Pioneering Portfolio Management
When I wrote the introduction to the first edition of Pioneering Portfolio Management in early 1999, Yale’s pathbreaking investment strategy had produced excellent results, both in absolute and relative terms, but had not yet been tested by adverse market conditions. In fact, Yale’s return for the ten years ending June 30, 1998 amounted to 15.5 percent per annum, more than three full percentage points short of the S&P 500’s 18.6 percent result. The endowment’s deficit relative to the then-highest-performing asset class of domestic equity caused naysayers to question the wisdom of undertaking the difficult task of creating a well-diversified equity-oriented portfolio.
The years following the first edition’s publication proved the worth of Yale’s innovative asset allocation. The continuation of the bull market in 1999 and early 2000 produced wonderful results for Yale, culminating in a 41.0 percent return for the year ending June 30, 2000, a result that trounced the average endowment return of 13.0 percent. Yet, the real test of Yale’s approach took place in 2001 and 2002 as the Internet bubble burst and marketable equities collapsed. Yale posted positive returns of 9.2 percent in 2001 and 0.7 percent in 2002, even as the average endowment reported deficits of 3.6 percent and 6.0 percent, respectively. In short, equity orientation continued to drive Yale’s strong results, while diversification kicked in to preserve the university’s assets.
From a market perspective, the vantage point of early 2008 differs dramatically from that of early 1999. For the ten years ending June 30, 2007, Yale’s 17.8 percent return emphatically exceeded the S&P 500’s
7.1 percent. Twenty-year results tell a similar tale with Yale’s 15.6 percent trumping the S&P’s 10.8 percent. In fact, Yale’s conspicuous success attracted the attention of many investors, making the university’s strategy seem less radical and more sensible, less pioneering and more mainstream.
In spite of widespread imitation of Yale’s portfolio management philosophy, the university posted stunning returns relative to peers. For the year ended June 30, 2007, Yale reported a 28.0 percent return, which exceeded the results of all of the educational institutions that participated in the 2007 Cambridge Associates Annual Analysis of College and University Pool Returns. More significantly, Yale’s results led the pack for five-, ten-, and twenty-year periods. The university’s pioneering portfolio management works in theory and in practice.
The most important measure of endowment management success concerns the endowment’s ability to support Yale’s educational mission. When I arrived at Yale in 1985, the endowment contributed $45 million to the university’s budget, representing a century-low 10 percent of revenues. For Yale’s 2009 fiscal year, in large part as a result of extraordinary investment returns, the endowment will transfer to the budget approximately $1,150 million, representing about 45 percent of revenues. High quality investment management makes a difference!
Institutions versus Individuals
When I wrote my second book, Unconventional Success, I characterized its message as “a sensible investment framework for individuals,” in contrast to the institutional focus of Pioneering Portfolio Management. I erred in describing my target audiences. In fact, I have come to believe that the most important distinction in the investment world does not separate individuals and institutions; the most important distinction divides those investors with the ability to make high quality active management decisions from those investors without active management expertise. Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns.
The correct strategies for investors with active management expertise fall on the opposite end of the spectrum from the appropriate approaches for investors without active management abilities. Aside from the obvious fact that skilled active managers face the opportunity to generate market-beating returns in the traditional asset classes of domestic and foreign equity, skilled active managers enjoy
the more important opportunity to create lower-risk, higher-returning portfolios with the alternative asset classes of absolute return, real assets, and private equity. Only those investors with active management ability sensibly pursue market-beating strategies in traditional asset classes and portfolio allocations to nontraditional asset classes. The costly game of active management guarantees failure for the casual participant.
No middle ground exists. Low-cost passive strategies, as outlined in Unconventional Success, suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions. The framework outlined in Pioneering Portfolio Management applies to only a small number of investors with the resources and temperament to pursue the grail of risk-adjusted excess returns.
The World of Endowment Management
The fascinating activity of endowment management captures the energy and imagination of many talented individuals charged with stewardship of institutional assets. Investing with a time horizon measured in centuries to support the educational and research missions of society’s colleges and universities creates a challenge guaranteed to engage the emotions and the intellect.
Aside from the appeal of the eleemosynary purposes that endowments serve, the investment business contains an independent set of attractions. Populated by unusually gifted, extremely driven individuals, the institutional funds management industry provides a nearly limitless supply of products, a few of which actually serve fiduciary aims. Mining the handful of gems from the tons of mine ore provides intellectually stimulating employment for the managers of endowment portfolios.
The knowledge base that provides useful support for investment decisions knows no bounds. A rich understanding of human psychology, a reasonable appreciation of financial theory, a deep awareness of history, and a broad exposure to current events all contribute to development of well-informed portfolio strategies. Many top-notch practitioners confess they would work without pay in the endlessly fascinating money management business.
The book begins by painting the big picture, discussing the purposes of endowment accumulation and examining the goals for institutional portfolios. Articulation of an investment philosophy provides
the underpinnings for developing an asset-allocation strategy—the fundamentally important decision regarding the portion of portfolio assets devoted to each type of investment alternative.
After establishing a framework for portfolio construction, the book investigates the nitty-gritty details of implementing a successful investment program. A discussion of portfolio management issues examines situations where real world frictions might impede realization of portfolio objectives. Chapters on traditional and alternative asset classes provide a primer on investment characteristics and active management opportunities, followed by an outline of asset class management issues. The book closes with some thoughts on structuring an effective decision-making process.
