Introduction This book provides readers with a window on the world of institutional funds management, drawing on my fourteen years of experience in managing Yale's endowment, which totaled $7.2 billion at June 30, 1999. During my tenure the university pioneered the move away from heavy reliance on domestic marketable securities, emphasizing instead a collection of asset classes expected to provide equity-like returns driven by fundamentally different underlying factors. Aside from reducing dependence on the common factor of U.S. corporate profitability, the asset allocation changes ultimately exposed the portfolio to a range of less efficiently priced investment alternatives, creating a rich set of active management opportunities.
In spite of a systematic reduction in exposure to domestic equities during one of the greatest bull markets ever, the Yale endowment produced extraordinary returns. Measured from the bottom of the U.S. market in 1982, Yale's return of 16.9 percent per annum stands in the top 1 percent of institutional funds. Stated differently, had the university generated returns equivalent to the average for institutions of higher education, endowment assets would be $3.3 billion lower as of June 30, 1999. Yale's strong investment results stem from disciplined implementation of equity-oriented asset allocation policies, combined with successful exploitation of attractive active management opportunities.
The World of Endowment Management
The fascinating activity of endowment management captures the energy and imagination of the many talented individuals who have accepted responsibility for stewardship of institutionalassets. Investing with a time horizon measured in centuries to support the educational and research mission of society's colleges and universities creates a challenge guaranteed to engage the emotions and intellect of fund fiduciaries.
Aside from the appeal of the eleemosynary purposes that endowments serve, the investment business contains an independent set of attractions. Populated by unusually gifted, extremely driven individuals, the institutional funds management industry provides a nearly limitless supply of products, a few of which actually serve fiduciary aims. Identifying the handful of gems in the tons of quarry rock provides intellectually stimulating employment for the managers of endowment portfolios.
The knowledge base that provides useful support for investment decisions knows no bounds. A rich understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events all contribute to the development of well-informed portfolio strategies. Many practitioners confess they would continue to work without pay in the endlessly fascinating money management business.
The book begins by painting the big picture: discussing the purposes of endowment accumulation and examining the goals for institutional portfolios. Articulation of an investment philosophy provides the underpinnings for developing an asset allocation strategy -- the fundamentally important decision regarding the portion of portfolio assets devoted to each type of investment alternative.
After establishing a framework for portfolio construction, the book investigates the nitty-gritty details of implementing a successful investment program. A discussion of portfolio management issues examines situations where real-world frictions might impede realization of portfolio objectives. Chapters on asset class management provide a primer on investment characteristics and active management opportunities, followed by an outline of performance evaluation issues and tools. The book closes with some thoughts on structuring an effective decision-making process.
The linearity of the book's exposition of the investment process masks some complexities inherent in the portfolio management challenge. For example, asset allocation relies on a combination of top-down assessment of asset class characteristics and bottom-up evaluation of asset class opportunities. Since quantitative projections of returns, risks, and correlations describe only part of the scene, investors supplement the statistical overview with a ground-level understanding of specific investments. Because bottom-up insights into investment opportunity provide information important to assessing asset class attractiveness, effective investors evaluate portfolio alternatives with simultaneous consideration of top-down and bottom-up factors. By beginning with an analysis of the broad questions regarding the asset allocation framework and narrowing the discussion to issues involved with managing specific investment portfolios, the book lays out a neat progression from macro to micro, ignoring the complex simultaneity of the asset management process.
Rigorous Investment Framework
Three themes surface repeatedly in the book. The first theme centers on the importance of taking actions within the context of an analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities. In dealing with the entire range of investment decisions from broad-based asset allocation to issue-specific security selection, investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.
Establishing an analytically rigorous framework requires a ground-up examination of the investment challenge that the institution faces, evaluated in the context of the organization's specific characteristics. All too often investors fail to address an institution's particular investment policy needs, opting instead to adopt portfolio structures similar to those pursued by comparable institutions. In other cases, when evaluating individual investment strategies, investors make commitments based on the identity of the co-investors, not on the merits of the proposed transaction. Playing follow the leader exposes institutional assets to substantial risk.
Disciplined implementation of investment decisions ensures that investors reap the rewards and incur the costs associated with the policies that the institution adopts. Among the many important investment activities that require careful oversight, maintaining policy asset allocation targets stands near the top of the list. Far too many investors spend enormous amounts of time and energy constructing policy portfolios, only to allow the allocations they established to drift with the whims of the market. The process of rebalancing requires a fair degree of activity, buying and selling to bring underweight and overweight allocations to target. Without a disciplined approach to maintaining policy targets, fiduciaries fail to achieve the desired characteristics for the institution's portfolio.
Making decisions based on thorough analysis provides the best foundation for running a strong investment program. The tough competitive nature of the investment management industry stems from the prevalence of zero-sum games, where the amount by which the winners win equals the amount by which the losers lose. Carefully considered decisions provide the only intelligent basis for profitable pursuit of investment activities, ranging from sweeping policy decisions to focused security selection bets.
