We've already talked about
our guest today. This is David Swensen. Remember, I said he was the
inventor of the swap, which is a real claim to fame, because
swaps total in the hundreds of billions -- PROFESSOR DAVID SWENSEN:
Trillions. PROFESSOR ROBERT SHILLER:
It's amazing. PROFESSOR DAVID SWENSEN: I
thought this was going to be a polite introduction. I used to be proud of the
swap thing, but that was before the crisis. PROFESSOR ROBERT SHILLER:
Well, that's financial innovation. I think, swaps are a very
important new technology. We've been talking about that. So anyway, just to
remind you -- David Swensen came to Yale in
1985, when the portfolio was worth less than $1 billion. And as of June, 2010,
it's $16.7 billion. PROFESSOR DAVID SWENSEN:
And climbing. PROFESSOR ROBERT SHILLER:
And climbing. And this is a financial crisis,
but between 2009 and 2010, the portfolio went up $1.4
billion, so there's no crisis around here. Well, there was a little
hitch at one point. But that kind of
thing happens. I take pride in training young
people in finance. David Swensen has done the same
with many young people. Notably, Andrew Golden, who
heads the Princeton portfolio, is one of your trainees. And he's had an almost as
spectacular record as well. Well, with that introduction,
I will turn it over to David Swensen. PROFESSOR DAVID SWENSEN:
Thank you. [APPLAUSE] PROFESSOR DAVID SWENSEN: So,
I've been at Yale for, I guess, more than 25 years now. And for most of the 25 years,
if there was any publicity, the publicity was pretty good. For the past couple of years,
it's been a little bit mixed. And, I liked it better, before
the publicity was mixed. I liked it, when every article
that you would read had something great to say about
the Yale Approach or the Swensen Model. But after the collapse of Lehman
Brothers and the onset of the financial crisis, it
didn't take very long for the negative headlines to appear. As a matter of fact, I carry
around this Barron's article that appeared in November
2008, and the title was ''Crash Course.'' And it talked
about colleges cutting budgets, freezing
hiring, scaling back building projects. And it blamed the Yale Model and
the Swensen Approach for being too aggressive. They said in Barron's that
university endowment should own more stocks and bonds, less
in alternatives, because the alternatives provided too
little diversification and too little liquidity. So, I thought what we could do
today as a jumping off point is, talk about what it is that
Barron's meant when they were talking about the Swensen
Approach or the Yale Model and -- I think, when it was successful,
it was the Yale Model, and when it failed, it
was the Swensen Approach, which I really don't like. There's an asymmetry there. I keep thinking that I should
name it after one of the guys in the office. Maybe it should be the Takahashi
Approach instead of the Swensen Approach. It's time for him to have
some glory, right? Talk about what it is that
Barron's meant by Swensen Approach or the Yale Model, and
see, whether, indeed, the criticisms that they levy,
that there's too little diversification and two little
liquidity, whether those criticisms are valid. But to do that, let's go
back to 1985, when I first arrived at Yale. It was April 1, 1985, for those
of you who care about April Fools' Day. I came from a six-year stint on
Wall Street, and I had no significant portfolio management
experience. As Bob mentioned in his
introduction, I'd been involved with structuring the
first swap transaction in 1981, when I worked for
Salomon Brothers. It was a swap between IBM
and the World Bank. And later, Lehman Brothers hired
me to set up their swap operations. So, generally what I was doing
on Wall Street was working with new financial technologies
and being involved with the early days
of swaps transactions. It was a much smaller
market then, it wasn't hundreds of trillions. And it was a much less efficient
market then, so the trades were incredibly
profitable. Commodity swaps today trade on
razor thin margins, and tend not to be anywhere near as
profitable as they were when the markets were much
less efficient. How did I end up at Yale? Well, one of my dissertation
advisors called me and said they needed somebody to
manage the portfolio. And after coming to New Haven
and talking to them about the job, I realized that my heart
wasn't in Wall Street. My heart was in the world of
education, and at Yale in particular. So I came up here, amazed that
I was responsible, as Chief Investment Officer, for
this portfolio. It was less than $1 billion,
but close to $1 billion. And the first thing I did was,
I looked around to see what other people were doing. That seemed like a sensible way
to approach the portfolio management problem. There must be some smart people
at Harvard or Princeton or Stanford putting together
portfolios that make sense for endowed institutions. What I saw was that colleges
and universities had, on average, 50% of their portfolio
in U.S. stocks, 40% of their portfolio in U.S. bonds
and cash, and 10% in a smattering of alternatives. Even though I had no direct
portfolio management experience, I had studied at
Yale and Jim Tobin and Bill Brainard were my dissertation
advisors. And I understood some of
the basic principles of corporate finance. And one of the first things that
you learn when you study finance theory, is that diversification is a great thing. Jim Tobin won the Nobel Prize
in part for his work related to the subject of
diversification. In fact, when a New York Times
reporter asked Jim to explain, in layman's terms, what it was
that he won the Nobel Prize for, Jim said, well, I guess you
could say, don't put all your eggs in one basket. I didn't know you got a Nobel
Prize for that, but that's -- PROFESSOR ROBERT SHILLER: We
told our students that that phrase goes back to 1802. [correction: Lecture
4 mentions an investment manual from 1874. According to
ngrams.googlelabs.com, the phrase can actually be
traced back to 1800.] PROFESSOR DAVID SWENSEN: OK,
so if it goes back to 1802, Jim was just picking up on the
