Pioneering Portfolio Management (A Book Review)

Last week, a couple of fellow bloggers (Sleepy on Sunday and Musings from the Hinterlands) discussed the danger of giving too much information and ruining the surprise when writing book reviews. I don't think I have to worry about that with a book like this one! It may not be every one's cup of tea, but I found a lot to ponder in this book and it is fun to spend some time outside of one's chosen field. As I sit on two endowment boards, I find myself reading more and more investment theory...

David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, Fully Revised and Updated (New York: Free Press, 2009), 408 pages.

Favorite quote from the book: “[S]uccssful investment cultures encourage professionals to find new mistakes to make, instead of simply repeating old errors.” (page 304)

Originally published in 2000, Swensen updated his classic work on institutional investments early this year. Swensen’s writing is systematic, which should be expected from the Chief Investment Officer at Yale University. He begins by exploring the reasons for endowments and the necessity of appropriate polices for spending and investments. After establishing a base level of understanding in these areas, he delves into a detailed outline of asset allocation and asset classes. Much of this material (especially his work on equity and bond investments) is also covered in his book, Unconventional Success: A Fundamental Approach to Personal Investing, which I reviewed last year. However, there are numerous differences between the goals and the approaches of an individual and of institutional investors. Non-profit institutional investors, for whom the book is written, don’t have to worry about the tax consequences in the same way an individual investor must consider them. Another major difference is the expanded number of assets available to institutional investors. Such institutions have a longer time horizons, more available resources for managing alternative investments and larger amounts of cash to expand into such investments. By moving into alternative investments, an institution can hedge their positions to allow for growth while protecting their principle. Swensen goes into details on alternative investments, which make up a significant portion of Yale’s portfolio. These investments are more than just hedge funds and include natural resources such as oil, gas and timber, commercial real estate, private equity, venture capital and investment buyouts pools.

Instead of providing a “how-to” manual, Swensen focuses on investment philosophy. The institution’s investment policy is a tool to help maintain an appropriate risk level for investments, by spreading investments around to hedge from a massive loss in one particular sector or class. Institutions need to have a policy that outlines assets allocations and then the discipline to do regular rebalancing of the portfolio to maintain allocation targets. As one investment rises in price and begins to claim a larger percentage of the investment pool, Swensen advises to sell and reap profits, while reinvesting in those areas in which the portfolio is down. Such “contrarian thinking”, according to Swensen, is the best way to “buy low and sell high.” Swensen tells the story of insisting on a firm hand at Yale in the aftermath of the 1987 crash. After the stock market had a major loss, most people pulled money out of the market and put it into bonds. Yale did the opposite and reaped big gains in the months afterwards, when the markets recovered.
Swensen recommends that for investments in “efficient markets” (such as many of the equity markets in the United States, Europe and Japan) one employ a passive investment strategy. Efficient markets are those in which financial conditions are shared and well-known and in which the market is free to correct over or under priced securities. Passive investments are tied to indexes (such as the S&P 500) and have much lower fees than their active counterparts. Swensen’s observation, backed by massive amounts of data, is that active management in efficient markets seldom benefits the investors. Active management cost more and the fees often eat up any profit generated from the manager’s strategies.

However, Swensen acknowledges the role of active investment in inefficient markets (such as emerging markets, hedge funds, etc). More complicated investments require an active strategy. Alternative investments such as hedge funds, real estate and natural resources, along with emerging markets all require specialized knowledge and insight which can only be gained by employing active managers. I found his chapter on Alternative Asset Classes to be the most enlightening in the book. Not only does Swensen outline each type of investment, he explains the liquidity and fee structures for each type of investment as well as how the interest of the investors aligns with the manager of the funds and with other participating parties. He also exposes many myths, such as showing how (even in their heyday) hedge funds were not as attractive as we were lead to believe due to "survivorship bias" and that the top venture capital and private equity funds are mostly closed to new investments, requiring new investors to accept lesser quality funds if they are interested in investing in these arenas.

This book provides an investor with many questions to ask managers. He explains fee structures, which are often unfair to the investor and what one should be on the lookout for. He explains topics such as “survivorship bias” and “backfill bias” which often skews an index’s performance. He suggests that one good way to insure a good active managers in the world of private equity is to find one who has a significant “co-investment” (as related to their net worth), meaning that if manager benefits, everyone will benefit. Too often, as he points out, due to fee schedules, an investment can flounder while the managers thrive. Swensen also explains how, especially in the bond market, powerful forces aligned against the investor. As he did in Unconventional Success, he recommends staying away from corporate bonds. However, he does provide an understanding into the various categories of such bonds.

This book came out in February 2009. I wish Swensen had waited and updated it based on the economic crisis of late 2008. Unfortunately, nothing is mentioned of the crisis with the exception of a brief discussion of the tightening in the credit markets in late 2007. I’m sure this book is not for everyone. I also wish he would have included more on taxes non-profits have to pay such as excise taxes. The book is academic; however, occasionally the reader is treated to a glimpse of his dry humor.