Practice English Speaking&Listening with: 9. Guest Lecture by David Swensen

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Professor David Swensen: Let me start out by

putting what I think is a relatively controversial

proposition on the table and that's that this investment

management business, when stripped down to its bare

essentials, is really quite simple.

Now, why do I say that? Well, I think if we took the

group here today and divided you up into smaller groups of four,

or five, or six and asked you to talk about what's really

important in managing a portfolio that has a very long

time horizon, I think that almost all the

groups would come to very similar conclusions.

If you're investing with a long time horizon,

having an equity bias makes sense;

stocks go up in the long run. Bob Shiller's friend,

Jeremy Siegel, wrote a book that has the very

simple title, Stocks For The Long Run.

Well, the book is assigned; you all know it.

The other thing that I think would come out of the

discussions is that diversification is important.

Anybody whose read a basic finance text,

as a matter of fact, I think anybody who thinks

about investments in a common sense fashion knows that

diversification is an important fundamental tenet of portfolio

management. As a matter of fact,

Harry Markowitz called diversification a "free lunch."

We spend all our time in intro. econ.

figuring out there is no such thing as a free lunch but

Markowitz tells us that diversification is a free lunch.

For any given level of return, you can reduce--For any given

level of risk, you can increase the return;

sounds pretty good. That's pretty simple, right?

Two tenets, an equity bias for portfolios with a long time

horizon and diversification. Bob mentioned in his

introduction that I showed up at Yale in 1985,

after having spent six years on Wall Street,

and I was totally unencumbered by any portfolio management

experience. I thought that was pretty neat.

Here I was, back at Yale, with a billion dollar

portfolio--it seemed like a lot of money at the time--no

portfolio management experience. What do I do?

Well, one of the things I think is a sensible thing to do in

life is look around at what others are doing,

so I looked at what colleges and universities had done in

terms of asset allocation. Turns out that 50% of endowment

assets in the mid-1980s were invested in common stocks,

40% of endowment assets were in U.S.

bonds and U.S. cash, and 10% in a smattering

of alternatives. Well, I looked at that and I

thought, this doesn't really make a lot of sense.

You have half of your assets in one single asset class:

U.S. common stocks.

You've got another 40% of your assets in U.S.

bonds and cash. So 90% of your portfolio is in

domestic marketable securities and only 10% is invested in

things like real estate or venture capital or private

equity--hardly enough to make a difference in terms of the

portfolios returns. Unencumbered by,

I guess, the conventional wisdom, we started out at Yale

on a path that I think is--fundamentally that changed

the way that institutions manage portfolios.

A few years ago, I wrote a book called

Pioneering Portfolio Management.

The reason you could put an audacious title like

Pioneering Portfolio Management on the cover of

the book was that we moved away from this traditional model with

50% in stocks and 40% in bonds and cash to something that was

much more equity-oriented and much more diversified.

What I'd like to do today is talk to you about how it is that

we moved from this old model to what it is that today many

institutions call the Yale model.

The way that I would like to talk about this journey that we

took is by looking at the tools that we have available to us as

investors--these tools are the same tools that we have whether

we're operating as individual investors or institutional

investors--and describe how we employ those tools at Yale and

how they led us to the portfolio that we have today.

Those three tools are asset allocation, market timing,

and security selection. The first, asset allocation,

basically deals with which assets you have in your

portfolio and in which proportion you hold each of

those assets. The second, market timing,

deals with short-term deviations from the long-term

asset allocations that you establish.

And the third, securities selection,

speaks to how it is you manage each of your individual asset

classes. Are you going to hold the

market portfolio, index your assets,

match the markets results? Or are you going to manage each

individual asset class actively, trying to beat the market and

generate risk-adjusted excess returns?

Let's start out with the first: asset allocation.

I think it's pretty widely known that asset allocation is

far and away the most important tool that we have available to

us as investors. As a matter of fact,

it's so widely believed that asset allocation is the most

important tool that I think some people have come to the

conclusion that it's some sort of law of finance that asset

allocation is the most important tool.

It turns out that it's not a financial law that asset

allocation takes center stage; it really is more a description

of how it is that we behave. Yale actually has a lot more

than the billion dollars that we started with in 1985.

I think the estimate sheet that I got yesterday morning said

that we've got about $22.5 billion dollars;

so that's been a nice run. If I went back to my office

after speaking with you this morning and took Yale's $22.5

billion dollars and put all of it into Google stock,

asset allocation would have very little to say about what

Yale's returns would be. As a matter of fact,

security selection would absolutely dominate the results.

The idiosyncratic behavior of Google stock from the time that

we purchase it to the time that we sell it would define Yale's

returns. Alternatively,

if I went back to the office and took Yale's $22.5 billion

dollars and decided that I was going to day trade bond futures,

security selection wouldn't have anything to say about the

returns; asset allocation wouldn't have

anything to say about the returns.

The returns would be attributable solely to my

ability to market time the bond futures market.

Now, I'm not going to do either one of those things.

I'm not going to put Yale's entire portfolio in Google

stock, I'm not going to go back and take Yale's entire portfolio

to day-trade bond futures; in part, because it would be

bad for me personally. I think I would be fired as

soon as people found out what it was that I was doing with the

portfolio and, overwhelmingly more important,

it would be bad for the University.