vernacular and used it as a way to describe what it is
that he did his work for. And Harry Markowitz, who
actually did a fair amount of his work on modern portfolio
theory at Yale's Cowles Foundation, has said that diversification is a free lunch. I mean, didn't you learn in
introductory economics and intermediate [clarification:
intermediate economics] that there ain't no such
thing as a free lunch? Economists are always talking
about trade-offs. If you want more of this,
you have less of that. Well, with diversification,
that's not true, right? If you diversify your portfolio
for a given level of return, you can generate that
return at lower risk. If you diversify for a given
level of risk, you can generate higher returns. So, diversification is this
great thing, it's a free lunch, it's something that
everybody should embrace. Well, if you look at the
portfolios that I saw in the world of endowment investing in
the mid-1980s, they weren't diversified. If you've got half of your
assets in a single asset class, U.S. stocks, and you
have 90% of your assets in U.S. marketable securities,
you're not diversified. Half your assets in a single
asset class is way too much. And the 90% that are in stocks
and bonds under many circumstances will respond to
the same driver of returns, interest rates, in
the same way. Lower interest rates,
mathematically, are good for bonds, and lower interest rates
lower the discount rate that you use to discount future
earning streams, so they're probably going to
be good for stocks too. And vice versa. And the second thing I thought
about was the notion that endowments have a longer
time horizon than any investor that I know. And if you've got a long time
horizon, you should be rewarded by accepting
equity risks. Because those equity risks,
even though they might not reward you in the short
run, will reward you in the long run. So, with a mission, as a manager
of an endowment, to preserve the purchasing power
of the portfolio in perpetuity, I expected that
other endowments would have substantial equity exposures, to
take advantage of the fact that, in the long run, that's
where you're going to generate the greatest returns. But if you think about those
endowment allocations that I saw in the mid-1980s, 40% of the
assets were in bonds and cash, which are low expected
return assets. So, the portfolios that I saw
when I got to Yale failed the basic common sense test of
diversification and equity orientation, and it prompted
me and my colleagues to go down a different path, to put
together a portfolio that had reasonable exposure to equities,
and put together a portfolio that was sensibly
diversified. So, I'd like to talk about how
it is that we got from where we were in the mid-80s to
where we ended up in the early- to mid-90s, and where
we remain today. And to do that, I'd like to put
it in the context of the basic tools that we have
available to us as investors. And these tools are the tools
that you can employ if you're managing your portfolio as an
individual, or the tools that I have to employ when I'm
managing Yale's portfolio as an institutional investor. And there are basically three
things that you can do to affect your returns. First of all, you can decide
what assets you're going to have in the portfolio and in
which proportions you'll hold those assets. So, that's the asset allocation
decision. How much in domestic stocks,
how much in foreign stocks, how much in real estate. If you're an institutional
investor, how much in timber, how much in leveraged buyouts,
how much in venture capital. The fundamental decision of how
it is that the portfolio assets are allocated. The second thing that
you can do is make a market timing decision. So, if you establish targets
for your portfolio -- targets with respect to how much
in domestic socks, how much in domestic bonds, how
much in foreign stocks. And then, because in the short
run, you think that -- let's say domestic stocks are
expensive and foreign stocks are cheap -- you decide to hold more foreign
stocks and less in domestic stocks. That bet, that short-term bet
against your long-term targets, is a market
timing decision. And the returns that are
attributable to that deviation from your long-term targets are
the returns that would be attributable to market timing. And the third source of
returns has to do with security selection. So, you've got your allocation
to domestic equities. If you buy the market -- and
the way that you buy the market is to buy an index fund
that holds all the securities in the market in the proportions
that they exist in the market -- if you buy the
market, then your returns to security selection are zero,
because your portfolio is going to perform in line
with the market. But if you make security
selection bets, if you decide that you want to try and beat
the market, then that bet or that series of bets will
define your returns attributable to security
selection. So, if you decide that you think
the prospects of Ford are superior to the prospects
of GM, well, you want to overweight Ford and
underweight GM. And if that turns out to be a
good bet and you're rewarded, because Ford outperforms and
GM underperforms, then you have a positive return to
security selection. If the converse is true, then
you have a negative return to security selection. But one of the really important
facts about security selection is that, if
you play for free, it's a zero sum game. Because if you've overweighted
Ford and underweighted GM, there has to be some other
investor or group of investors that are underweight Ford and
overweight GM, because this is all relative to the market. And so, if you're overweight
Ford and underweight GM and somebody else is underweight
Ford and overweight GM, well, at the end of the day, the
amount by which the winner wins equals the amount by
which the loser loses. And so, it's a zero-sum game. Of course, if you take into
account the fact that it costs money to play the game,
it turns into a negative-sum game. And the negative-sum is the
amount that's siphoned off by Wall Street. And Wall Street takes its pound
