Risk and Return

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy . Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally
-John Maynard Keynes

Random Roger wants to know what his readers think of the strategy of trying to replicate the type of portfolio that David Swensen of Yale has created.

It is certainly a good question, as Yale’s returns are stunning. His interest is peaked by taking a look at this article in Registered Rep magazine.

So what do I think? I suspect regular readers, and our clients, know we are enthusiastic about the approach, though we do tackle it a bit differently. So Let’s take a look at what Yale does, and David Swensen recommends for retail investors:

YALE ENDOWMENT ASSET ALLOCATION TARGETS

Real Assets 27%
Absolute Return 25%
Private Equity 17%
Foreign Equity 15%
Domestic Equity 12%
Fixed Income 4%

Source: Yale Corporation

SWENSEN’S RETAIL ASSET ALLOCATION TARGETS

Domestic Equity 30%
Foreign Developed Market Equity 15%
Foreign Emerging Market Equity 5%
Real Estate 20%
Short-Term U.S. Treasuries 15%
Inflation-Protected U.S. Treasuries 15%

Source: David Swensen

Actually, not a bad strategic allocation on the retail side, and according to Registered Rep it did pretty well through last Summer. What it lacks is any direct hedging similar to the absolute return option, Real assets other than Real Estate, and Private Equity.

Real Assets can be replicated to some extent through ETF’s and some mutual funds. Absolute Return vehicles can include long/short funds, Managed Futures, and for some, actual hedge funds. In addition, direct hedges from mutual funds can be used where appropriate. You will not have access to the favorable cost structure that Yale gets.

A word about Private Equity.

David Swensen speaks to this in his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment but some of the lack of volatility is a statistical artifact present in some of his real assets and private equity. Since they are illiquid, the value of these investments often cannot be known, it is estimated or marked to model, rather than to the market. In reality Private Equity is both very volatile, and likely very correlated to the public equity market.

What Private Equity really provides to Yale, is higher returns. Swensen believes they can get top managers, but he admits that if you don’t have top managers that Private Equity does not even outperform once adjusted for risk. He feels though that the dispersion of skill is higher, and that with proper due diligence it can be identified. His results seem to confirm that.

Our twist upon this theme

So, whether we are talking about non accredited, or accredited, investors, how does our approach differ and can it be replicated? We add a tactical element. That goes for private equity as well. In our discussions we have been very wary of private equity, we didn’t think money being invested over the recent past was being invested in a way likely to generate much return, and possibly it would be disastrous. In essence we saw a Private Equity bubble about to pop.

The returns had been reasonably good mostly due to leverage built on easy access to credit. Leverage is fine if you know what you are buying, our suspicion is that most people didn’t realize the risk they were facing if the market turned south, credit dried up, recession, etc. To put it another way, the risk vs. return ratio was out of whack. I think our fear during that time of greed was as usual a good thing to have. We may get a bit greedier when there is a lot more fear in general.

Yale has a pure strategic asset allocation, in essence the managers in the Real Asset and Absolute Return spaces make the tactical decisions. We do the same, but we also tactically increase and decrease (within the constraints of the Investment Policy Statement of our clients) our net exposure to any given traditional benchmark, or beta. We are quite willing to hedge our exposure to US stocks for example, or to go short one part of the market, long another. That is, if we see the expected gap in performance over a two to three year time span as being quite large. We don’t want to be operating in the area where random noise can eliminate that potential return. “Fat pitches” only need apply when it comes to such strategies.

In addition, when upside returns look low, and the potential downside looks high, we increase our allocation to absolute return managers and strategies.

That goes to the problem I have with the strategic retail portfolios I see discussed by Roger and his links (including in the comments.) While over the long haul I believe a portfolio such as the ones examined might do better than more traditional allocations with consistent rebalancing (they have in the past) I don’t think it will get investors where they want to be over the nearer term, say the next five years, and it will take some awfully good years for them to ever catch up to the type of compounded rate of return investors expect.

Unlike 2000-2006, a period that started with a few over valued areas and many components of the market ranging from reasonably priced to under priced, nothing as an asset class is cheap right now. The reasons Real Estate (in the form of REIT’S) was such a fine diversifier are not as applicable now. Traditional asset class diversification may help (though adding huge slugs of Real Estate, something until recently we have always had, made little sense when the article Roger is discussing was written) but it will likely lead to very low returns relative to history. After eight years of low returns another five to seven more is likely to really alter people’s financial plans.

Rather, we suggest adding in diversification of strategies as well. That means portable alpha, or portable alpha inspired strategies, hedges and other strategies to emphasize absolute returns at the portfolio level until markets go through an extended cathartic sell off. Until that happens, whether over the next six months or three years, permanent returns are likely to be hard to get with a mix of diverse, but over valued securities. The eventual sell off will likely eliminate most of the returns gained during any upturns, leaving the investor with returns barely above, and quite possibly below, the rate of inflation. The most over valued areas should likely just be avoided or used as a hedge.

Of course, as Jeremy Grantham recently pointed out, cash isn’t such a bad thing either.

To put it another way, the publicly traded diversifiers of the past have been bid up in price and are now likely very correlated, at least on the downside.

What is the longer term problem with tactical approaches?

They are difficult to do. Both from a knowledge standpoint, and psychologically. Most investors, including professionals, have no idea what the historical valuation of the market is, or what return the market is priced to deliver in various asset classes. Essential information to adequately pursue this kind of strategy.

As the quote I began this post with states, the largest constraint is the psychological will to allow themselves returns that do not track the larger market. We say we want non correlation, but what we mean is we don’t want to go down with the market. The idea of not tracking the market on the upside is not what we want to hear. Even tremendously successful investors, like Jeremy Grantham, Rob Arnott and John Hussman suffer for the impatience of their clients, no matter their great track records and the logic of what they are doing.

Yet, unless one has the ability to time pretty closely the market, that is exactly what you have to do to carry off such a strategy. That will also be true of the type of replicated portfolios Swensen and others are proposing. The goal is performance over several years time. Hedges which over time turn out hugely profitable will not be received kindly during the upward marches which populate even extreme bear markets. Intelligent active asset allocation is therefore the province of the few and the thick skinned, thus the popularity of static strategic asset allocation.

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Technorati Tags Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale

Tags: Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale

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