It's not a rational thing to do. What will happen is that Yale

will continue to hold a relatively well-diversified

portfolio as defined by the range of asset classes in which

it invests. When you look at each of those

individual asset classes--domestic equities,

foreign equities, bonds, real assets,

absolute return and private equity--each of those individual

asset classes is going to be relatively well-diversified in

terms of exposures to individual positions or individual

securities. Because that's true,

then asset allocation ends up being the overwhelmingly

important determinant of the University's results.

Because we hold relatively stable, relatively

well-diversified portfolios, security selection turns out

not to be an important determinant of returns for most

investors and market timing turns out not to be an important

determinant of returns. The last man standing is asset

allocation and that tends to drive both institutional returns

and individual returns. Roger Ibbotson,

who is a colleague of Bob Shiller's and mine at the School

of Management, has done a fair amount of work,

studying the relative importance of these sources of

returns. He's come to the conclusion

that over 90% of the variability of returns in institutional

portfolios is attributable to asset allocation and that's the

number that I think most people hear cited when they are looking

at Roger Ibbotson's work. I think one of the more

interesting and even simpler concepts that comes out of his

study is that more than 100% of returns are defined by asset

allocation. Now, how can that be true?

How can asset allocation be responsible for more than 100%

of investment returns? Well, it can only be true if

security selection and market timing detract from

institutional returns or individual returns in the

aggregate. Of course, if think about it,

as a community, the investment community is

going to lose from security selection decisions.

If security selection is a zero-sum game,

the amount by which the winner wins equals the amount by which

the loser loses--winners and losers being defined by

performance after a security selection that has been

made--well, that sounds like a zero-sum

game. But then, if you take into

account that you create market impact when you trade,

that you pay commissions when you trade and you frequently pay

advisors substantial amounts of money--whether they're mutual

fund managers or institutional fund managers--there's this

leakage from the system that causes the active results for

the community as a whole to be negative.

Absolutely the same thing is true on the market timing front.

I mean, to the extent that you're making these short-term

bets against your long-term policy, it requires trading and

trading is expensive. It's very expensive when you

take into account not only the direct costs,

but also the costs that you pay advisors to help you make these

decisions. So, it's not surprising that

asset allocation explains more than 100% of returns and that,

for the community as a whole, market timing and security

selection are costly and lower the community's aggregate

investment returns. It's a little bit of a

digression, but one of the things that I've witnessed over

the past twenty years is that the leakage of the--the leakage

from the system in terms of the returns that go to the owners of

capital--leakage has increased enormously.

Think about the advent of hedge funds--twenty or twenty-five

years ago, hedge funds were a blip on the radar screen.

Today, they're a very important part of the fund's management

framework. Well, those hedge funds charge

enormously more than what a standard manage or marketable

securities firm charges. Well, that leakage--that 1.5%

or 2% that you pay your hedge fund manager--plus the 20% of

profits really reduces the amount of return that's

available for the owners of capital.

This idea that the difference between the returns that you

would get if you took your asset allocation,

implemented passively, and the actual results that the

active investors get--the gap between those two numbers--is

becoming larger and larger over time,

generating more and more returns for the provider of

investment management services and lower and lower returns for

those that are hiring those external advisors.

To get back on track, let's look at the basic

underpinnings to this notion that asset allocation is at the

center of the investor's decision-making process.

There are two points that we talked about--the hypothetical

points that came out of the small group discussions that I

suggested we might think about at the beginning of this talk.

First, in terms of equity bias. Now, we're going to go back to

Roger Ibbotson at the School of Management.

He did some path breaking work in terms of describing capital

markets returns over reasonably long periods of time.

I guess you've already looked at Stocks for the Long

Run; you've seen 200 years worth of

data. Roger Ibbotson's data goes back

to 1925 and these are the actual numbers we used when we first

started doing our mean-variance optimization in our simulations,

trying to come to conclusions about what the appropriate

allocations would be for Yale's portfolio.

I'm sure you're familiar with the drill--you put a dollar into

various asset classes, in this case,

at the end of 1925 and hold those asset classes for,

in this case, eighty-one years;

the numbers go through the end of 2006.

As you put a dollar in treasury bills, you end up with a

nineteen multiple; that sounds pretty good.

You get nineteen times your money over eighty-one years,

but then if you take into account the inflation consumes a

multiple of eleven and you're an institution like Yale that

consumes only, after inflation returns,

putting your money into treasury bills really didn't get

you very much. Suppose you step out in the

risk spectrum and put a dollar into the bond market.

Over that eighty-one year period you would have gotten a

multiple of seventy-two. Well, now we're talking some

real after inflation returns that can be umed.

But, when you move from lending money to the government--either

short-term with bills or longer term with bonds--to investing in

the equity market, there's a stunning difference

in terms of the returns. Just by putting money into a

broadly diversified portfolio of stocks you would have gotten

3,077 times your money. If you would have stepped

further out of the risk spectrum and put your money into a

portfolio of small stocks you would have gotten 15,922 times

your money. So, ownership of stocks

absolutely crushes buying bonds--almost 16,000 times your

money or more than 3,000 times your money in the stock market

as opposed to 72 times your money or 19 times your money in

the bond market or the bill market.

It almost makes you wonder whether this diversification

thing makes any sense. I mean, why would you do that?

Why would you put any of your assets in bonds if stocks are

going to give you 16,000 times your money?

