Unconventional Success: A Fundamental Approach to Personal Investment

For the last 20 years, David Swensen has been the manager of Yale’s endowment. And the ol’ chappy has done the Eli proud. The Yalie fund has grown from a measly from $1.3 billion to a respectable UT-like $15 billion. Zounds and Huzzah for the money people!

Swensen then took pen to paper and was set to let all the wee widdle investors know how to invest just like Yale. But then, a funny thing happened on the way to Easy Street. The book’s thesis took a bit of a detour. I’ll let the Times take over (that’s The New York Times dear heart, not El Paso):

Instead, it shows why the little guy will never be able to invest the way Yale does.
For all the “democratization” that has taken place in the world of personal investing the deck is still stacked against the individual. That was Mr. Swensen’s fundamental discovery. And his willingness to change course and turn “Unconventional Success” into a polemic aimed primarily at mutual fund companies, but also at other Wall Street types who fleece the little guy, is to his everlasting credit. After all, he could have told us to buy stocks in companies whose products we buy at the supermarket, like a certain investment genius of a previous era.
Any regrets about that advice, Peter Lynch?

Oh lord. Where to start? First, we take a shot at Peter Lynch! I’ve re-read this a few times, and it still comes out of nowhere. Why is Peter Lynch the bad guy? His style of investing hasn’t been shown up at all. In fact, it’s as relevant as ever.

Lynch’s main point over the years is to ignore professional investors. He even calls them an oxymoron. Lynch never said to buy stocks in companies whose products we buy at the supermarket. He says that “the amateur investor has numerous built-in advantages that, if exploited, should result in his or her outperforming the experts, and also the market in general.” He’s exactly right. But that’s only half of Lynch’s argument. He also takes down the pros.
Lynch criticizes the group-think mentality of institutional investors who often have to clear their buys and sells past a committee. Lynch said that some of his best investments ideas have come from the power of common knowledge. That makes perfect sense, and I doubt Mr. Lynch has any regrets.

Secondly, we learn that despite the democratization that’s taken place, “the deck is still stack against the little guy.” Democratization is even placed in scare quotes as if it’s been a scam from the get go. Oh, please. Yes, Wall Street is being run by the evil plutocrats who are stomping on the throat of the little guy. Just the other day, I saw a phalanx of Morgan bankers marching down Broad Street, “Ooo – eeeee – hoo! Yooo – ho!” To be honest, they didn’t look that scary, but you get the idea.

Let’s be clear: The sole driver of Wall Street’s history for the last few decades has been the democratization of investing. This has been nothing short of a revolution. The changes have been stunning. Only 30 years ago there used to be fixed commission rates, no discount brokers, no decimal pricing, no IRAs, no 401k’s, no ETFs, no Reg FD, little of any disclose, no Sarbanes-Oxley. Ok, I could do without the last one, but at least they’re trying. In fact, one of the best books on the subject is “A Piece of the Action: How the Middle Class Joined the Money Class,” written by Joseph Nocera, the freakin’ author of this Times’ article (New York Times, not Northwest Indiana).

The article (Mr. Nocera) continues:

When Mr. Swensen first took over, Yale’s portfolio held stocks and bonds, period. Like most institutional portfolios of that time, “it was neither diversified nor particularly equity-oriented,” Mr. Swensen recalled. Today, the endowment has barely 5 percent in bond holdings. “The other 95 percent,” he said, “are in places that we think will provide ‘equity like’ returns.”
Which is not to say it is all in equities. On the contrary, the Yale portfolio is extraordinarily diversified, which both lifts returns and protects against disaster.

No! No! A thousand times no! Diversification does not in and of itself increase your return. The whole idea of Modern Portfolio Theory is that you can use diversification to lower your risk (protect against disaster) without impacting your return. I’m not being pedantic here. This is the entire foundation of modern financial economics.

In just a few paragraphs, we’ve taken on a straw man and lost, and now we’ve bravely flattened the efficient frontier.

Let’s read on, shall we?

