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Illiquidity Is Beautiful For Some

Remember when Chevy Chase used to wrap up the Weekend Update faux-news segment of Saturday Night Live with the line, I'm Chevy Chase and you're not? David Swensen, the manager of the Yale University endowment, has posted such consistently strong portfolio returns over the years that he could sign off his annual reports with a similar close. It's fair to say he probably won't. But the chief investment

Remember when Chevy Chase used to wrap up the “Weekend Update” faux-news segment of Saturday Night Live with the line, “I'm Chevy Chase and you're not”? David Swensen, the manager of the Yale University endowment, has posted such consistently strong portfolio returns over the years that he could sign off his annual reports with a similar close.

It's fair to say he probably won't. But the chief investment officer of the $18 billion fund deserves to gloat. On his 22-year watch, Yale's endowment has grown tenfold and has spun off enough cash to fund about a third of the university's annual operating budget. Swensen has cranked out an average annual return of 16.1 percent — the best performance of any college endowment in the land; by comparison, the S&P 500 posted an average annual gain of 12.3 percent during that period.

Although Swensen is managing an endowment with a time horizon best measured in centuries rather than decades, retail advisors are increasingly keeping an eye on his moves. After all, advisors managing assets for retirement-bound retail clients face many of the same issues that Swensen does — albeit on a smaller scale. Both depend upon the “spendable” funds their nest eggs produce.

How Does He Do It?

How does Swensen produce such handsome returns? And can you, should you — a retail financial advisor — try to mimic Swensen's asset allocation? Swensen, in his primer on endowment management, Pioneering Portfolio Management, argues liquidity is vastly overrated: It costs too much, and it's never there when you need it. You need only witness a stock gapping downward on bad news in the opening minutes of trading for proof of that.

You can find assets “at meaningful discounts to fair value” in less efficient, even illiquid, asset classes, Swensen says. So the Yale endowment portfolio includes a diverse mix, from real assets, such as commodities, real estate and timber, to alternative strategies, including private equity and hedge fund exposure. (See table on p.73, “Yale Endowment Asset Allocation Targets.”) He even keeps a relatively light exposure to U.S. stocks. That he took this course of action through the raging bull market of the late 1990s and still outperformed most other institutional investors is a testament to the validity of his argument. Clearly though, Swensen's approach is at odds with the mantra preached at brokers: “Stick with strategies built with well-known liquid stocks.”

Oddly enough, Swensen actually strives to produce equity market-like results for the Yale endowment. The expected return of his target portfolio is presently 10.1 percent per year with a standard deviation of 11.8 percent — a profile pretty much like that of the Russell 3000, the S&P 1500 and the Dow Jones-Wilshire 5000. While Swensen aims for the broad market's return, he diversifies the portfolio's other assets to provide insulation from the equity market's potential for outsized losses in any given year.

Be Like Swensen?

With the lessons learned from the recent bear market, many advisors, not surprisingly, are now asking themselves what it might take to “Be Like Swensen.” Here some things to consider if you have similar aspirations.

Being like Swensen entails producing equity-like returns with only a small exposure to the domestic stock market. The Yale endowment allocates just 12 percent to domestic equities. Of course, this pot is pretty easy to fill. If you don't have talent as a stock picker, you can use index-based products in either the mutual fund or exchange-traded fund (ETF) format to get your beta. The same goes for his foreign equity and fixed income allocations, 15 percent and 4 percent, respectively. There are plenty of products tracking international equities and domestic bonds available.

But Swensen's biggest allocations, to private equity, real assets and absolute return strategies, get a little trickier to match on the retail side. Nearly 70 percent of the Yale target portfolio, by weight, is allocated to these assets classes.

Private equity, essentially direct investment in businesses, is typically the playland of the super-liquid — reserved for endowments such as Yale's, pension funds or family foundations. Regular rich folk may have to make do with a private-equity ETF — such as the PowerShares Listed Private Equity Portfolio (PSP). PSP is comprised of 32 stocks of public companies that make private equity deals. (The portfolio's benchmark is the Red Rocks Capital Listed Private Equity Index.) From its launch in October, 2006 through the first week of May, 2007, PSP produced a 13.1 percent return with a standard deviation of 14 percent. Considering the broad equity market cranked out a contemporaneous 9.8 percent return with 10.3 percent risk, that's not so bad. But here's the real problem: PSP's correlation to the broad equity market is about 88 percent. Considering it's an index of public companies, this shouldn't be surprising.