of flesh in the form of market impact, in the form of
commissions, in the form of fees that are charged to manage
the portfolio actively, and then sometimes there are
even fees to consultants to choose the manager. So, there's an enormous drain
from the system that causes the active investment activity
to be a negative-sum game for those investors that
decide to play. So, let's take these in turn
and start out with asset allocation. Asset allocation is far and away
the most important tool that we have available
to us as investors. When I first started thinking
about this 25 years ago, I thought, well, maybe there's
some financial law that says that asset allocation is the
most important tool, because it seems pretty obvious that
that was going to be the most powerful determinant
of returns. But it turns out, that it's not
really a law of finance that asset allocation dominates
returns, it's a behavioral result of how it
is that we as individual investors, or we as
institutional investors, manage our portfolios. If I make it back to my office,
traversing these icy sidewalks, I could take Yale's
$17 or $18 billion dollars and put it all in Google stock. If I did that, I am not sure
how long I'd keep my job. It might be fun for a while,
but that would probably be damaging to my employment
prospects. But if I did that, asset
allocation would have almost nothing to say about
Yale's returns. It would be the idiosyncratic
return associated with Google that would determine whether the
endowment went up or down or stayed flat. And so, security selection
would be the overwhelming important determinant of returns
for Yale's endowment. And if it wasn't exciting enough
to sell everything and put it on Google stock, maybe
I could go back to my office and start day trading
bond futures. Well, if I took Yale's entire
$17 or $18 billion dollars and started trading bond futures
with it, asset allocation would have very little to
say about Yale's return. Security selection would
probably have very little to say about Yale's return, so it
would all be about market timing ability. And if I'm great at following
the trend -- the trend is your friend -- of course, that's
true until it's not. Or if I've got some sort of
marvelous scheme to outsmart all the other smart people, who
are trading in the bond market, I could generate
some nice returns. But those returns would have
nothing to do with asset allocation, nothing to do with
security selection, and everything to do with
market timing. Of course, these sound like
ridiculous things, right? I mean, everybody in this room
knows, that I'm not going to go back and put Yale's entire
endowment in one stock. And we also know, that I'm not
going to go back and day trade futures with the endowment. I'm going to go back, and the
portfolio is going to look a lot like it looked yesterday,
and the day before, and the month before that, and the year
before that, because as investors, whether we're
individual investors are institutional investors, we
tend to have a sensible, stable approach to
asset allocation. And within the asset allocation
framework that we employ, we tend to hold
well-diversified portfolios of securities within each
of the asset classes. So, that means that asset
allocation is going to be the predominant determinant
of returns. Bob Shiller and I have a
colleague at the School of Management, Roger Ibbotson,
who's done a fair amount of work looking at the
various sources of returns for investors. And a number of years ago, he
came out with a finding that more than 90% of the variability
of returns in institutional portfolios had
to do with the asset allocation decision. And that was a very widely
read, and widely accepted conclusion. In that same study, I thought
that there was a more interesting conclusion, and that
was that asset allocation actually determined more than
100% of investor returns. How could that be, how could
asset allocation determine more than 100% of returns? Well, it goes back to the
discussion that we had about security selection and the fact
that it's not free to play the game, and the
same thing's true about market timing. If somebody is overweighting
a particular asset class relative to the long-term
targets that they've got, well, there's got to
be an offsetting position in the markets. Market timing is expensive in
the same way that security selection is expensive. And so, it, too, is a zero-sum
game, even though the analysis that you'd apply to market
timing isn't quite as clear and crisp as in the closed
system that you've got with any individual securities
market. So, if security selection
and market timing were negative-sum games, then asset
allocation would explain more than 100% of the returns. And, on average, for the
community as a whole -- because investors do engage in
market timing, investors do engage in security
selections -- those are going to be
negative-sum games, and you have to subtract the leakages
occurring because of security selection and market timing,
in order to get down to the returns that you would get if
you just took your asset allocation targets and
implemented them passively. So, it turns out that asset
allocation is the most important way that we express
our basic tenets of investment philosophy. I talked about the importance
of having an equity bias. Well, these are some
of Ibbotson's data. He's got this publication called
Stocks, Bonds, Bills, and Inflation, although he
might have sold it to Morningstar, so maybe it's
Morningstar's publication now. And it actually is an outgrowth
of some academic research that he did
decades ago. And the basic drill was,
starting in 1925, looking at a number of asset classes -- the ones that I've got here are
Treasury bills, Treasury bonds, large stocks, small
stocks, and then, as a benchmark, inflation -- starting the investment at the
end of 1925, taking whatever income was generated from that
investment, reinvesting it and seeing where you end up at
the end of the period. I've got here the numbers
from 1925 to 2009. And if you did that with
Treasury bills, which are short-term loans to the U.S.
