There are few investors with a better long-term track record than David Swensen, the chief investment officer of Yale's endowment since 1985 (approximately 13.5% annualized). So when Swensen sits down to talk about how he achieved his long-term investment success and about how he views today's investment risks and opportunities, I listen with full attention. Two days ago, Swensen did just that, in a Council on Foreign Relations-sponsored discussion with former Treasury Secretary Robert Rubin.
In response to Rubin's question about today's investment environment, Swensen had this to say:
"You have to think about what’s going on in the tails of the distribution. I think that’s incredibly important. We spend too much time in finance class, in business schools or in colleges, thinking about normal distributions. And we know—we know the distribution isn’t normal. If securities returns were normally distributed, the crash in 1987 wouldn’t have happened. It was a 25-standard-deviation event. That’s an impossibility.
And when you look at defining moments for portfolio management, they come in 1987, they come in 1998, they come in 2008-2009. And if you ignore that, you’re not going to be able to manage your portfolio effectively. But when you start out, you were talking about fundamental risks in this world. And when you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling, and makes me wonder if we’re not setting ourselves up for an ’87 or a ’98, or a 2008-2009".
Rubin then pressed Swenson on how he was steering Yale's endowment in this "profoundly troubling" investment environment:
"So we’re absolutely not market timers, but I would talk about market timing as kind of a short-term swing in the portfolio to take advantage of some knowledge that you have or some belief that you have about where markets are headed in the short term. But I think we have to take strategic positions in the portfolio. One of the most important metrics that we look at is the percentage of the portfolio that’s in what we call uncorrelated assets. And that’s a combination of absolute return, cash, and short-term bonds. And those are the assets that would protect the endowment in the—in the event of a market crisis.
Prior to the downturn in 2008, we were probably about 30 percent in uncorrelated assets. By the time 2009-2010 rolled around, we were probably around 15 percent. And the reason for the dramatic decline is these are the sources of liquidity in times of stress. And so today we’ve rebuilt that. It actually works out quite nicely from a cyclical perspective, if you’ve got a rebound afterwards. Instead of being 70 percent in risk assets, you’re 85 percent in risk assets. But over the years subsequent to the crisis, we’ve rebuilt our uncorrelated assets position to an excess of 30 percent. And we’re currently targeting about 32 ½ percent, which is somewhat above the long-term goal".
Swensen continued on this topic in the audiance Q&A session:
Q: "Did I hear you say that you have 32 percent now in uncorrelated assets? More than you had in ’08, when we were in recession? Do you think we’re in recession, or what scares you that you really want to have a recession-level of cash"?
Swenson: "Yeah. So I’m not worried about the economy so much. I have no idea what economic performance is going to be over the next five or 10 years. What I’m concerned about is valuation. I think when you look at pretty much any asset class anywhere in the world, it feels expensive. And the handful of areas that I talked about where I thought there were opportunities are kind of niche-y—short-selling, Japan, I think there’s some opportunities in China and India, although it’s hard to call either of those markets screamingly cheap either. So it’s really a question of valuation, not a question of economic fundamentals".
As my regular readers know, we too are concerned about today's high valuations, particularly in US equities and long duration fixed income. Accordingly, we are running "uncorrelated" assets in AlphaGlider strategies at historically high levels: 47.0% in our conservative strategy (AG-C), 38.5% in our moderately conservative strategy (AG-MC), 29.5% in our balanced strategy (AG-B), 23.0% in our moderately aggressive (AG-MA), and 17.5% in our aggressive strategy (AG-A). On expectations for returns over the next 10 years, Swensen was cautious given today's high valuations:
"So for most of the 32 years that I’ve been at Yale, the standard assumption for endowment returns for the operating budget was 8 ¼ nominal. And that turned out to be a pretty decent working assumption. I think our 32-year rate of return is something like 13 ½, so we’ve generated a substantial cushion over the budgetary assumption for more than three decades.
What I’ve been talking to the provost about for the past 12 or 18 months is, for the first time in this very long period, reducing the expected return assumption in the budget to 5 percent nominal".
Our valuation metrics are also pointing to much lower returns going forward than what we've enjoyed over the last 36 years — a period in which the 10-year Treasury rate fell from the mid-teens to today's 2.4%.
Swensen and his team at the Yale endowment use outside managers for many of their investments. Swensen gave us some insight into how they are selected — and it reminds me of what I and my analyst and portfolio manager colleagues at Janus and Artisan stressed when we were looking for companies, and more importantly, managers, in which to invest. I think these same qualities are also very relevant in choosing an investment advisor.
"Today, I would say that number one is the character and quality of the investment principles. Number two is the character and quality of the investment principles. Number three—(laughter)—you get the idea. And you have to go further down the list before you get to some of the nuts and bolts. And I’m absolutely convinced that there is nothing more important than being partners with great people.
In the investment world, if people are the way that you’re taught and—introductory econ—if they’re maximizers, they’re going to raise massive funds, charge high fees, and make a lot of money for themselves. I’m looking for somebody that’s got a screw loose and they define winning not by being as rich as they can be individually, but by producing great investment returns. And you do that—you can still make a great living, but instead of managing $20 billion, you probably manage $2 billion. And the other day we met with a manager, and they said their goal was to be in the IRR hall of fame. And I love that, because if they produce great returns, that’s going to benefit the university. But if they gather huge amounts of assets and charge high fees, that’s going to benefit them and not Yale.[...]
You know, the testing for character is largely subjective. One of the things we try to do is to spend time with prospective managers in a social setting, so it’s not just sitting across one another at a conference table. But by the time I’m having a final meeting before deciding whether or not we’re going to move forward, I’m thinking to myself during the entire meeting: Is this an individual that I want to be my partner? And it’s subjective, it’s gut feel, but that’s the most important criterion as far as—as far as I’m concerned".
A common theme throughout the discussion was the advantage of having, and maintaining, a long investment horizon. We couldn't agree more.
"If you can invest with a three- to five-year horizon, which is a pretty, pretty difficult thing to do—it might sound like it’s an easy thing to do if market conditions are benign, but you throw a 2008 or a 2009 in there and you have to really work hard to remember that this is temporary and that you need to keep on looking out three to five years when you’re making these decisions.
Ultimately, that, I think, is an incredibly powerful advantage. And the people that are on the quarter-to-quarter timeframe, they’re going to lose almost certainly. And they’re definitely going to be losing to the managers that are using the three- to five-year horizon. So I do know that it’s possible to extend your time horizon and succeed".