That bond multiple of 72 is just a drag on returns--what's

the point? This question,

particularly in the late 1980s, was very important to me

personally because we were trying to put together a

sensible portfolio for Yale and if that sensible portfolio just

involved identifying the high-risk asset class and

putting all your assets into, let's say, small stocks,

it wouldn't take the investment committee very long to figure

out that they didn't need to pay me to do that;

they could do that on their own. And if they didn't need to pay

me, then I wouldn't have any income to put food on the table

for my wife and children. So, there had to be more to it

than just identifying the high-risk asset class and

putting your assets there and letting it rip.

I went back and took a closer look at Roger Ibbotson's data

and there are lots of examples that will illustrate this point,

but the most dramatic occurs around the crash in October

1929. For every dollar that you had

in small stocks at the peak of the market, by the end of 1929,

you lost 54% of your money. By the end of 1930,

you lost another 38% of your money;

by the end of 1931, you lost another 50%;

and by the end of--by June of 1932, you lost another 32%.

So, for every dollar that you had at the peak,

at the trough you had $.10 left.

At some point, when your dollars were turning

into dimes, you'd say, forget this,

this is ridiculous, it doesn't make any sense for

me to own these risky small-cap stocks.

And you would sell your small stocks and put your money where?

Either in treasury bonds or treasury bills.

And of course, that's what the overwhelming

portion of the investment community did in the 1930s,

and in the 1940s, and in the 1950s.

As long as there was a memory of the searing experience that

people had in the equity markets around the time of the great

crash, people reacted to it by saying,

avoid this risky asset, it doesn't make any sense for a

fiduciary or for an individual to own these risky things called

stocks. As a matter of fact,

I was looking at some of the contemporary literature,

the popular literature, and there was an article in the

Saturday Evening Post that basically said,

you shouldn't call stocks securities--that was a

ridiculous thing to call them; they should be called

insecurities because they were so risky.

Of course, this attitude came at exactly the wrong time.

If you put a dollar into small stocks in June of 1932,

by the end of 2006, you would have had 159,000

times your money. Just at the point of maximum

opportunity people were at the point of maximum bearishness

about the equity markets. The take-aways are that an

equity bias is an absolutely sensible underpinning for

investors with long time horizons but that

diversification is important. You have to limit your exposure

to risky asset classes to a level that allows you to sustain

those positions even in the face of terribly adverse market

conditions. Let's move to the second point:

market timing. I actually have a quotation

here. A few months ago,

some former students of mine--former colleagues of

mine--gave this very nice party at the Yale Club.

I used to teach a big lecture class when I first got to Yale

in the late 1980s and my last lecture always involved taking

Keynes's General Theory, and quoting from what I think

is Keynes--is one of the most wonderful writers about issues

surrounding investment management.

This particular copy was pretty dog-eared;

as a matter of fact, it was a paperback copy and I

think it was in about eight or ten different pieces and the

people that threw this party remembered that,

so they gave me it at this celebration.

It made me wonder if they were trying to tell that I should

retire; it felt like a retirement party.

I feel like I'm way too young to retire.

But as a gift, they gave me a first edition of

Keynes's General Theory. I was coming back to New Haven

on the train afterwards and I came across this quote.

Keynes wrote that, "The idea of wholesale shifts

is for various reasons impracticable and indeed

undesirable. Most of those who attempt to

sell too late and buy too late and do both too often,

incurring heavy expenses and developing too unsettled and

speculative state of mind." He's absolutely right.

I wrote my first book--I already talked about that,

Pioneering Portfolio Management--that deals with

the challenges that face institutional investors.

Subsequently, I wrote a book called

Unconventional Success that deals with individual

investors. In Unconventional

Success, I did a study of individual behavior in their

mutual fund purchases and sales around the collapse of the

Internet bubble in March of 2000.

What I did was I took the ten best-performing Internet funds

and looked at the returns from 1997 to 2002.

Now this is, I think, a surprising starting

point. If you look at the ten

best-performing Internet funds from 1997 to 2002,

the time-weighted return is 1.5% per year positive,

so the funds went way up and then they went way down.

But it's positive 1.5% per year, time-weighted--that's the

number that you see in the prospectus or the number that

you see in the advertisements--so you say,

what's the big deal, no harm no foul.

Well, there's another way to look at returns--those are the

dollar-weighted returns--and the dollar-weighted returns actually

do a better job of describing the experience of the group of

investors that participated in these funds.

Dollar-weighted obviously takes into account when the cash flows

come in and when they go out. When you do the dollar-weighted

returns, you find out that there was $13.7 billion invested in

these funds and the investors lost $9.9 billion out of the

13.7 that they committed; so, 72% of the money that was

invested in these funds was lost.

Because of the way that we deal with taxes and mutual funds,

you can get a tax bill for gains that were realized by the

investment manager turning over the portfolio even though you

might not have held the shares during the period when the gains

were realized. So, in addition to losing $9.9

billion, there were capital gains' distributions of $3.3

billion dollars representing about 24% of the money that was

invested. So, adding insult to injury,

you lost 72% of the money and then you got a tax bill for 24%

of the amount that had been put in;

not a very happy experience. After I wrote the book,

Morningstar did a much more comprehensive study of every

single one of the equity categories that they follow.

There were seventeen categories of equity mutual funds and they

compared the dollar-weighted to the time-weighted returns.

In every one of those seventeen categories, the dollar-weighted

returns were less than the time-weighted returns.