government, one of the least risky assets imaginable, you
would have ended up with 21 times your money over
the period. If you think about that, 21
times your money, that's pretty good. But if you think about the fact
that inflation consumed a multiple of 12, well,
you didn't end up with a lot after inflation. And if you're an institution
like Yale and you only want to consume after-inflation returns,
so you can maintain the purchasing power the
portfolio, well, 21 times, but taking off 12 times for
inflation, not so good. One of the interesting things
about the Stocks, Bonds, Bills, and Inflation numbers
over long periods is that they correspond to our sense of the
relationship between the riskiness of the asset, and the
notion that, if you except more risk, you should
get higher returns. And so, if you move up the risk
spectrum and, instead of looking at Treasury bills, you
look at Treasury bonds, you end up with a multiple
of 86 times. That's pretty good, 86 times. I mean, it's a lot better
than 21 times for bills. It's still not a huge
return for decades and decades of investing. So, what happens if you move
away from lending money, in this case lending money to the government, to owning equities? The multiple over this period --
and this includes the crash in 1929, the market collapse in
1987, and the most recent financial crisis. In spite of those blips, you
would've ended up with 2,592 times your money. That's stunning, that's way
more than 86 times and way more than 21 times. So, over long periods of time,
you do end up being rewarded for accepting equity risk. And what would've happened if
you would have put the money in small stocks and
let her run? 12,226 times your money. So, the conclusion is
pretty obvious. This notion that, if you've got
a long time horizon, you want to expose your portfolio
to equities, it makes an enormous amount of sense. As a matter of fact, the first
time I took a look at these numbers was back in 1986,
when I was teaching -- probably a predecessor to the
class that Bob Shiller's teaching, it was a lecture
class in finance -- and I was preparing the lecture
that had to do with long-term investment
philosophy. And that's when I first saw
these numbers, and I was little bit disconcerted when
I put them together. Because I thought, gee, 21 times
for bills, 86 times for bonds, 12,226 times
for small stocks. Maybe the right thing to do
is to just put the whole portfolio into small stocks
and forget about it. And my first problem was that,
if that were true, what was I going to say for the next
ten weeks of lectures? My longer-term problem was,
that, if the investment committee figured out, that all
we needed to do is put the whole portfolio in small stocks,
and that that was the way to investment success,
I wouldn't have a job. They wouldn't need
me to do that. And I had a wife and young
children, and I like getting a paycheck and being able to
feed and house them. So, I took a look at the data
more carefully, and there are a number of examples of
what it is that I'm going to talk about. But the most profound example
remains around the great crash in 1929. And if you had your whole
portfolio in small stocks at the peak, by the end of 1929,
you would have lost 54% of your money. By the end of 1930, you would
have lost another 38% of your money, by the end of 1931,
you would have lost another 50% percent. And by June of 1932, for good
measure, you would've lost another 32%. So, for every dollar that you
had at the peak, at the trough you would have had $0.10 left. And it doesn't matter, whether
you're an investor with the strongest stomach known to
mankind, or you're an institutional investor with the
longest investment horizon imaginable, at some point, when
the dollars are turning into dimes, you're going to
say, this is a completely ridiculous thing to accept this much risk in the portfolio. I can't stand it. I'm selling all my small stocks
and I'm going to buy Treasury bonds or
Treasury bills. And that's exactly
what people did. And there was this sense in the
1930s, 1940s, even into the '50s and '60s, that heavy
equity exposures weren't a responsible thing
for a fiduciary. When I was writing my book, I
was fooling around looking at articles from the Saturday
Evening Post -- and I know everybody here is too young to
have seen the Saturday Evening Post when it was still
publishing, but you've all seen Norman Rockwell
prints, right? Well, he was famous for doing
covers for the Saturday Evening Post. And there was this
article in the 1930s -- that's actually before my time,
so I was looking at things in the library, not
things that actually had been delivered to my doorstep -- and the commentator said that it
was ridiculous that stocks were called securities. That they were so risky that
we should call stocks insecurities. There was just this visceral
dislike for the risks that were associated with the stock
market, because it had caused so many investors
so much pain. So yes, stocks are a great thing
for investors with long time horizons, but you need to
diversify, because you've got to be able to live through
those inevitable periods, where risky assets produce
results that are sometimes so bad as to be frightening. Second source of return,
market timing. A few years ago, a group of
former colleagues of mine gave me a party at the Yale Club, and
they presented me with a copy of Keynes's General
Theory -- because back, when I used to
teach a big finance class like this, the last class always
involved reading from Keynes. And I think Keynes is one of
the best authors about investing and financial
markets, bar none. I remember one of my students
telling me afterwards, that I was reading from Keynes as if I
were reading from the Bible. And I had this paperback copy
that was falling apart, and my former students remembered this
and they gave me this beautiful first edition
of Keynes. And I was on the train back from
New York, where the party had occurred, to New Haven
and I found this quote. "The idea of wholesale shifts
is, for various reasons, impracticable and indeed
undesirable. Most of those who attempt to,
sell too late and buy too late and do both too often, incurring
heavy expenses" -- there's that negative-sum game
thing -- "and developing too unsettled and speculative a
state of mind." And as, in most things, the data support
Keynes's conclusions. Morningstar did a study of all
of the mutual funds in the U.S. domestic equity market,
and there were 17 categories of funds. And what they did with this
study is, they looked at 10 years of returns and compared
dollar-weighted returns to time-weighted returns. The time-weighted returns are
simply the returns that are generated year in
and year out. If you get an offering
memorandum or a prospectus, they'll show you the
time-weighted return. If you look at the
advertisements, where Fidelity is touting its latest, greatest
funds, the returns that you see are time-weighted
returns. Dollar-weighted returns take
into account cash flow. So, in a dollar-weighted return,
