But let’s be honest. Are you interested? You know some people do become successful. Why not you?
I’m going to talk about this topic for this week’s blog post. Specifically, I discuss superstar investor David Swensen’s tactics for achieving active management success at the Yale endowment fund over the last two or three decades. And then I (briefly) opine on your or my chances for successfully mimicking some of his strategies and tactics.
Why David Swensen’s Ideas Matter
Let’s start with something you may already know… Swensen’s long-run investment track record is stupefying. As of the last revision of his masterpiece book, “Pioneering Portfolio Management,” his long run, nearly 25 year track record (from 1985 through 2009) is 17 percent annually.
By way of comparison, the S&P 500 over that same 25 year time frame returned about 10.5% annually.
Which means Swensen (and his team at the Yale Investments office) have delivered long-run returns that massively, massively best those earned by passive investors.
Consider this, for example: If you invest $10,000 and earn 10.5% annually over 25 years, your $10,000 grows to slightly more than $100,000.
If you invest $10,000 and earn 17% annually over 25 years, however, your $10,000 grows to slightly more than $500,000.
Amazing, right? And so you or I should ask, “How does someone do this?” And more interestingly, “Is there any way that we can duplicate such success?”
Well, in Swensen’s telling of the story, you and I need to do three, simple-to-describe things in order to succeed wildly as active investors. (As we go along, I’ll try to offer up some thoughts about whether you or I can really implement Swensen’s “simple-to-describe” strategies and tactics…)
Successful Active Investor Tip #1: Move to Alternative Asset Classes
The first thing you or I need to do? Transition away from the traditional asset classes (like domestic stocks).
Swensen points out that the only way an active investor can hope to earn excess returns (returns over and above benchmarks even after paying investment costs) is by moving into alternative asset classes.
Alternative asset classes include absolute return investments (like hedge funds), real asset investments (like real estate, timber and oil and gas), and private equity investments (like venture capital).
Swensen rather effectively argues that traditional asset classes like domestic or international stocks and then bonds don’t dependably provide even a clever active investor with opportunities to beat the averages. In the language of financial experts, these traditional asset classes are too efficient in the manner information gets reflected in prices.
I want to show you a table of percentages to make this information really stand out. The table’s first column of percentages shows the “passive investing approach” asset allocations that Swensen recommends for individual investors in his other excellent book “Unconventional Success.” The second column of percentages comes from Swensen’s “Pioneering Portfolio Management” and shows the “active investing approach” asset allocations that the Yale endowment used when Swensen last updated that book.
Those are striking different asset allocations right?
One can see that Swensen’s approach to active investing has him almost eliminating allocations to US stocks and bonds.
In their place, his approach makes big bets on real assets like oil and timber and on absolute return investments like hedge funds.
Successful Active Investor Tip #2: Identify Top Quartile Managers
The second thing you and I need to do? Identify top quartile managers. And this is way more important than you or I might at first think if we’ve been investing in traditional asset classes.
In a traditional asset class, the markets are, as noted, so efficient that active managers can’t easily beat the averages even before looking at their fees. But this efficiency also means that active managers usually don’t get too beat up by the averages either.
Swensen reports in “Pioneering Portfolio Management” that for the ten years ending June 30, 2005, the median return of the US stocks asset class equaled around 11%, the top quartile earned about 12% and then the bottom quartile earned about 10%. That tight band means basically nobody beats the market but also that (especially before fees) nobody gets beat up by the market, too.
In the alternative asset classes, reflecting the inefficiency of these markets, the range is much wider. For venture capital investments, the same time year ten frame suggests a roughly -1% median return, a top quartile return of roughly 29% annually and a bottom quartile return of roughly -15% annually.
The upshot? In traditional asset classes, picking the wrong investment manager doesn’t actually hurt you that badly. At least before fees. And relatively speaking.
However, with alternative asset classes, picking the wrong investment manager destroys your portfolio. And picking a merely average investment manager turns out to a very poor substitute as compared to just accepting the average return from something like the S&P 500.
Why accept a -1% (that’s minus one percent!) annually when you could have received 10% annually from a cheap, way less risky below average S&P 500 index fund?
Swensen provides lengthy discussions of how the Yale Investments Office tries to identify top investment managers. And you’ll want to carefully read those chapters of his book if you decide to go active. But quite candidly, hey, we need to be honest with ourselves here. How likely is it that you or I can identify not Ray Dalio or George Soros, but rather the next Ray Dalio or George Soros.
And let me also point out another fly in the ointment. You or I not only need to be able to identify Ray Dalio or George Soros (or the next Dalio or Soros) as a top quartile manager, we also would need the opportunity to invest with one of these top quartile managers. And that sort of opportunity probably doesn’t exist for most of us.
Top venture capital funds, hedge funds and real asset funds, Swensen suggests, easily get all the funding they need from the giant endowments, pension funds, and private foundations with whom they have long and large dollar relationships.
Successful Active Investor Tip #3: Align Incentives of Managers and Investors
One final point and I’ll make this quick. Swensen discusses at length the importance of making sure an investment manager’s incentives align with those of the investors putting money into deals.
This is key.
Commonly, incentives don’t align. Investment managers may be incented to take giant risks, for example, creating bets where the situation is “heads they win and tails you lose.”
Further, investment managers may be paid generous management fees regardless of whether they actually create value for their investors, thereby creating a situation where the investment managers don’t worry about portfolio performance but simply work to gather assets.
Accordingly, a third key to success discussed by Swensen is doing the hard but important work of making sure, to the extent possible, that investment manager compensation aligns the goals of the manager with the goals of the investor.
Here are my final thoughts related to individual investors and an active management approach to investing…
Individual investors typically can’t employ the approaches used by the Yale Investments Office to achieve gigantic returns. (The one exception to this may be if someone has the opportunity to invest directly in their own small business.)
Sorry. I wish that weren’t so. But individuals don’t have the skills, the resources or even in most cases actual real opportunities to do the sorts of things that a successful active investor (like the Yale Investments Office) can do. I wish we did. I really do. But we don’t…
One pretty uplifting thought: The good news is that you and I can use a pretty darn good, passive approach to investing and get really good results. Which is what Swensen recommends for individual investors anyway…
And a postscript: Last Wednesday, Harvard University announced it was giving up trying to run their endowment fund like David Swensen would do. That’s got to tell you something. (Here’s a link to one of the Fortune articles that skims over the details.)