Well, how does that happen? The same way that these

investors and the Internet tech funds lost their money.

They bought after the funds had gone up and they sold after they

had gone down. When you buy high and sell low

it's really hard to generate returns, even if you do it with

great enthusiasm and great volume.

The Morningstar study is incredibly damning in terms of

the market timing abilities of individual investors.

Systematically, investors are buying after

things have gone up, selling after they've gone

down, and the problem is most severe

in those funds that show the greatest volatility.

The gap in what Morningstar calls the "conservative

allocation fund" is .3% per year.

Now, that's not a huge number but, obviously,

when you're hoping to beat the market by a point or two,

losing by .3% per year because of your market timing inability

is a bad thing. But if you look at the tech

fund category, the difference between the

dollar-weighted and the time-weighted returns--this is

over a ten-year period--is 13.4% per annum;

that's stunning. Compound that 13.4% over ten

years and there's just an enormous gap between those

mutual fund numbers that are in the prospectus and in the

advertisement--the time-weighted returns and the dollar-weighted

returns that talk about the actual experience of the

investment community. I'm not just going to pick on

individual investors, I'm going to pick on

institutional investors too. One of the studies that I did

for my first book, Pioneering Portfolio

Management, looked at the behavior of

endowments and foundations around the crash in October

1987. I used to talk about the crash

in October 1987 without explaining what it was and I do

still teach a seminar in the economics department in the

Fall. I started talking about what

happened in October 1987 and I looked around the room and I

realized that I think the students were three or four

years old in 1987 and weren't yet reading The Wall Street

Journal. So, just to give you a little

bit of context, the crash was really an

extraordinary event. According to my calculations it

was a twenty-five standard deviation event.

One standard deviation happens one draw out of three,

two standard deviations one out of twenty, three standard

deviations is one out of one hundred.

An eight standard deviation event happens once out of every

six trillion trials. You can't come up with a number

to describe the twenty-five standard deviation event;

it's just too large a number, I think, for any of us to

really comprehend. In essence, this collapse in

stock prices--the one-day collapse in stock prices--I

think in the U.S. the price was,

depending on which index you were looking at,

were down 21-22% in a single day.

Interestingly, most major markets around the

world were off by a similar magnitude.

This one-day collapse in stock prices was a virtual

impossibility. Of course, this was just a

change in stock prices; it wasn't related to any

fundamental change in the economy or any fundamental

change in corporate prospects. It was just a financial event.

If stock prices went down--by the way, bond prices went up.

When people were selling stocks, money had to go

somewhere. Well, it went into the bond

market. There was a huge rally in

treasury bonds on October 19,1987.

So, stocks were cheaper and bonds were more expensive.

Well, what do you do? You buy what's cheap and sell

what's expensive. But what did endowments and

foundations do? Well, if you look at the annual

reports of their asset allocation, in June of 1987,

their equity allocation was higher than it had been for

fifteen years. The '70s were a terrible time

to invest in stocks, a bull market had started in

1982. We were five years into this

bull market and people were getting excited about the fact

that stocks were going up and equity allocations were at a

fifteen-year high. Of course, the money had to

come from somewhere, so bond allocations were at a

fifteen-year low. Fast forward to June 30,1988

and stock allocations had dropped and, not only had they

dropped, they dropped by more than the

decline in stock prices associated with this collapse in

October 19,1987. Bond allocations had increased

by more than could be explained by the increase in bond prices

over the course of the year. The only conclusion that you

could draw is these supposedly sophisticated institutional

investors sold stocks in November and December and

January because they were fearful and they bought bonds in

October, November, and December--maybe

because they were fearful or maybe because they were greedy.

Emotion ruled the decisions, not rational economic calculus.

The costs were huge--not just the immediate costs in terms of

the move from stocks to bonds. It took these institutions

until 1993--a full six years--to get their bond allocation back

down to where it had been prior to the crash in October 1987.

And this is in the context of one of the greatest bull markets

ever. You certainly have to measure

the bull market, from 1982 to 2000 and some

people would say that 2000 was just a blip and we're still in

this bull market. But regardless of how you

measure it, for a full half-dozen years,

in the midst of this bull market,

colleges and universities were over-allocated to fixed income

relative to where they had been in June of 1987.

The take-away is to avoid market timing.

The underlying driving force behind market timing decisions

seems to be emotional--fear, greed, chasing

performance--buying something after it has gone up,

disappointment, and sales after something has

declined. As opposed to rationally

stepping up when something appears relatively attractive

and overweighting and then leaning against the wind by

selling something that's performed well.

Final source of returns--security selection.

We've already talked about how security selection is a zero-sum

game. The only way that somebody can

overweight Ford Motor Company in the market is to have somebody

have a counter position where they underweight Ford Motor

Company; only one of those is going to

be right. It's measured by subsequent

performance in the amount by which the winner wins equals the

amount by which the loser loses, but it costs a lot to play the

game. As a matter of fact,

it costs an increasing amount to play the game when you look

at the fees that are paid to investment managers and hedge

funds. So, after taking into account

the market impact, and the commissions,

and the fees, this zero-sum game becomes a

negative-sum game. When you look at the returns

for institutions, you see exactly what it is that

you'd expect. Here's ten years worth of data

from the Frank Russell Corporation, the benchmark

Wilshire 5000. For the ten years ended June

30,2005, it returned 9.9% per year and then the average return

for the actively managed equity fund was 9.6% per year,

so we're back to that thirty basis points.

