to the yearly return based on the investment vehicles I used in the model).

    The 2nd run I started on January 1, 2003 and that run (3.8 years) produced yearly gains of over 16%, not including dividends.

    I haven’t run the model on a longer time frame, ie 10 years or more, but I would guess that it would produce returns somewhere in the middle of that range, maybe 12% annually with no market timing. If one were to use bullish % numbers to time their investments maybe they could supercharge those returns.

  13. Mike Alfred commented on Feb 19

    I think you can build an endowment style portfolio in 2007 using only ETFs and essentially model Yale’s endowment. The biggest portion of the Yale endowment that will be nearly impossible to model is absolute return because it consists of vehicles like hedge funds and private equity. That said, I think he is right on in saying that average investors have been heavily overweighted in domestic stocks and bonds and should gradually re-position their portfolios to take advantage of commodities, real estate, and other assets that can be targeted using some of the new ETFs (that everyone seems to want to bash).

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