At the end of the 2004 fiscal year, Yale had a mere 15 percent of its assets in domestic equities, and another 15 percent in foreign stocks. It had 15 percent in private equity, and 18 percent in “real assets,” which includes investments in timber and energy. But its biggest percentage, 26 percent, was in something called “absolute return.” That is a category invented by Mr. Swensen in 1990. It means hedge funds.

This guy owns hedge funds and he’s complaining about how mutual funds fleece the little guy. Does he have any idea how much hedge funds charge? Also, is this guy a manager or does he just pick other managers?

His new book has given Mr. Swensen a greater appreciation of the enormous advantages he has as an institutional money manager, starting with the obvious fact that he has a staff that spends full-time researching investment possibilities. Thus, he takes it as a given that individuals shouldn’t pick stocks themselves. “I see every day how competitive the markets are, and how tough. So the idea that you can do this yourself, that’s out the window.”

He’s confusing cause and effect. The markets are competitive precisely because people are picking their own stocks. Yes, it’s hard to beat the market. Very hard. But if you’re well-diversified, it’s hard to lose to the market too. We never hear that part. For books like this, there are only victims. Wall Street is an unending drama of victims and exploitation, us against them. (Duck, I hear more guards coming!)

This is where the book drowns in its own conventionality. I’m sure the author believes he’s advocating self-denial and conservatism. Swensen indeed picks the right (and easiest) targets, but his entire view of the markets is wrong, wrong and wrong.

The financial markets are not a game of one side opposite another. That’s simply a metaphor that people use to understand how the market operates. It’s easy to understand. If you wanted to write a stock market book at any time for the last 70 years, just throw the words “big shot,” “fleeced,” “screwed,” and “little guy” in the title and off you go.

Just in the past few years, we’ve seen dozens of these types of books. The former head of the SEC even jumped in with “Take On the Street: What Wall Street and Corporate American Don’t Want You to Know.” See. You’re the victim of “them.” Never of the SEC of course. Another one is “You got Screwed! Why Wall Street Tanked and How You Can Prosper,” by someone calling himself James Cramer. I’m sure he means well.

This us-against-them view is just a metaphor and nothing else. Thanks to democratization, this metaphor is like some cartoon cat getting clanged on the head by the frying pan of reality. I guess that’s actually a simile, but you see where I’m going. I hate to break it to some people, but there’s no one “in charge” of the economy, or Wall Street. There’s no board room with a dozen fat bald white guys sitting around conspiring against you, and perhaps ruling the world during their breaks.

Financial markets are hugely decentralized structures with countless participants who aren’t coordinating with another, but they influence each other nonetheless. In fact, understanding this is one of the best arguments in favor of free enterprise. (James Surowiecki’s “The Wisdom of Crowds” is a good book on this subject.) Looking for Wall Street experts is like asking who’s the king of a traffic jam. It just doesn’t exist.

What is it about mutual funds Mr. Swensen finds offensive? Just about everything. He hates the way the loads and all the hidden fees mean that the investor is always behind the eight ball. (When I asked him about hedge fund fees, which are much higher, Mr. Swensen replied: “I don’t mind paying a lot for actual performance. Besides, when we negotiate fees, it’s sophisticated investor versus fund manager. It’s a fair fight.”)

Yuck! What Buffett and Lynch have been saying for years is that anybody can do what they do. Unlike Mr. Swensen, Buffett makes it’s clear that he doesn’t have a large staff. The last thing Warren Buffett would call himself is sophisticated. He steers clear of tech stocks because he freely admits that he doesn’t understand them.

So does Mr. Swensen offer any hope at all? Some. He thinks we’d all be better off sticking with index funds, instead of trying to beat the market. He thinks we should get our index funds from Vanguard, with its rock-bottom fees. (As a not-for-profit company, Vanguard also doesn’t have the central conflict of interest.) We should have a diversified portfolio of index funds, for the same reason Yale does. We should be disciplined in our approach, especially in rebalancing our portfolio to stick to our diversification targets. Of course, this invariably means paring back on winners and increasing our investment in laggards.

