Unconventional Success

Add to del.icio.us

Published in 2005 by David Swensen, this book provides a strategy for personal investing. The general idea is to follow three main points of advice:

  1. Construct a portfolio with your money allocated to 6 core asset classes — diversify among them and have a bias toward the equity sections
  2. Rebalance your portfolio on a regular basis (rebalancing back to the original weightings of the asset classes in your portfolio)
  3. In the absence of confidence in a market-beating strategy, invest in low-cost index funds and ETFs. Be very watchful of costs as some indices are poorly constructed and some fund companies charge excessive fees (or generate large tax liabilities).

He slams many mutual fund companies for charging excessive fees and not living up to their fiduciary responsibility. He really highlights the conflict of interest inherent in the mutual funds – they want high fee, high turnover funds while investors want the opposite.

Core Asset Classes

You should diversify your assets among what he calls the core asset classes. Core asset classes share many of the same characteristics: they contribute valuable, differential characteristics to the portfolio, rely on market-generated returns not active management and derive from broad, liquid markets.

  1. Domestic equities: Enjoy equity premium of returns, provide long-term protection against inflation, generally good alignment of interests between company management and shareholders. Some risk in future returns underperforming since historic gains in money invested in equities was largely driven by dividends (over 80% of the historical returns) but current dividend rates are at a very low level.
  2. International developed country equities: Similar equity level returns as the US market, having foreign currency diversification is valuable, and not large correlation in returns between US and international markets. One issue is that the interests of shareholders are generally not as aligned with company management in international equities as they are in the US equities.
  3. International emerging market equities: Serves as a high-risk and high-return portion of a portfolio. Have similar diversification value as international developed equities with higher risk. The interests of shareholders are less aligned than in international developed equities due to less developed legal frameworks and potentially harmful government intervention.
  4. Real Estate: Return and risk that falls between bonds and equities, high correlation with inflation, and there is good general alignment of incentives when investing in REITs.
  5. US Treasuries: Gives diversifying power and protects against financial market collapses, provide diversification relative to equities when inflation differs dramatically from expectations, and the US Treasury is more a neutral party in the bond market as opposed to issuers of corporate bonds.
  6. US Inflation Protected Treasuries: Perfect hedge against inflation.

He doesn’t give extremely firm advice about how to construct your allocation. It depends on your timeframe and risk tolerance. He does urge for an equity bias since they generate higher expected returns. Also, you shouldn’t have more than 30% in one asset class — if you do, you’re not diversifying. Additionally, you can reduce your risk position as you get older.

Here is a sample portfolio that he presents:

30% Domestic equities
15% International developed country equities
5% International emerging market equities
20% Real Estate
15% US Treasuries
15% US Inflation Protected Treasuries

He doesn’t describe the type of individual that this allocation would be appropriate for.

Non-Core Asset Classes

There are many asset classes that broadly don’t effectively deliver characteristics to a portfolio that are not already captured by the core assets classes.

  • Domestic Corporate Bonds: Holders of corporate bonds have several factors working against them including credit risk (the risk that the company will have its credit downgraded during the period that you own the bond), lower levels of liquidity, call provisions in bond contracts and a lack of alignment of interest with the corporate management. He feels that the premium paid by corporate bonds is not sufficient to cover these downsides.
  • High Yield Bonds: High yield bonds suffer from the same issues as corporate bonds but in a much more concentrated manner. Call provisions can be especially damaging here because they can eliminate any of the upside that the bondholder may be seeking to earn. The alignment of interests is bad because the bond issuers tend to be much more sophisticated than the bondholders.
  • Tax Exempt Bonds: Market mechanisms will move tax-free and taxable bonds to equal value (after taxes are considered). Additionally, these bonds often include call options that are generally not fairly priced from the bondholders’ standpoint.
  • Asset-backed Securities: These include mortgage-backed and other collateral-backed fixed income instruments. There is some optionality in the case of mortgage-backed securities (where homeowners may pay back mortgages as interest rates climb) that can hurt the holders of the security. Pricing these is difficult to do and the individual investors stand at a marked disadvantage to the professionals who issue these securities.
  • Foreign Bonds: Basically he argues that it is better to gain foreign currency diversification through equities which have higher rates of return.
  • Hedge Funds: This class can be worthwhile if you have a strong belief that the fund’s strategy can beat the market. However, as a general class, he recommends avoiding it since the fees can be large and the statistics about historical returns are inflated by survivorship bias.
  • Leveraged Buyouts: He thinks that the high fees and increased risk make this an asset class worth avoiding. Yale did a study of some LBOs where they compared the post-fee returns to the return if you took a leveraged position in the S&P 500. They found that the LBO deals underperformed. Again, if you have specific knowledge of a firm’s strategy and believe it to be sound, then it can be a good investment.
  • Venture Capital: Returns can be spectacular (he talks about the Benchmark eBay investment) but he warns that the top-tier fund tend to get the best deals and will have superior returns. If you can’t invest in these funds, then the high fees and increased risk will probably lead to disappointing returns.