Maybe on average institutions lose thirty basis points,

but it's kind of Lake Wobegon, where we all believe that we're

better than average, so we're going to overcome that

thirty basis points--that's not such a big hurdle.

There's a very important phenomenon that you need to take

into account when you look at these histories of returns that

are generated by active managers.

This is true whether you look at the universe of the mutual

fund managers that we might have available to us as individuals

or whether it's institutional data,

such as those that I just cited; that concept is survivorship

bias. The only numbers that appear

for the trailing ten years are numbers that are associated with

firms that are still in business.

There were probably a number of firms that, over that ten-year

period, went out of business. Now, which firms do you think

went out of business? Not the ones that are producing

great results. The problem is even more severe

when you're looking at mutual funds because there's kind of a

cynical game that mutual fund management companies play.

If they have an underperforming fund, sometimes they allow it to

die a dignified death; although, that doesn't happen

very often. What they usually do is they

take the underperforming fund and they merge it with one that

has a better track record. All of a sudden the

underperforming fund's record disappears and the assets are in

a fund that has a better record--a record that you can

actually market. Then when we look at the

statistics, all we see are a lot of assets in the fund that

performed well and the underperforming fund that was

merged out of existence isn't there anymore.

How important is this survivorship bias?

If you look at the Frank Russell data--and I just cited

ten-year returns ending June 30,2005, so that period started

in 1996--well, in 1996 there were 307 managers

that reported returns. By the time 2005 rolled around,

there were only 177 managers that reported returns,

so 130 managers disappeared. Now, more than 130 managers

failed because, in addition to survivorship

bias, there's something called backfill bias.

That's when a new manager appears subsequent to the

beginning of the ten-year period;

they'll put not only the new numbers in, but they'll take the

history of the new manager and put that history into the

database. Which direction is that going

to move the numbers? Well, that's going to inflate

the numbers too because the only managers that kind of raise

their hand and say, hey I've got this interesting

new approach to managing domestic equities--or whatever

the asset class is--are the ones that have succeeded.

You've got survivorship bias taking out bad records and then

you've got backfill bias adding good records.

They both cause the universe of active management returns to

appear to be better than the reality because there's a lot in

there that doesn't have anything to do with the average

experience of, in this case,

an institutional investor. Sometimes the numbers can be

pretty dramatic; I mean, 2000 was a year of

great flux in the markets because that's when the Internet

bubble burst. If you looked at the domestic

equity return--the average return that was posted in

2000--it was -3.1%. Then if you fast forward to

2005 and look at the average return that was posted for 2000,

it was +1.2%. So, the combination of

survivorship bias and backfill bias for that one year made 4.3

percentage points difference. As reported contemporaneously

in 2000, the number was -3.1% but if you look at the number

reported for 2005, because bad records had

disappeared and good records had been added, all of a sudden the

average experience for that year went up to +1.2%.

This is incredibly important because, when you look at this

number that we started out with, saying the benchmark was 9.9

but net of fees the managers on average only lost thirty basis

points--or .3%--you'd say, well that's a game I don't mind

playing. Then if you adjust for

survivorship bias, you end up concluding that the

deficit wasn't .3% but the deficit was actually 2%.

In a world where, if you could win by a

percentage point or two relative to the market,

to have the average be minus two full percentage points is

pretty daunting. That's the kind of issue with

survivorship bias and backfill bias in the relatively

established asset class of domestic equities.

The problem is even more severe when you look at something

that's relatively new, like the hedge fund world.

Now, why is that? Well, if hedge funds first

became mainstream maybe fifteen years ago, then what are you

looking at in terms of history? The only history that you would

have had fifteen years ago would have been those funds that

produced great returns, so it's all identified after

the fact. At least in the domestic equity

world you've got a pretty stable base that you were looking at

ten years ago, so the survivorship bias and

the backfill bias would be much, much more of a problem in the

hedge fund world. Burt Malkiel who wrote a book

called A Random Walk Down Wall Street,

which if it's not on your reading list you ought to pick

up and take a look at because it's really fun to read but it's

also extremely insightful, took a look at survivorship

bias and backfill bias in the hedge fund world.

He looked at a group of hedge funds that numbered 331 in 1996

and by 2004, eight years later, 75% of them had disappeared.

Looking at this particular group, he estimated survivorship

bias to be 4.4% per year and backfill bias to be 7.3% per

year. So, we're talking about a group

of funds that in aggregate probably produced somewhere in

the low teens returns and he's got 11.7% per year combined

survivorship bias and backfill bias.

Roger Ibbotson took a look at a larger group of

funds--3,500--funds over a ten-year period and found

survivorship bias at 2.9% per year and backfill bias at 4.6%

per year. So, huge amounts of

institutional funds and individual funds are going into

this hedge fund world. You look at the returns that

are reported for hedge funds in aggregate--they're generally

12%, 13%, 14% per year for the last five or ten years.

In the case of Burt Malkiel's data, more than 11% per year and

in the case of Roger Ibbotson's data,

between 7% and 8% per year of those returns can be explained

either by backfill bias or survivorship bias.