We should be unconventional by investing in index funds. The very idea of an index fund is that you’re following everybody else. Yet Swensen constantly wants to portray himself as some brave non-conformist standing against the herds of Wall Street sheeple. This is the most synthetic dissent possible. Swensen wants to inherit the moral glamour of being a maverick, while not actually doing anything to depart from the conventional wisdom.

There’s nothing wrong with being conventional. Swensen is from the very heart of the Wall Street establishment. He’s the manager of Yale’s endowment! Christ, they’re not going to turn that over to Nelly.

That’s fine being a member of the establishment. Just don’t tell me how unconventional you are. People who are truly unconventional usually have no clue how marginal they are. It just doesn’t occur to them. They’re not self-conscious because they don’t friggin care. That’s part of the unconventionality. But Swensen insists on telling us how different he is. In fact, this is second book, and the second one with the “unconventional” in the title (Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment and Unconventional Success: A Fundamental Approach to Personal Investment).

Swensen makes several references to his contrarian strategy of investing in a passively managed index fund. First off, there’s no such thing as a passive fund. Every fund, index or not, have a built-in bias. If you’re investing in an S&P 500 index fund, you’re inherently buying dollar futures. That’s an active investment. You’re also skipping small-cap stocks. Even if you get a total market index fund, you’re still skipping bonds and commodities. You can never escape making an active decision with any fund. And by the way, an index fund by definition doesn’t pare back on winners and lean towards laggards. Since the indexes are weighted by market value, the index funds do just the opposite.

I don’t much like index funds, but they’re not the worst thing out there. Some people simply don’t have the time of inclination. That’s fine, but they’re probably not going to read Swensen’s book anyway.

But don’t tell me that the market can’t be beaten. It can be beaten, it’s just very, very hard. This isn’t just a hope of mine either. The economy runs on the fact of its inefficiency. People find innovations and new ways of doing things. If regular people can do that every day, there’s no reason why they can’t beat the market.

There is a reason we as a culture have accorded hero-like status to great investors like Warren E. Buffett and Peter Lynch. For all the cultural reinforcement we get that investing is something anybody ought to be able to master, we know in our bones it’s not true. Mr. Buffett and Mr. Lynch are like great athletes, who have the skill and the emotional makeup to do something well that the rest of us can only dream about.
That describes David Swensen, too. What he has to say is worth listening to. But will we ever truly hear it?

Buffett and Lynch are not at all like great athletes. I believe anyone can do what they’ve done and Buffett and Lynch have repeatedly said so. Another successful manager of a college endowment was John Maynard Keynes. He multiplied the wealth of King’s College, Cambridge from 30,000 pounds to 380,000 pounds. Keynes felt he didn’t need to put much effort into the job. Each morning, he got his investing work out of the way before breakfast so he could get on with more important work. I doubt he ever used a hedge fund either!

If I thought investing for the masses was a lousy idea, I’d say so. I’m not interested in being a populist for the sake of populism. The reason everyone can invest for themselves is because that’s what free enterprise is. Mr. Swensen’s worldview is so wrong, he doesn’t realize how wrong he is. His concern for the welfare of average investors is admirable, but he ought to care a lot less. I wish he understood that his concern isn’t helping. This worldview has outright contempt for individual investors. Swensen feels that investors simply can’t be trusted. For example, he also writes about Social Security reform, and to little surprise, he’s against it.

Another point that bugs me is that if this is what he really believes, then he should give us some strategy to change the landscape. But Swensen just wants individual investors to accept their lot in life.

This book was written with one thing in mind—to get good reviews. It sounds like it’s judicious. He uses lots of jargon. It sounds like it’s focuses on self-denial. It sounds like it’s unconventional (after all, it tells us many times). I have no doubt this book will get many positive reviews. But it gives the wrong message to investors.

Posted by on August 16th, 2005 at 4:34 pm


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