Portfolio Rebalancing

It is crucial to rebalance your portfolio at regular periods (he doesn’t specify exact intervals). This rebalancing is meant to put your portfolio back into your pre-determined allocations among the asset classes. You must be thoughtful of tax consequences of rebalancing. The process of rebalancing goes against traditional thinking because you will be selling your asset classes that over-performed and buying asset classes that under-performed. The type of contrarian behavior that rebalancing forces would have served investors very well after the crash of 1987 and the bursting of the internet bubble in 2001. In practice, it seems that very few personal investors actually rebalance their portfolios. When markets have excess volatility, rebalancing will enhance portfolio returns.

He spends significant time detailing how disastrous it can be to base investment decisions on recent past performance. However, many investors are swayed by recent past performance and money will move rapidly into high performing sectors or funds. This could drive up asset prices and lead to depressed future returns. He is quite critical of Morningstar for a ranking system that heavily relies on past returns. While they have dubious risk measures and base their rating so much on recent returns, they do seem to influence investors.

Security Selection

He points out the difficulty of beating the market through active management. A 20 year study is discussed which compares mutual fund performance to the Vanguard S&P 500 Index fund. The average margin of pre-tax shortfall is 2.1% annually (after tax that is 2.8%). Over 80% of all mutual funds under-performed this index! Here’s why there is a difference:

  • The average equity fund has fees of 1.3% versus Vanguard’s fee of 0.2%
  • Trading commissions result in more costs — Vanguard’s is a low turnover index fund
  • Although Vanguard is not specifically managed to reduce tax liabilities, the active trading of other funds creates higher dividend and capital gain tax liabilities

Starting with this evidence, he digs into mutual funds as instruments that are not particularly well designed to serve shareholder interest. The main issue is the high costs imposed on investors. Here is his list of sources for mutual fund failure:

  • Mutual fund fees: Sales loads, management fees (Vanguard is listed as having much lower fees than industry averages), distribution and marketing fees (12-b fees), incentive fees for management, payments to intermediaries to market funds (Schwab is one such intermediary), and the lack of sharing of the benefits of economies of scale (Vanguard does reduce fees as assets under management grows).
  • Portfolio turnover: Trading costs (both transaction execution and the market impact costs), tax consequences of trading and then the investors themselves impose more turnover cost by buying and selling their mutual fund shares. Index funds generally have lower turnover. Note that some indices (Russell 2000) are poorly constructed and require high trading since the components of the index change so frequently. One other interesting point is that when you buy into a mutual fund, you are assuming the over-hanging capital gain position that already exists in the fund. If the manager is consciousness of not incurring capital gains on a yearly basis, then they can be building up a capital gain position that future investors will inherit.
  • Pricing Games: Historically, mutual funds are employed a series of pricing rules that favored professional investors (including two-price systems, backward pricing and stale pricing). These gains were at the expense of the average shareholders of the mutual fund.
  • Soft Dollars: Mutual funds will sometimes move trading activity to firms that provide research or other kickbacks to the mutual fund and incur a higher trading cost.

For many of these causes, he highlights funds that have egregious levels of fees, turnover, etc.

He describes in detail Southeastern Asset Management’s Longleaf Partners Fund as a mutual fund with a number of desirable characteristics

ETFs are a potentially good alternative to index funds. They were developed as instruments for institutional investors to have passive positions in indices. Since the institutional investors are very demanding in terms of low fees, etc., it can be beneficial for individual shareholders to buy ETFs are enjoy the advantages of ride the coattails of the institutions. Here are some things to consider when buying ETFs:

  • Brokerage Fees: ETFs are openly traded so you must deal with a brokerage firm to buy and sell them. Fees vary among brokers so going with the low-cost internet options is best.
  • Market Depth: Some ETFs are not traded in the most liquid markets so their can be a disparity between the price of the ETF and the value of the underlying securities. This is not a favorable position.
  • Tax Efficiency: The arbitrage mechanism of ETFs results in the ability to better manage tax positions that standard index funds.
  • Core Asset ETFs: Make sure that the ETFs that you buy correspond to core asset classes
  • Fees: Again there is disparity in management fees for ETFs so you must be careful to find the low cost ones. State Street Bank seems to offer ETFs with lower fee levels.

Finally, he touts Vanguard as a good spot for your mutual fund money. They are not-for-profit and generally have much lower fees than anyone else. The alignment of interests is stronger there than at any of the profit-driven mutual funds. They’re not perfect but he makes a very compelling argument that they are your best choice.