If you subtract those numbers from the reported numbers,

the returns that the investors that were actually investing in

the funds that are defined as part of the universe at the time

are low, maybe mid-single digits--far

less than people would expect for the amount of risk that

they're taking to be exposed to this particular group of active

managers. The final point that I want to

make with respect to security selection actually is a little

bit different. It has to do with the degree of

opportunity. This is once you've decided

that you're going to be an active manager and try and

pursue market beating strategies,

how do you decide where it is that you want to spend your time

and energy? Now, I think it's logical that

if you're going to try and beat the markets, you'd want to beat

the markets where the opportunity was greatest.

Where's the opportunity greatest?

The opportunity's greatest where assets are least

efficiently priced. How do you figure out where

things are least efficiently priced?

Well unfortunately, financial economists don't have

any direct measures of market efficiency,

but I think there's a story that you can tell about groups

of active manager returns that will help point you toward those

asset classes that are least efficiently priced.

If an asset class has constituents that are

efficiently priced, then it's very hard to generate

excess returns. As a matter of fact,

if things were perfectly efficiently priced,

there wouldn't be any opportunity to generate excess

returns and if you make active bets--if you make bets against

the market--then whether you win or lose has to do with luck.

How are managers going to behave in an asset class where

things are efficiently priced? Well, they're not going to make

big bets, right? If they do make big bets maybe

they get lucky once, or twice, or three times,

but ultimately their luck is going to run out.

And when their luck runs out, they'll post bad results and

get fired. How do you stay in business?

You stay in business by looking a lot like the market.

What market might be efficiently priced?

The bond markets, in general, and the

high-quality bonds in particular are probably easiest to value.

It's all about math. The government bond,

you don't have to worry about default.

Generally, you don't have to worry about optionality or call

provisions and so it's math. You're given coupon payments

every six months and then, when the bond matures,

you get your money back. So there's not a lot of room in

the government bond market or other high-quality bond markets

to generate excess returns. How about the other end of the

spectrum? The other end of the spectrum

is a market that is very hard to define.

As a matter of fact, there might not even be a

benchmark against which you can measure results and you'd think

about the venture capital world. How do you hug the market in

the venture capital world? You can't;

it's very idiosyncratic. If you're doing early-stage

venture investing, you're backing entrepreneurs

and ideas and they're operating out of their garage.

I mean, this romantic notion of what goes on in Silicon Valley

actually still holds true in a lot of cases but there's

absolutely no way, as a venture capital investor,

you could index the venture capital market.

If you look at the behavior of groups of active managers and

the dispersion of returns, I think it gives you some idea

of what the efficiency is with which assets in these individual

assets classes are priced. Just as I foreshadowed,

if you look at the difference between the first and third

quartile in the bond market--these are active returns

over a ten-year period, again ending June 30,2005--and

the fixed income market, the difference between first

and third quartile is a half a percent per annum.

That's an incredibly tight distribution of returns.

Half of the returns are within a spread of a half-percent.

Then as you move out to the equity markets where it's harder

to price things as efficiently--large-cap

stocks--there are two-fold percentage points,

first to third quartile. Small-cap stocks are tougher to

price than large-cap stocks, so there's a 4.7% differential,

first to third quartile. The hedge fund world is 7.1%

first to third quartile, real estate 9.3% per annum,

leveraged buyouts 13.7% per annum--this is over a ten-year

period, so now we're starting to talk about some pretty

significant dispersion. Of course, in the venture

capital world, the least efficiently priced of

all, there's a 43.2% differential

between the top quartile and the bottom quartile.

If I'm going to be active in terms of managing my portfolio,

should I spend my time and energy trying to beat the bond

market? Where even if you can find

somebody who's going to be a first quartile manager,

there's almost no difference between the first quartile

return and the third quartile return.

Or should I spend my time and energy trying to find the top

quartile bond, top quartile real estate

manager, or buyout manager,

or venture capital manager? I think the answer is pretty

obvious. You want to spend your time and

energy pursuing the most inefficiently priced asset

classes because there's an enormous reward for identifying

the top quartile venture capitalist and almost no reward

for being in the top quartile of the high-quality bond universe.

The overall conclusions are that, with respect to asset

allocation, you want to create an equity-oriented diversified

portfolio. With regard to market timing,

you don't want to do it. And with respect to securities

selection, you want to consider your skills and you want to

consider the efficiency of markets when you're making your

decisions as to whether or not to pursue passive management or

active management. Where did this lead us in terms

of Yale's portfolio? Our current portfolio has 11%

allocated to domestic equities, 15% to foreign equities,

and 4% to bonds, so traditional marketable

securities account for 30% of assets.

The absolute return portfolio, which is a group of hedge funds

that strive to produce fundamentally uncorrelated

returns, accounts for 23% of assets;

our real assets portfolio, which includes timber,

oil and gas, and real estate,

amounts to 28% of the portfolio;

and private equity, which includes venture capital

and leveraged buyouts, is 19% of assets.

So, 70% of the portfolio is in absolute return,

real assets, private equity,

alternatives--broadly defined. If you take this portfolio and

apply the tests that we articulated at the outset of the

lecture today--equity orientation and

diversification--the portfolio is clearly equity-oriented;

96% of assets are invested in some type of vehicle that we

would expect to generate equity-like returns over

reasonably long periods of time. In terms of diversification,

there are half a dozen asset classes with weights that range

between 4% and 28%. So, if you just came down and

took a look at that and compared it to 50% in domestic stocks,

40% in domestic bonds and cash, and 10% in a smattering of

alternatives, you'd say that this is really a

much, much better diversified

portfolio than the one with which we started.

