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08/23/2010

Book Review: Pioneering Portfolio Management


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Pioneering portfolio managementTo be sure, Yale CIO David Swensen believes most institutions and the vast majority of individuals lack the abilities and resources to pursue active portfolio management strategies. That caveat aside, however, his updated edition of Pioneering Portfolio Management provides a comprehensive view of Yale’s highly successful endowment fund, and is an essential tool for those seeking returns and diversification beyond traditional asset classes.

The revised edition contains substantive improvements, such as coverage of Treasury inflation-protected securities, timber, and oil and gas. There’s also a new fixed income appendix on investment-grade corporate bonds, high-yield bonds, asset-backed securities, and foreign bonds. And there’s a slew of additional real-world examples that illustrate, very effectively, the many challenges of portfolio management for investors of all types.

After articulating the unique needs and missions of university endowments, Swensen begins establishing a framework for portfolio construction. Typically, institutional portfolio management focuses on allocation as the main return generator, with security selection and market timing playing minor roles. Swensen disagrees, and he thoroughly examines the potential contribution to returns of each of those three factors.

Scrutinizing the performance of outside investment managers by asset class sheds light on where to employ resources in security selection. It turns out that in highly liquid traditional asset classes security selection makes little long-term difference, as most managers hug a benchmark. For example, a table comparing managerial performances reveals that the US fixed income asset class shows a miniscule 0.5% difference over 10 years in the first and third performance quartiles. Low-cost index funds, which are easy to implement, serve the portfolio well. With more mispriced securities in illiquid alternative asset classes, a manager’s ability to actively select securities for superior returns is widely dispersed, as evidenced by the 43.2% difference in returns between the first and third quartiles of venture capital managers.

Swensen opposes timing markets to generate returns because he wants to avoid moving away from agreed-upon policy portfolio allocations. That’s why the Yale endowment adheres strictly to allocation targets through daily rebalancing. Risk management is really the overriding concern of this contrarian strategy, although selling into strength and buying weakness does yield a small rebalancing bonus over time. Still, putting the portfolio on automatic pilot in this way can test commitment. It is revealing that, during the 1987 crash, even Yale needed additional meetings with the endowment investment committee.

The discipline of rebalancing prevents both active and passive investors from chasing winners, a dangerous behavior to which even institutional investors are prey. Swensen calculates a gap of 4.8% per year between time-weighted returns, which are divorced from the flow of investments in and out of a fund, and the dollar-weighted returns experienced by investors in aggregate in an institutional international value fund run by a highly regarded manager.

He warns value-oriented investors against naïvely buying low multiple stocks on either a price-to-earnings or price-to-book basis. That tactic has delivered high returns, but at higher levels of risk. A better approach to secure returns, in his view, lies in evaluating the quality of business management and future earnings prospects.

Potential allocations are examined through the prism of diverse asset pricing models. The inherent problems of mean variance analysis mean that optimization can only be a starting point in determining a portfolio with risk–return efficiency. In a neat extension of model inputs, Yale’s investment office simulates portfolio outcomes in order to explore the trade-off between providing stable funding and preserving principal over time.

Many will take issue with Swensen’s belief that most investors should steer clear of active investments. Even those at odds with his philosophy, though, should familiarize themselves with this book. His examination of the alignment of interests between investor and issuer, of inflation sensitivity, and of the market characteristics of each asset class provides a keen and useful perspective.

–Paul Tanner, CFA, is principal of Granite Hill Capital Management, LLC, in Ridgefield, Connecticut.

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