As for real assets, these are the complement of paper assets and include real estate, commodities, timber and oil/gas deals. While there are numerous mutual funds that provide exposure to these kinds of assets, Swensen says they are too expensive. There are, however, a limited number of exchange-traded funds that provide exposure to real assets.

REIT ETFs, with a 53 percent correlation to equities, have provided a fair amount of diversification since they were launched in late 2000. An ETF based on the Dow Jones U.S. Real Estate Index (IYR), for example, grew at an average annual rate of 37.8 percent against the broad market's 3.4 percent average return during the past six years.

Pure commodity plays are another recent addition to the ETF universe and have distinguished themselves as having characteristics most complementary to the domestic equity set. The -1.4 percent return earned by an ETF tracking the Goldman Sachs Commodity Index (GSG) since its October 2006 launch bespeaks its 20 percent correlation to the broad equity market.

Absolute return strategies (ARS) is a term used to describe a combination of hedge fund plays in an allocation that produces consistent — albeit modest — positive returns with below-market volatility, regardless of market conditions. ARS are often found in “fund of hedge fund” formats, where they bring together relative value, event-driven and directional trading programs.

If you look for absolute return strategies in an ETF, you'll hit a roadblock; there just aren't any yet. There are, however, self-described ARS mutual funds, though these tend to be expensive. The Rydex Absolute Return Strategies H Class Fund (RYMSX), for example, carries an 1.83 percent expense ratio while the Geronimo Multi Strategy Fund (GPHIX) can cost you up to 3.00 percent. Recent research indicates, too, that alternative strategy mutual funds may not provide the same benefits offered by the hedge funds they hope to emulate.

Try Active/Passive Instead

In the end, the dearth of off-the-shelf exposures for Swensen's non-equity allocations leaves retail investors a little in the lurch. In fact, Swensen's advice to those would emulate him is, simply, “Don't.” Swensen is an unabashed active investor, rebalancing his portfolio at least daily. He can well afford to be active, too; he has a cadre of 20 analysts sifting for investment gems. To boot, he has an $18 billion cudgel that allows him to negotiate away a lot of the rich fee structure built into private equity and hedge funds, something the average advisor and investor can only dream about.

And yet, in his most recent book, Unconventional Success: A Fundamental Approach to Personal Investment, Swensen concludes the best thing investors can do for their portfolios is to steer clear of active management altogether. It's too expensive and most portfolio managers aren't very talented. Besides, individuals “tend to behave in ways that undermine the effects of active management,” writes Swensen. “You've got a lot of people crashing around doing dumb things.”

Swensen advises sticking to low-cost index products — but this doesn't mean he's advocating an entirely passive strategy. In fact, Swensen proposes turning beta into alpha through smart asset allocation and regular rebalancing. (See table at left, “Swensen's Retail Asset Allocation Targets”.) This can be done using a suite of Vanguard mutual funds. (See table at left, “In the Vanguard”.) Despite holding large slices of non-domestic equity, his suggested retail portfolio produces returns very much like the domestic equity market, reflected in the portfolio's 82 percent correlation to the Dow Jones-Wilshire 5000.

Spending dividends and rebalancing monthly, Swensen's retail portfolio outgunned the broad market by better than 136 basis points per year since 2002 by my calculations. And that outperformance was won with a quarter less risk than stocks alone would have produced.

The bottom line is this: Using essentially nothing more than beta exposures, Swenson's portfolio cranked out a two percent annual alpha and eight percent total return. Granted, an eight percent return isn't quite what Swensen & Co. turns out for the Elis, but who can turn down market-beating results nowadays?

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


Performance characteristics of a Swensen-inspired portfolio built with Vanguard funds.

Swenson Portfolio DJ-Wilshire 5000 (DWC)
Compound Annual Growth Rate 8.43% 7.07%
Volatility 8.99% 12.11%
Sharpe ratio 0.67 0.39
Correlation to DWC 0.92
Beta vs DWC 0.82
Alpha vs DWC 0.02
Portfolio allocation: 30% Vanguard Total Stock Market Index Fund (VTSMX), 15% Vanguard Total International Stock Index Fund (VGTSX), 20% Vanguard REIT Index (VGSIX), 15% Vanguard Short Term Treasury Fund (VFISX), 15% Vanguard Inflation-Protected Securities Fund (VIPSX) and 5% to Vanguard Emerging Market Index Fund (VEIEX). Technically, VFISX and VIPSX are not index funds, but their characteristics are so close to their respective benchmarks that they are reasonable proxies for their asset classes. Performance does not include redemption fees.
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