Consistent with active portfolio management, the book stressed three themes. The first addressed "taking action within the context of an analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities" (p. 4). The second theme, agency issues, confronted the personal, internal, and external forces which inhibit portfolio managers from adhering to their fiduciary responsibilities--from fee chasing to purchasing assets of companies that compromise investor interests. The last theme, active management challenges focused on the two variables of active management, market timing and security selecting, to realize rewarding pricing for assets.
In explaining the investment goals of Yale University, Swensen articulated the need for sustainability. He quoted Tobin, "the trustees of an endowed institution are the guardians of the future against the claims of the present" (p. 25). To achieve this goal, Swensen defined his investment philosophy, "by choosing to place asset allocation at the center of the investment process, investors ground the decision-making framework on the stable foundation of long-term policy actions . . . expressing an equity bias and maintaining appropriate diversification provide the foundation for building strong investment portfolios" (p. 52).
Swensen also specified Yale endowment’s spending philosophy. Sustainability requirements result from the balance of preserving the endowment and funding operations. Specifically, “Yale’s policy relates current year spending both to the previous level of spending from endowment and to the previous endowment market value. Under Yale’s rule spending for a given year equals 80 percent of spending in the previous year plus 20 percent of the long-term spending rate applied to the endowment’s market level at the previous fiscal year end” (p. 29). The older the endowment value the smaller the weight given to that value, ensuring less volatility and allowing greater risk. “Target spending rates sit at the center of fiscal discipline”, stated Swensen (p. 37).
Portfolio managers classify asset classes in a variety of ways. Swensen designated the groups noting the "broad sweeping differences in fundamental character" Debt versus equity, domestic versus foreign, inflation sensitive versus deflation sensitive, private versus public, liquid versus illiquid" (p. 101). Furthermore, Swensen described the type of economic environment in which each of the classes performed best.
"Under normal circumstances, bond returns exhibit high positive correlation to stock returns When interest rates fall, bond prices rise as a result of the inverse relationship between prices and yields. When interest rates decline, stock prices tend to rise as investors subject future earnings streams to lower discount rates. Strong positive correlations between stocks and bonds in normal environments produce little diversifying power. In the case of unanticipated inflation, bonds suffer. Inflationary price increases erode purchasing power of fixed nominal bond payments, causing investors to push bond prices down. While inflation may have negative short-term consequences for stocks, in the long run stocks react positively to inflation. With unexpected inflation, the long-term correlation between stocks and bonds prove to be low, providing substantial diversification to the portfolio. In a deflationary environment stocks perform poorly as economic woes cause earnings to suffer. In contrast, bonds generate handsome returns since fixed payments appear increasingly attractive as rice levels decline. During periods of deflation, low or negative correlations between stocks and bonds provides strong diversification" (p. 117-118).
In the context of the economic factors that influence asset allocation, the investor must decide on a portfolio. Yale identified the following two goals: "preservation of purchasing power and provision of substantial, sustainable support for operations" (p. 122). Given these goals, Yale defined its "'spending trauma' as a 10 percent reduction in real endowment distributions over five years" (p. 122). The responsibility rested on the portfolio manager "in selecting the portfolio best suited to satisfy, to the extent possible, both goals" (p. 123).
Having established portfolio management philosophies, goals, objectives, and investment and spending targets, the Yale team undergoes iterative portfolio simulations to verify performance. "Returns for each asset class, based on assumed returns, risks, and correlations and drawn from the specified distributions, determine portfolio returns for the initial period. The spending rule dictates the amount withdrawn from endowment, leaving the residual to be invested in the second period. After rebalancing the portfolio to long-term policy weights, repeating the return level for the subsequent year. The process continues, creating a time series of spending and endowment values" (p. 123). The team had multiple criteria for judging portfolio performance: failure to meet the team's goals and failure to realize both goals in equal weights. The exercises of simulations "encourage investors to create well-diversified portfolios" (p. 127), containing larger domestic equity classes, smaller reliance on bonds, and the inclusion of "private assets, including venture capital, leveraged buyouts, real estate, timber, and oil and gas" (p. 127). This exhibits a strategy geared to higher returns with less risk than the less-diversified endowments, the 'free lunch'.
In his chapter on portfolio management, Swensen emphasized, that the "fundamental objective of portfolio management is faithful implementation of long-term asset allocation targets" (p. 130). He continued, "If investors allow actual portfolio holdings to differ materially from asset class targets, the resulting portfolio fails to reflect the risk and return preferences determined by the asset allocation process" (p. 130).
After establishing asset allocation targets, Swensen contends that “risk control requires regular rebalancing to policy targets” (p. 132). A contrarian mindset lies at the heart of a rebalancing philosophy. Rebalancing requires discipline. An investor’s frequency of rebalancing ranges from daily, monthly, quarterly, or annually. “Since rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to sell what others are buying and buy what others are selling, thereby providing liquidity to the market . . . To the extent that markets exhibit excess volatility, continuous rebalancing generates excess returns” (p. 134-135).
