David Swensen was the only guest on the Connie Mack show this week and had some interesting things to say.
He said that when he first got to Yale the typical endowment had 50% in US stocks, 40% in US fixed income and 10% in alternatives and that mix made no sense to him. He said that diversification is a great thing. It was a great thing then and it is a great thing now. Endowments may have thought they were diversified but he said there is no way you can argue that having 90% of your assets in US marketable securities represents diversification.
If you have a long investment horizon you should have an equity orientation because over long periods of time equities should produce superior returns and if they don’t, Swensen said, then it means capitalism isn’t working. He also echoed a sentiment mentioned by many which is that after a decade long decline for stocks and more than a decade of big gains for bonds, stocks now are likely to outperform and bonds underperfom.
Roger chiming in: Despite the emotion that exists today this is a logical way to think of things.
Back to Swensen who noted that diversification isn’t going to help in the middle of a financial crisis. It “failed” in 1987, 1998 and now. During a crisis people rush to treasuries which causes them to go up in price and everything else to drop in price.
To him this crisis reminded him the people pay too much for illiquid investments like hedge funds. Too much in terms of the extra return they provide.
He thinks that the things that are important about diversification for endowments are just as important as for individuals but the path to that point means different types of products. He noted disappointment in not being able to replicate the Yale endowment for individuals with ETPs . He said the type of active management needed for all the asset classes is not available for individuals. Investors need to be either very active or completely passive. Individuals are probably better off being completely passive because he believes the quality of the management in the mutual fund industry is not high but it is very expensive.
He spelled out some of his model portfolio for individuals and has made two tweaks from the book. He reduced his REIT allocation from 20% to 15% and increased emerging market equity exposure from 5% to 10%.
30% US stocks
15% treasury bonds
now 15% REITs
15% foreign developed equities
now 10% emerging markets
Ok, all done paraphrasing Swensen.
I have been critical of his model portfolio mostly because of the 20% in REITs. Even the new 15% is way more than I would ever want. When people talk about correlations going to 1 during the crisis REITs are the first thing I think of. I had one REIT targeted at a 2-3% weight toward the end of the bull market but I sold it early on. REITs will be a fine hold again at some point but I no longer trust them in terms of being a diversifier.
On a brighter note I believe it has gotten much easier to build a portfolio with the type of diversification that Swensen seems to be looking for. Private equity remains elusive but I am not really a fan of that anyway. Certain types of hedge fund strategies are available but not the ones that go up 500% thanks to shorting all the stuff that dropped 90% in 2007 and 2008 (or whatever the equivalent of that type of trade will be in the future).
Long time readers will know that I find what the endowments do to be fascinating. They provide a great opportunity to learn but not emulate. That people have learned a lot of things about their own tolerance for volatility from the double bear market of this decade is a good thing, that it might send them to a portfolio of 30% equities, 30% bonds and 40% “diversifiers” would probably be a bad thing especially for people younger than 60.
If something more like 15% in diversifiers for someone with a low to middling tolerance for volatility is right then I think the investment product landscape offers a lot of choice with more choices to come.
One thing that Swensen addresses (along with many other people) that I try to emulate is to not let the conversation get too far away from logic and how markets tend to work. The point above he makes about stocks having a good chance to outperform bonds after how the chips have fallen over the last 20 years or so is very logical. An asset class has a good chance to outperform if it has lagged for a meaningful period of time. The sentiment guarantees nothing but it puts the odds in the favor of equities.
This is not a conversation about where or when the bottom is but looking out over some number of years the odds are that stocks will outperform. That is not an emotional statement it is a logical statement about probabilities.