if investors put more money into the fund in a
particular year, that year's return will have a greater
weight in the calculation. So, here we have all the mutual
funds in the U.S., 17 categories, time-weighted
versus dollar-weighted. In every one of those
categories, the dollar-weighted returns
were less than the time-weighted returns. What does that mean? That means, that investors
systematically made perverse decisions, as to when to invest
and when to disinvest from mutual funds. What investors were doing, they
were buying in after a fund had showed strong relative
performance and selling after a fund had shown
poor relative performance. So, they were systematically
buying high and selling low, and it doesn't matter whether
you do that with great enthusiasm and in great volume,
it's a really, really bad way to make money. Very difficult. So, the conclusion for these
individuals that operate in the mutual fund market is that
their market timing decisions were systematically perverse. I also took a look at the top
10 internet funds during the tech bubble, something I
published in my book for individual investors. And if you looked at the top 10
internet funds three years before and three years after the
bubble, the time weighted return was 1.5% per year. You look at that and you say,
1.5% per year, well, the market went way up and way
down, but 1.5% per year, that's not so bad. No harm, no foul. Investors invested $13.7 billion
and lost $9.9 billion, so they lost 72% of what
they invested. How could it be that they lost
72% of the money that they invested, when the time-weighted
return was 1.5% per year for six years? Well, they weren't invested in
the internet funds in '97, and they weren't invested in
'98, and they weren't invested in early '99. It was in late '99 and early
2000, that all the money piled in at the very top. And then, in 2001 and
2002, bitterly disappointed, they sold. So, they lost 72% of what they
put in, even though the time-weighted returns were
1.5% per year positive. So, institutions don't get
a free pass either. If you look at the crash in
October, 1987, which was an extraordinary event -- I think, the calculation I did
put it at a 25 standard deviation, which is essentially
an impossibility. But however you measure it, it
was an extraordinary event. And what happened on
October 19, 1987? Well, stock markets the
world around went down by more than 20%. What people forget is, along
with the stock markets going down, there was a huge
rally in government bonds, flight to safety. So, stocks were cheaper, bonds
were more expensive. What did institutional
investors do? Well, they got scared,
and they sold stocks and bought bonds. Same thing, buying high
and selling low. As a matter of fact, endowments
took six years to get their post-crash equity
allocations back up to where they were before the crash,
arguably underweighted in equities in the heart of one of
the greatest bull markets of all time. So, the teams of investors,
whether they're individual or institutional, have this
perverse predilection to chasing performance. Buying something after it's
gone up, selling something after it's gone down, and using
market timing to damage portfolio returns. The final tool that we have
available to us as investors is security selection. I cite a study in my book,
''Unconventional Success,'' conducted by Rob Arnott, that
does a very good job of looking at 20 years worth
of mutual fund returns. And he says that there's about
a 14% chance that -- or historically there was a 14%
chance -- of beating the market after adjusting
for fees and taxes. So, you think a zero-sum game
would be a coin flip, 50-50. But because of the leakages from
the system, and because of taxes, the probability of
winning goes down to 14%. But oh by the way, that
14% ignores two very important things. One is that a huge percentage
of mutual funds have front-end loads. If you call your friendly broker
to buy a mutual fund, they'll extract a payment of
2% or 3% or 4% or 5% or 6%. Those numbers aren't included,
so, if you included the loads, that would make the likelihood
of winning substantially less than 14%. But even more important is the
concept of survivorship bias. If you look at 20 years worth
of returns, the only returns you can look at are the returns
of the funds that survived for 20 years. Well, which funds
didn't survive? Almost always, the
funds that don't survive are the failures. So, you're only looking
at the winners. If you look at the winners and
you only have a 14% chance, if you take into account the
losers, that 14% chance has to go to, essentially, zero. And is survivorship bias an
important phenomenon? It is. The Center for Research in
Securities Prices has a survivorship bias-free U.S.
mutual fund database, meaning that it tracks the
funds that fail. There were 30,361 funds
in the database. 19,129 were living. 11,232 were dead. So, more than a third of the
funds in this survivorship bias-free database were
ones that had died. And they died mostly,
because they failed. And that's kind of an honorable
way to die. There are other ways to die. If you're a big mutual fund
complex like Fidelity and you've got an underperforming
fund, what you tend to do is something like, oh, let's merge
that into this fund that has good performance. And guess what happens? Fidelity loses a fund that has
bad performance, and one that has good performance has more
assets, because they merge the underperforming fund into it,
and makes them look like they're a more successful
fund management firm. There's one other aspect of
security selection that's important, an aspect other
than the fact that it's a negative-sum game that's
very tough for practitioners to win. And that has to do with the
degree of opportunity that you've got in various
asset classes. A number of years ago, I wanted
to come up with a way of identifying, in an analytical
manner, where it is that we could find the most
attractive investment opportunities. And, as far as I know, financial
economists haven't determined a way to directly
measure, how efficient individual markets are. So, I took a look at
distributions of returns for various asset classes. And I had this notion that,
if a market priced assets efficiently, the distribution
of returns around the market return would be very tight. Why would that be? Well, if somebody makes a big
bet in an efficient market, by definition, whether that
succeeds or fails has to do with more luck than sense. Because the premise is, that
these assets are efficiently priced, and you don't make a big
win on a big bet, unless there's an inefficiency that
you're exploiting. So, if you're making big bets
in an efficiently priced market, you might win one year
and gather more assets, and you might win another year and
gather more assets, but, ultimately, your luck is
going to run out and you're going to fail. And then, people will fire
you, and you'll lose your assets, and lose your
income stream. So, the right thing to do in an
efficiently priced market is to hug the benchmark. People call it Closet