The results have been okay. Over the past twenty years,

we've generated 15.6% per annum return, but that headline number

obviously has a lot to do with the equity orientation of the

portfolio but doesn't describe the importance of the

diversification. We've had no down years since

1987--1987 that was the crash in October that I talked about

earlier. In that year,

we were early on in terms of diversifying the portfolio--we'd

only been working on that program for two years--and even

so, the negative return was less

than 1%, so it was a modest negative return.

Probably a more important test of the portfolio was what

happened around the collapse of the Internet bubble in 2000.

In the year ending June 30,2001 and 2002, returns for

institutional investors were on average negative in both of

those years and actually in every year since 1987 Yale has

had positive returns. The equity orientation drove

the returns but the diversification allowed us to

deliver those returns in a stable fashion,

which is incredibly important for an institution like Yale

that requires a steady supply of funds to finance its operations.

When I started in 1985, the distribution to the

operating budget was $45 million.

That represented 10% of revenues and that was the lowest

level for the entire century--the entire twentieth

century--10% of revenues. The amount that we're spending

for the year ending June 30,2008 is $843 million--that represents

37% of revenues--and we're projecting expenditures for the

following year of $1.15 billion. The results have been really

quite extraordinary. My favorite way to measure the

results is actually to compare what Yale achieved with what we

would have had if we would have just experienced average returns

over the past twenty years. The difference between the

average return for colleges and universities and Yale's returns

has added $14.4 billion dollars to the University's coffers.

Whether you measure it in terms of dollars of value added or in

terms of returns, Yale has the best record among

colleges and universities for the past two decades.

So with that, I'd be happy to take any

questions that you might have. Student: [inaudible]

Professor David Swensen: The question is,

if a group of Yalies started a hedge fund, what would they have

to do to convince me to invest in them?

One of the things that we've done over the years has been

open-minded about backing groups that don't have traditional

investment credentials. If you went to a corporate

pension plan or a state pension manager, they'd have a very

bureaucratic process--probably a fifty or hundred page

questionnaire that you had to fill out,

you'd have to deal with consultants, and you'd have to

have ten years or five years worth of audited performance

statistics. We tend to think that that's

not the richest pond within which we should fish.

We think that the more interesting investment

opportunities are kind of outside of the mainstream with

more entrepreneurial firms and ones that might have less

traditional backgrounds. That said, we just don't take

flyers on people that we think have interesting resumes;

we want to have a demonstrated ability to operate in the

markets that the investment management firm is suggesting

that we back. I would say,

part of what we look at are hard quantitative factors,

but probably more important than the numbers are the soft

qualitative attributes. It's almost like what you

looked for in a Boy Scout or a Girl Scout.

You want people of high integrity.

You want people of unimpeachable character.

You want people that are smart, incredibly hard-working.

And in the investment world, you want somebody who's really

obsessed with the markets--somebody who doesn't

define winning by getting as rich as they possibly can

because, if that's their goal,

there are all sorts of things that they can do to get rich

that don't have anything to do with generating investment

returns. We want people who are

maniacally focused on beating the markets, generating superior

investment returns. That's an incredibly important

distinction because, think about it,

if what you want to do is get rich,

you can put together a reasonable investment record and

then raise staggering amounts of money.

Size is the enemy of performance.

So that staggering amount of money then impairs the fund

managers' ability to continue generating excellent returns,

but they can stay in business and collect the fees that they

get for having this huge pile of money.

The type of manager we're looking for is somebody who

strives to generate excellent returns and they'll frequently

raise modest amounts of money and close to new investors,

measuring their success by beating the market not by

generating huge flows of fees for themselves.

It's a combination of looking at kind of objective attributes

and subjective characteristics and finding people who

ultimately will be good partners for the University.

Student: How has Yale's endowment dealt with the falling

house prices? You said, if we invest in real

estate [inaudible] Professor David Swensen:

The question is how we've dealt with decline in housing prices.

We don't have really much of any direct exposure to

homebuilders or to the housing industry.

Most of our real estate exposure is

institutional--acquisitions of office buildings--largely in

major markets--central business districts.

So, you'd find Yale with interests in office buildings in

New York, Washington D.C., Chicago, San Francisco,

Los Angeles, some in secondary markets as

well, but predominantly in large metropolitan downtown areas.

There are also some hotel investments, retail properties,

smattering of industrial properties--not a lot of

exposure to individual houses. The only way that we would get

that occasionally would be through some sort of

lot-financing activities, but that's not something that

I've generally liked. I don't think the housing

industry, in general, is a good place to be because

of its, sometimes, violent cyclicality.

We did have a large, short position in subprime

mortgage-backed securities, which has paid off enormously

for the University and really helped protect assets in the

past nine months or a year. I think that,

generally speaking--and Bob Shiller can speak to this with a

lot more authority than I can--this bubble was not

something that should have surprised people.

I thought the University positioned itself well to take

advantage of this really not surprising collapse in housing

prices. Isn't that market timing?

I mean, it all depends on your perspective.

I think market timing, as I've defined it,

has to do with short-term deviations from your long-term

policy targets. I mentioned that our domestic

equity target was 11%. If I came to the office next

week and decided domestic stocks were too high--I want to move

that target down to 8%--in the way that I've described market

timing, that would be a market timing

move and we're very careful not to do that.