On consequences of active management, Swensen reiterated that active management and deviation from indexing, passive management involves risk. Additionally, the belief of investors that "portfolio biases create potential for significant value added . . . value strategies dominate growth strategies . . . that small-capitalization stock provide superior stock picking opportunities" (p. 136). Regarding active management, Swensen differentiates explicit and implicit leverage. Explicit leverage occurs when investors borrow funds to finance investment purchases. Implicit leverage happens when holding positions that embody greater risk than contemplated by the asset class within which they are categorized, such as derivatives.
Within the category of traditional asset classes, Swensen mentioned domestic equities, or stocks, U.S. Treasury bonds, foreign equities, and emerging markets. Swensen described the nature of these instruments, the hedge they act against inflation and deflation, the reasons they add diversity to the portfolio, the alignment of the interests of their managers and that of investors, and the interplay between the American and foreign markets and currency fluctuations. Previous discussion has detailed how domestic equities and U.S. Treasuries operate according to factors. Regarding foreign equities, Swensen concluded that historical data "supports the assumption of approximate equivalence between expected returns for domestic and international equities" (p. 170). However, he observed that "sensible investors invest in foreign equity markets through thick and thin" (p. 174). The political and economic stability and regulatory immaturity of emerging economies cause a high degree of risk for investors of these securities. Analysis has shown that many suffer periods of either "nationalization or war" (p. 175). "Of the thirty-six markets that operated in 1900, fully fifteen remained classified as emerging markets more than 100 years later" (p. 175). Although Swensen saw a correlation between inflation on domestic equities and emerging markets, he observed, "basic commodities play an important role in a number of emerging markets economies. To the extent that the U.S. suffers commodity-price induced inflationary pressures, investments in emerging markets stocks may provide partial protection against the inflation" (p. 177).
In his chapter on the investment process, Swensen argued that two principles should govern an organization that manages endowments: "developing an organization with the capability of selecting high quality active managers, and (b) deploying a strategy with an emphasis on bare bones passive vehicles" (p. 297). Some asset classes do not allow for passive investment success, according to the author: "absolute return*, real assets, and private equity" (p. 299).
Annual performance reviews
When making decisions, place allocations targets at the center on the discussion, targets that undergoes a review once a year. Other strategic reviews include the portfolio evaluation. This review details the "character and performance of the overall endowment and individual asset classes in depth, placing results in the context of conditions and identifying factors that influence significant investment opportunities" (p. 317).
"Portfolio review memoranda describe individual asset classes in depth, placing results in the context of market conditions and identifying factors that influence significant investment opportunities. The positioning of an asset class relative to its benchmark with respect to fundamental characteristics--such as size, sector, and style--highlights significant portfolio bets that are evaluated retrospectively and prospectively. Active management efforts receive grades in the form of detailed report cards for each manager. The individual manager assessments include not only performance data, but information on reporting, transparency, fee structure, and co-investment. Analysis of strengths and weaknesses of portfolio strategies leads to an outline for future projects to improve portfolio management. In essence, the portfolio evaluation meeting provides a backward-looking assessment and a forward-looking strategic plan" (p. 317).
"The remaining two quarterly meetings generally have a topical focus, frequently involving in-depth analysis of a specific asset class. Meetings centered on individual asset classes drill deep to provide a granular view, allowing committee staff to evaluate thoroughly every aspect of asset class management. Decision-making assessments consider the impact of bets regarding size, sector, and style . . . Asset class reviews provide a chance for external investment manages to engage investment committee and staff in discussion of significant market issues" (pp. 317-318).
Performance Assessment
Swensen listed both qualitative and quantitative factors in evaluating a portfolio. qualitative factors encompass "the quality and commitment of a firm's principals and maintenance of an appropriate organizational structure, regular face-to-face meetings between fund managers and external advisors constitute the most important tool for performance evaluation" (p. 326).
"Portfolio return data provide essential hard input into the performance assessment process. By comparing manager returns to passive market benchmarks and active manager benchmarks, investors measure the successes and failures of an investment program" (p. 326).
"If the sense of partnership diminishes because of changes in people, philosophy, or structure, then tough-minded fiduciaries move on" (p. 327).
* Absolute return investing consists of inefficiency-exploiting marketable securities positions that exhibit little or no correlation to traditional stock and bond investments . . . Merger arbitrage represents a typical event-driven absolute return strategy, with results related to the manager's ability to predict the probability that a deal will close, the likely timing and the expected consideration for the transaction" (p. 183).
Swensen, D. F. (2009). Pioneering portfolio management: An unconventional approach to institutional investment. New York: Free Press.
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