A second theme concerns the prevalence of agency issues that interfere with the successful pursuit of institutional goals. Nearly every aspect of funds management suffers from decisions made in the self-interest of the decision makers, not in the best interest of the fund. Culprits range from trustees seeking to make an impact during their term on an investment committee, to portfolio managers pursuing steady fee income at the expense of investment excellence, to corporate managers diverting assets for personal gain. Differences in interest between fund beneficiaries and those responsible for fund assets create potentially costly wedges between what should have been and what actually was.
The wedge between principal goals and agent actions causes problems at the highest governance level, causing some fiduciary decisions to fail to serve the interests of a perpetual life endowment fund. Individuals desire immediate gratification, leading to overemphasis of policies expected to pay off in a relatively short time frame. At the same time, fund fiduciaries hope to retain power by avoiding controversy, pursuing only conventional investment ideas. By operating in the institutional mainstream of short-horizon, uncontroversial opportunities, committee members and staff ensure unspectacular results, while missing potentially rewarding longer-term contrarian plays.
Relationships with external investment managers provide a fertile breeding ground for conflicts of interest. Institutions seek high risk-adjusted returns, while outside investment advisers pursue substantial, stable flows of fee income. Conflicts arise since the most attractive investment opportunities fail to provide returns in a steady, predictable fashion. To create more secure cash flows, investment firms frequently gather excessive amounts of assets, follow benchmark-hugging portfolio strategies, and dilute management efforts across a broad range of product offerings. While fiduciaries attempt to reduce conflicts with investment advisers by crafting appropriate compensation arrangements, interests of fund managers diverge from interests of capital providers even with the most carefully considered deal structures.
Most asset classes contain investment vehicles exhibiting some degree of agency risk, with corporate bonds representing an extreme case. Structural issues render such bonds hopelessly flawed as a portfolio alternative. Shareholder interests, with which company management generally identifies, diverge so dramatically from the goals of bondholders that lenders to companies must expect to end up on the wrong side of nearly every conflict. Yet even in equity holdings where corporate managers share a rough coincidence of interests with outside shareholders, agency issues drive wedges between the two classes of economic actors. In every equity position, public or private, management at least occasionally pursues activities providing purely personal gains, directly damaging the interests of shareholders. To mitigate the problem, investors search for managements focused on advancing stock owner interests, while avoiding companies treated as personal piggy banks by the individuals in charge.
Every aspect of the investment management process contains real and potential conflicts between the interests of institutional funds and the interests of the agents engaged to manage portfolio assets. Awareness of the breadth and seriousness of agency issues constitutes the first line of defense for fund managers. By evaluating each participant involved in investment activities with a skeptical attitude, fiduciaries increase the likelihood of avoiding the most serious conflicts with institutional fund goals.
Active Management Challenges
The third theme relates to the difficulties of managing investment portfolios to beat the market by exploiting asset mispricings. Both market timers and security selectors face intensely competitive environments in which the majority of participants fail. The efficiency of marketable security pricing poses formidable hurdles to investors pursuing active management strategies.
While private markets provide a much greater range of mispriced assets, investors fare little better than their marketable security counterparts as the extraordinary fee burden typical of private equity funds almost guarantees delivery of disappointing risk-adjusted results. Active management strategies, whether in public markets or private, generally fail to meet investor expectations.
In spite of the daunting obstacles to active management success, the overwhelming majority of market participants choose to play the loser's game. Like the residents of Lake Wobegon who all believe their children to be above average, all investors believe their active strategies will produce superior results. The harsh reality of the negative-sum game dictates that in aggregate, active managers lose to the market by the amount it costs to play, in the form of management fees, trading commissions, and dealer spread. Wall Street's share of the pie defines the amount of performance drag experienced by the would-be market beaters.
The staff resources required to create portfolios with a reasonable chance of producing superior asset class returns place yet another obstacle in the path of institutions considering active management strategies. Promising investments come to light only after thorough culling of dozens of mediocre alternatives. Hiring and compensating the personnel needed to identify out-of-the-mainstream opportunities imposes a burden too great for many institutions to accept. The alternative of trying to pursue active strategies on the cheap exposes assets to material danger. Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win.
Even with adequate numbers of high-quality personnel, active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. Unless institutions maintain contrarian positions through difficult times, the resulting damage imposes severe financial and reputational costs on the institution.
Although the investment lessons in this book focus on the challenges and rewards of investing educational endowment funds, the ideas described here address issues of value to all participants in financial markets. Whether considering mutual fund investments to finance a child's college education or venture capital commitments to support a corporation's pension plan, chances for investment success increase with an understanding of mistakes to avoid and an appreciation of strategies to emphasize.
Beyond the pragmatic possibility of improving investment skill, students of finance might enjoy the book's exploration of the thought process underlying the management of a large institutional fund. Because fund managers operate in an environment that requires insights into tools ranging from the technical rigors of modern finance to the qualitative judgments of behavioral science, the funds management problem spans an improbably wide range of disciplines, providing material of interest to a broad group of market observers.
Copyright © 2000 by David F. Swensen