We establish these targets, we review them once a year,

we don't make changes in many years,

they're quite stable, and when we do move them we

don't move them by a lot. That doesn't mean that we don't

manage the portfolio actively. So, if we see areas that are

particularly interesting, we're more than happy to deploy

capital to take advantage of what we think are cheap assets

or expensive assets. We made a big bet against

Internet stocks in 1999 and 2000 that was very profitable for the

University. As I mentioned,

there was a big bet that credit spreads, both in mortgages and

in corporates, were way too narrow in the past

couple of years and that--we thought that if they were priced

rationally those spreads would widen and we put ourselves in a

position to profit from that. Today, we're looking at

opportunities in distressed securities.

A lot of these loans that were made in 2005 and 2006 and early

in 2007 were made at very, very narrow spreads and there

are opportunities out there to buy bank loans,

which are at the very top of the capital structure,

that we believe will be money good for prices in the '80s.

If it turns out that they're money good, you get your

interest and you get $1 for every $.85 that you invested in

a few years. If markets offer us

opportunities, we're more than happy to take

advantage of them.

So, we will make valuation bets. We'll look at

things--sectors--say they're cheap or expensive and exploit

the opportunity; but at least in terms of how I

define market timing, it wouldn't be included in

that--it wouldn't be included in that definition.

Student: [inaudible] Professor David Swensen:

The first question is, what's the beta of the Yale

portfolio? That's not a way that we really

think about it, but I do believe that the risk

level of the University's portfolio is really quite low in

statistical terms--much lower than the risk level that you'd

have if you had a traditional portfolio dominated by

marketable securities. The reason it's low is that we

do have, what I think is, superior diversification and

that really lowers the University's risk.

A lot of people look at Yale's portfolio and say,

oh it's risky because you've got venture capital and you've

got timber--we have all these things that you might believe

are individually risky, but part of the magic of

diversification is if you've got things that are individually

risky but they're not well correlated one to another,

the overall portfolio risk level is quite low.

I believe that we have quite a low risk portfolio.

The second part of the question dealt with the changes in our

exposure to foreign assets and that's an area that we've been

very interested in. Our foreign exposure is not

limited to the marketable security exposure,

which I cited as being 15% of the fund,

but there's foreign exposure in real estate, there's foreign

exposure in leverage buyouts, there's foreign exposure in

venture capital. It's something that permeates

the portfolio and, I think, provides really

interesting investment opportunities because a lot of

the foreign markets are less efficiently priced than those

that you find in the U.S. And I think the fact that our

foreign investments are generally denominated in

currencies other than the dollar is also attractive--a good

diversifying tool for the university.

Student: [inaudible] Professor David Swensen:

The question was whether we were looking to take more short

positions as the economy appears to be moving into recession and

I guess the second part of the question was how do you remain

bullish in this kind of environment.

I think the best answer to that is a quote from one of my

contemporaries, who I think is one of the best

investment managers out there. A guy named Seth Klarman,

who works at a fund in Boston called Baupost,

said that what he does is worries top-down and invests

bottom-up. I read The Wall Street

Journal every morning and I worry about the credit crisis,

and I worry about credit cards, and I worry about auto loans,

and I worry about corporate loans,

and I worry about the solvency of the banking system,

and then I go to work and I try and find the best opportunities

that I possibly can. So, the worrying top-down helps

because you don't want to put yourself in a position where

you're going to get hurt by some adverse macro,

sectoral circumstance, but there's no way that you can

take $22.5 billion dollars and be in the markets when they're

attractive and out of the markets when they're not

attractive. So you just say,

okay fine, this is the macro circumstance that we're dealing

with and we're going to do absolutely the best job we can

identifying individual, specific, bottom-up

opportunities to deploy the funds.

Student: [inaudible] Professor David Swensen:

Well, I think one of the questions---the question is how

can you successfully invest in a market where,

I guess, people say you might catch a falling knife.

You buy something that's down 30% but it's got another 50% to

go and I think it just has to do with time horizon.

Particularly if you have a value orientation,

you tend to buy things early. If you bought them with a good,

sound, fundamental investment case and prices are down from

where you made your purchase, have enough dry powder so that

you can purchase some more at the now lower price but have

enough confidence in your thesis to be able to hold the position

through the decline and wait for the markets to recognize the

value that you identified. I think one of the most

pervasive problems in the financial markets is investment

with too short a time horizon. The fact that people look at

quarterly returns of mutual funds is incredibly

dysfunctional. I mean, there's no way that you

can expect somebody quarter in and quarter out or month in and

month out to produce superior returns.

There just aren't pricing anomalies that are significant

that are going to resolve themselves in a matter of months

or weeks and so it's a silly game to play.

By extending your time horizon to three years,

or four years, or five years,

it opens up a whole host of investment opportunities that

aren't available to people that are playing this silly,

short-term game. So, it's not a big deal to buy

something at a price that you think is attractive,

have it go down 20, or 30, or 40%;

that ought to be almost a positive thing because you get a

chance to add to the position of even lower prices,

as long as you're ultimately right that sometime in the

three-, or four-, or five-year time horizon you

have your investment thesis proves out and you're ultimately

able to exit the position at a profit.

Student: [inaudible] Professor David Swensen:

The question is about housing indexes.

I'll defer those to Bob Shiller-- I couldn't answer a

question like that in front of him.

Great, thank you very much.

The Description of 9. Guest Lecture by David Swensen