Indexing, look like everybody else. And we're human beings, we don't
like firing people and we don't like admitting
we're wrong. And so, if somebody has
market-like performance, and maybe it's not all that
outstanding, say, OK fine, we'll just continue with this
particular investment strategy, even though it's not
doing great things, at least it's not doing terrible
things. On the other end of the
spectrum, maybe there's not even a market that you
can match with your investment strategy. I mean, think about
venture capital. I mean, how is it that you could
index venture capital? You can't, that's a bunch of
private partnerships and a bunch of idiosyncratic
enterprises. And even if you wanted to, you
couldn't match the market. So, you're forced to go out and
forge your own path, and live and die by the decisions
that you make. So, how does this thought piece translate into real numbers? So again, we're looking at 10
years worth of returns for various asset classes. I look at the difference between
the top quartile manager and the bottom
quartile -- the difference between first and
third [correction: fourth] quartile, you can use
any measure of distribution that you want. And in the bond market, which
is probably the most efficiently priced of all
markets -- and the reason it's most efficiently priced
is, because bonds are just math, right? You've got coupons, you've
got principal, you've got probabilities of default, it's
the most easily analyzed of all the assets in
which we invest. The difference between top
quartile and bottom quartile is 0.50% per annum. Almost nothing. All bond managers are jammed
together right in the heart of the distribution, because if
they were out there making crazy bets and generating
returns that were fundamentally different from the
market, they'd be in that category of, yes, sure, it's
great, when it works, but when it doesn't, you're dead. Large cap stocks, less
efficiently priced than bonds, but still pretty efficiently
priced, two percentage points per annum difference first to
third [correction: fourth] quartile over 10 years. Foreign stocks, less efficiently
priced than those in the domestic markets,
four points per year. Then you move into the hedge
fund world, the part of the hedge fund world that we call
absolute return at Yale, 7.1 percentage points, first to
third [correction: fourth] quartile. Real estate, much less
efficiently priced than marketable securities, 9.3
percentage points, top to bottom quartile. Leveraged buyouts, 13.7%
difference, top quartile to bottom quartile. And the venture capital, 43.2
percentage points difference, top to bottom quartile. So, the measure that we have
here of market inefficiency points us toward spending our
time and energy trying to find the best venture capital
managers, trying to find the best leveraged buyout managers,
and spending far less of our time and energy
trying to beat the bond market or beat the stock market. Because, even if you win there,
even if you end up in the top quartile, you're not
adding an enormous amount of value relative to what you would
have had, if you just would have bought the market. So, with that background, let's
revisit the criticisms that Barron's leveled
at the Yale Model and the Swensen Approach. First of all, they talk about
diversification failing. And the fact is that, in a
panic, only two things matter: risk and safety. And I saw this in 1987, saw it
in 1998 with the collapse of Long Term Capital, and saw it in
2008 in a way that was even more profound than
in '87 and '98. Investors sold everything that
had risk associated with it to buy U.S. Treasuries. Safety was all that mattered. And of course, in that narrow
window of time, diversification does fail. The only diversification that
would matter in that instance is owning U.S. Treasuries. But if you owned a substantial
amount of U.S. Treasury bonds -- and what's a substantial
amount? 25%, 30%, 35% of
your portfolio. Then, under normal
circumstances, under the circumstances, in which we live
most of our lives, you're paying a huge opportunity
cost. So, you could have a portfolio
with 30% in U.S. Treasuries, and year in and year out you
would pay this opportunity cost. And then, when the crisis
comes, you can be happy for six or 12 or 18 months, and
then you go back to paying the opportunity cost. And I
would argue that, if you expand your time horizon to a
sensible length of time, that the strategy, where you hold
relatively little in the high opportunity cost U.S.
Treasuries, is the best strategy for a long-term
investor. And there are those, who say
that, well, diversification doesn't protect you in
times of crisis. What does it matter? Why would you want
to diversify? Well, think about Japan. If you were local Japanese
investor and you wanted to have an equity bias in your
portfolio -- so, you owned lots of Japanese stocks -- in 1989, at the end of the year,
the Nikkei closed at about 38,000. At the end of 2009, 20
years later, the Nikkei closed at 10,500. So, with your long time horizon
and equity bias in your portfolio over
two decades, you would have lost 73%. So, diversification makes an
enormous amount of sense in the long run, even if there are
occasional panics, where you're disappointed that the
diversified approach that you had to managing the portfolio
didn't produce results. The second criticism,
overemphasis on alternatives. Let's just look at the last
decade in Yale's portfolio. Over the 10 years ended June
30, 2010, domestic equities produced returns of negative
0.7% per year, bonds produced returns of 5.9% per year. Let's look at the alternatives,
as opposed to domestic marketable
securities. Private equity, 6.2% per year,
real estate, 6.9% per year, absolute return, 11.1% per year,
timber, 12.1% per year, and oil and gas,
24.7% per year. I think the numbers speak
for themselves. If you have a sensibly long
time horizon, these basic principles of equity
orientation and diversification make an enormous
amount of sense. And if you look at the bottom
line, which is performance, when I began managing Yale's
endowment in 1985, it was less than $1 billion. The amount that we distributed
to support Yale's operations that year was $45
million dollars. For the year ended June 30,
2010, the endowment stood at a little bit above $16
billion dollars. The amount that we distributed
to Yale's operations was $1.1 billion. So, an enormous positive
change over 25 years. If you look at Yale's
performance over the last 10 years, it's still better
than that of any other institutional investor,
8.9% per annum. And that compares to an average
for colleges and universities of about
4.0% per annum. And that translates into $7.9
billion of added value, relative to where we would have
been had we had average returns over the
past 10 years. And the comparable numbers for
20 years are Yale at 13.1% per annum, again, the best record of
any institutional investor in the United States. Relative to an average for
colleges and universities of 8.8% per annum, and $12.1
billion of value added. So, the slings and arrows
of outrageous fortune. I would suggest that the
Barron's articles really took far too short a time horizon. And looking at Yale's
performance and then looking at the Yale Model, which
emphasizes a portfolio that's well diversified and has
a strong equity bias. And I think if we were back in
this room five years or 10 years from now, we'll see that
the portfolio will continue to produce the same kind of strong
long-run results as it has for the past 10, 20 years. With that, I'd love to answer
any questions that you might have. STUDENT: How is your job similar
or different to what a hedge fund manager would do? And what are the concerns that
an institutional investor has to have, versus a personal
investor, a wealthy individual? PROFESSOR DAVID SWENSEN: So,
the fundamental difference between what we would be doing
at Yale, as opposed to a hedge fund manager, or a domestic
stock manager, or a buyout manager, is that we're
essentially one step removed from the security selection
process. So, our job is to find the best
hedge fund managers, find the best domestic equity
managers, find the best buyout managers, and put together
partnerships that work for them and work for
the university. And it's a tricky thing to
do, because, in the funds management world, there are
all sorts of issues with respect to what economists
call the principal-agent problem. And we're principals for the
university engaging agents, the hedge fund managers or the
buyout managers, and trying to find ways to get those agents
to act primarily in the university's interests, to get
rid of those agency issues. And it's a challenge, but a
fascinating challenge, because in doing this, you end up
meeting an enormous number of incredibly intelligent,
engaged, thoughtful individuals that are
involved in the funds management business. And it's a fabulous career, at
least from my perspective, because I get to do this and
do it to benefit one of the world's great institutions,
Yale. In terms of differences between
individuals and institutions, there's some
structural differences. We don't pay taxes. And taxes are an enormously
important determinant of investment outcomes
for individuals. As an individual, you want to
avoid paying taxes or defer paying taxes, because taxes
are just a huge drag on investment returns. We don't have to worry about
that, by and large, in managing Yale's portfolio. Another very fundamental
difference has to do with the resources that we
can bring to the investment management problem. Most individuals, and many
institutions, just don't have the wherewithal, either the
background or the time, to make high quality active
management decisions. Markets are incredibly tough. Beating those markets is an incredibly difficult challenge. And doing it, by spending a
couple of hours on a weekend once a month, isn't
going to cut it. And so at Yale, we've got
20, 21, 22 investment professionals, who are
dedicating their careers to trying to make these high
quality active management decisions, so we can go out
and have a decent shot at beating the domestic stock
market and the foreign stock market, and putting together a
superior portfolio of venture capital partnerships and
hedge fund managers. And over the past five, 10, 15,
20 years, we've produced market-beating results. In contrast, an individual has
almost no chance of beating the market. So I've written two books,
one, Pioneering Portfolio Management that talks about
how it is that, I think, institutions should manage
their portfolio. And if they've got the resources
-- and it's not just dollars, it's the human
resources -- to make those high quality
decisions. They can follow what Barron's
referred to as the Yale Model or the Swensen Approach. But the book that I've written
ostensibly for individuals, but it's really individuals and
institutions that don't have the same resources that
Yale does to make these high quality active decisions. That book says, basically, what
you should do, is come up with a sensible asset allocation
policy, and, then, implement it using index funds,
which are low-cost ways of mimicking the market. And oh, by the way, because they
have very low turnover, generate very little in terms
of tax consequences for the holders of those funds. So, it's kind of an interesting
world, where the right solution is either one
extreme or the other extreme. You're either completely
passive or you're aggressively active. But as in most things, most
people are kind of in the middle, right? They're neither aggressively
active nor completely passive, but in the middle you lose. Because you end up paying high
fees for mediocre active results, and that's where most
people end up, and most institutions. STUDENT: Hi, so, my question
is about -- given you were talking about your equity
orientation and bias, and given what's going on right
now with the stock market, just what your views are. Whether or not the stock market
is currently expensive, and whether or not you have any
money in tech stocks, with all the valuations and
IPOs that have been going in that space. What do you think about that? And also, what would you do in
terms of investing it in response to what your view is? Thank you. PROFESSOR DAVID SWENSEN: So, one
of the great things about having a diversified portfolio
is that you can worry less about the relative level of
valuation of various assets in which you invest. So, if you
go back to the mid-'80s and you've got a portfolio that's
50% in domestic stocks, you have to worry a lot about the
valuation of that portfolio, because half of your
assets are in that single asset class. But if you've got a
well-diversified portfolio with, let's say, minimum
allocation of 5% to 10%, and now a maximum allocation of 25%
to 30% in an individual asset class, the relative
valuation of each of those asset classes matters less. And there's another
nice aspect to a rebalancing policy. If you set up your targets and
you faithfully adhere to those targets -- Suppose, the domestic equities
have poor relative performance. Well, then you're going to buy
domestic equities to get them back up to target, selling
whatever it is that had superior relative performance
to fund those purchases. And vice versa. If domestic equities have great
relative performance, you'll be selling to get back
to your long-term target and buying other assets that have
shown poor relative performance. So, if you're in a circumstance,
where domestic stocks are expensive, where
you're selling into this superior relative performance
that the domestic equities are exhibiting, thereby maintaining
your risk exposure at a level that's consistent
with what's implicit in your policy asset allocation. So, that's kind of a long way
of saying, that, if somebody asked me whether stocks are
expensive or cheap, my first line of defense, it doesn't
really matter all that much to me, because we're
well-diversified and because we do a great job
of rebalancing. But the reality is that those
questions are just incredibly tough to answer. If they were easier to answer,
I guess I'd be much more excited about market timing as
a way to generate returns. In terms of the second question,
with respect to technology, Yale's had a
long-standing commitment to venture capital. And over the decades, it's
produced extraordinary returns for the university. And we continue to have a
world-class group of venture capitalists. We've got exposure to companies
like LinkedIn and Facebook and Groupon. And I hope that this wave of
IPOs that people are writing about in the press actually
occurs, because that would be very good for the university's
portfolio. It's been a long time, right? We benefited enormously in the
internet bubble in the late 90s, and the last decade
has been a bit fallow. We also find, on the marketable
securities side, that technology stocks tend to
be less efficiently priced than many other securities. And so, we have a manager that
is heavily focused on information technology stocks
and another manager that's very heavily focused on
biotechnology stocks. And both those managers have
produced very handsome absolute and relative returns. And that's an important
part of our domestic equity strategy. STUDENT: Thanks for coming. So, in recent years, the number
of hedge funds, private equity firms, has gone up. And I wasn't sure, how that's
changed the efficiencies of these alternative asset
allocation markets. And if it's changed the
efficiencies, how have you changed your investment
philosophies? And I was wondering, also,
what are the structural patterns of these markets that
would prevent the market from becoming very efficient, even if
there are a lot hedge funds and a lot of funds of funds. Thanks. PROFESSOR DAVID SWENSEN: That's
a really good question. I think, the most fundamental
issue with the explosion of hedge funds and the explosion of
private equity funds has to do with this negative-sum game
that we were talking about. If you go back to the 1950s,
the most common way that institutional assets were
managed would be for an institution like Yale
to go to a bank like Chemical Bank or JP Morgan. And they would pay a small
fraction of 1% for a reasonably diversified
portfolio, stocks, bonds, and there'd probably be some foreign
stocks, and some domestic stocks. But the leakage from the
system was very small. You look at hedge funds and
private equity funds, they're essentially dealing with the
same set of securities that an institution used to pay two
tenths of a percent a year, or three tenths of a percent a
year for admittedly sleepy bank management. But it's the same set
of securities. Now, those securities are traded
in a hedge fund format, or taken in a private
equity fund format. And the fees that you are paying
are a point, a point and a half, two points. The typical ''two and 20.''
And you're paying a significant percentage
of the profits. The 20 in the ''two and 20.''
Think about that. The leakage from the system that
goes to Wall Street is enormous, compared to what it
was 10 years ago, or 20 years ago, or 30 years ago. So, there's that much less
left for us as investors. And I think that has huge
consequences for endowments, foundations, pension plans,
institutions of all stripes. And to the extent that
individuals get exposure to these types of assets -- and
they're largely wealthy individuals that end up getting
the exposure -- they're going to suffer the same
consequences of this huge leakage of higher fees
and the profits interest to Wall Street. The question as to whether or
not the money flowing to hedge funds is going to make the
markets more efficient and take away opportunities -- I don't worry too
much about that. I think, the best talent is
going to hedge funds, because if they're in a long only
domestic equity environment, maybe they can charge three
quarters of a percent or a percent, or if they're in the
mutual fund world, maybe they charge a percent and a half,
or something like that. Well, you'd rather have ''two
and 20'' than 0.75, right? That's easy. So, there's a huge migration
of talent to the hedge fund world. But what I care about, when
I look at the degree of investment opportunities, is
this dispersion we talked about, and I haven't seen the
dispersion of results, top quartile to bottom quartile,
compress at all. So, I don't think, that we're
increasing the efficiency of the pricing of assets. I still need to go out there and
be able to identify people in the top quartile or top
decile, so that we can win relative to the markets, after
adjustment for the risk that we take. So, as long as we have plenty of
dispersion in the results, it's still an interesting
activity for us to pursue. STUDENT: Can I ask? PROFESSOR DAVID SWENSEN:
It better be good, it's the last question. STUDENT: I'll try. So, my question is about
performance of the Yale portfolio, and we heard that
it grew from less than $1 billion -- but close to
it, apparently -- in 1985, to $16 billion, which
is very impressive. And it's documented in
newspapers, it's online, Wikipedia, Professor
Shiller introduced you with these facts. But what about the
Sharpe ratio? And why do you think that people
talk more about total returns than, say,
the Sharpe ratio? PROFESSOR DAVID SWENSEN: So, I
think that one of the things that needs to happen in the
funds management world is, that we need to have better
measures of risk. And so, one of the reasons,
why I don't talk about the Sharpe ratio, is, that just
looking at standard deviation of returns doesn't capture
risk in a way that is meaningful. I mean, I've seen other people
do an analysis of the Yale portfolio, and show relative
Sharpe ratios. And, obviously, because our
returns have been so good, if you just look at the pattern
of those returns, we end up scoring high when looking at
Sharpe ratios across different institutional portfolios. But the risks that exist in the
portfolio aren't really captured by the standard
deviation of the returns. Just a quick example: If you
look at real estate, or timber, or even any of our
illiquid assets, they're appraised relatively
infrequently. There tends to be a huge
stability bias in the appraisals. If somebody looks at a piece of
real estate 12 months ago, six months ago, and today,
they're likely to see pretty much the same thing that they
saw over that period. You can compare and contrast
that to the volatility they've got in the stock market. I think Bob Shiller deserves
credit for coining the term "excess volatility." There's no
question that stock prices are way more variable than they
need to be to adjust for changes in the underlying
fundamentals. So, if you've got a portfolio
that's largely marketable securities, you're going to
see a lot more standard deviation of returns than if
you've got one of illiquid assets, where you've got this
stability built in because of the appraisal nature of
the valuation process. And if you end up comparing
those two portfolios, one dominated by marketable
securities, one dominated by private assets, you're going to
end up with measures that are apples and oranges. Thank you very much. [APPLAUSE]