The linearity of the book’s exposition of the investment process masks the complexities inherent in the portfolio management challenge. For example, asset allocation relies on a combination of top-down assessment of asset class characteristics and bottom-up evaluation of asset class opportunities. Since quantitative projections of returns, risks, and correlations describe only part of the scene, top-notch investors supplement the statistical overview with a ground-level understanding of specific investments. Because bottom-up insights into investment opportunity provide information important to assessing asset class attractiveness, effective investors consider both top-down and bottom-up factors when evaluating portfolio alternatives. By beginning with an analysis of the broad questions regarding the asset allocation framework and narrowing the discussion to issues involved with managing specific investment portfolios, the book lays out a neat progression from macro to micro, ignoring the complex simultaneity of the asset management process.
Rigorous Investment Framework
Three themes surface repeatedly in the book. The first theme centers on the importance of taking actions within the context of an analytically rigorous framework, implemented with discipline and undergirded with thorough analysis of specific opportunities. In dealing with the entire range of investment decisions from broad-based asset allocation to issue-specific security selection, investment success requires sticking with positions made uncomfortable by their variance with popular opinion. Casual commitments invite casual reversal, exposing portfolio managers to the damaging whipsaw of buying high and selling low. Only with the confidence created by a strong
decision-making process can investors sell mania-induced excess and buy despair-driven value.
Establishing an analytically rigorous framework requires a ground-up examination of the investment challenges faced by the institution, evaluated in the context of the organization’s specific characteristics. All too often investors fail to address the particular investment policy needs of an institution, opting instead to adopt portfolio structures similar to those pursued by comparable institutions. In other cases, when evaluating individual investment strategies, investors make commitments based on the identity of the co-investors, not on the merits of the proposed transaction. Playing follow-the-leader exposes assets to substantial risk.
Disciplined implementation of investment decisions ensures that investors reap the rewards and incur the costs associated with the policies adopted by the institution. While many important investment activities require careful oversight, maintaining policy asset-allocation targets stands near the top of the list. Far too many investors spend enormous amounts of time and energy constructing policy portfolios, only to allow allocations, once established, to drift with the whims of the market. The process of rebalancing requires a fair degree of activity, buying and selling to bring underweight and overweight allocations to target. Without a disciplined approach to maintaining policy targets, fiduciaries fail to achieve the desired characteristics for the institution’s portfolio.
Making decisions based on thorough analysis provides the best foundation for running a strong investment program. The tough competitive nature of the investment management industry stems from the prevalence of zero-sum games where the amount by which the winners win equals the amount by which the losers lose. Carefully considered decisions provide the only intelligent basis for profitable pursuit of investment activities, ranging from broad policy decisions to narrow security selection bets.
A second theme concerns the prevalence of agency issues that interfere with the successful pursuit of institutional goals. Nearly every aspect of funds management suffers from decisions made in the self-interest of the agents, at the expense of the best interest of the principals. Culprits range from trustees seeking to make an impact during their term on an investment committee to staff members acting to
increase job security to portfolio managers pursuing steady fee income at the expense of investment excellence to corporate managers diverting assets for personal gain. Differences in interest between fund beneficiaries and those responsible for fund assets create potentially costly wedges between what should have been and what actually was.
The wedge between principal goals and agent actions causes problems at the highest governance level, leading to a failure to serve the interests of a perpetual life endowment fund. Individuals desire immediate gratification, leading to overemphasis of policies expected to pay off in a relatively short time frame. At the same time, fund fiduciaries hope to retain power by avoiding controversy, pursuing only conventional investment ideas. By operating in the institutional mainstream of short-horizon, uncontroversial opportunities, committee members and staff ensure unspectacular results, while missing potentially rewarding longer term contrarian plays.
Relationships with external investment managers provide a fertile breeding ground for conflicts of interest. Institutions seek high risk-adjusted returns, while outside investment advisors pursue substantial, stable flows of fee income. Conflicts arise since the most attractive investment opportunities fail to generate returns in a steady predictable fashion. To create more secure cash flows, investment firms frequently gather excessive amounts of assets, follow benchmark-hugging portfolio strategies, and dilute management efforts across a broad range of product offerings. While fiduciaries attempt to reduce conflicts with investment advisors by crafting appropriate compensation arrangements, interests of fund managers diverge from interests of capital providers even with the most carefully considered deal structures.
Most asset classes contain investment vehicles exhibiting some degree of agency risk, with corporate bonds representing an extreme case. Structural issues render corporate bonds hopelessly flawed as a portfolio alternative. Shareholder interests, with which company management generally identifies, diverge so dramatically from the goals of bondholders that lenders to companies must expect to end up on the wrong side of nearly every conflict. Yet, even in equity holdings where corporate managers share a rough coincidence of interests with outside shareholders, agency issues drive wedges between the two classes of economic actors. In every equity position, public or private, management at least occasionally pursues activities providing purely personal gains, directly damaging the interests of shareholders. To mitigate the problem, investors search for managements focused on advancing stockholder interests, while avoiding companies treated as personal piggy banks by the individuals in charge.
Every aspect of the investment management process contains real and potential conflicts between the interests of the institutional fund and the interests of the agents engaged to manage portfolio assets. Awareness of the breadth and seriousness of agency issues constitutes the first line of defense for fund managers. By evaluating each participant involved in investment activities with a skeptical attitude, fiduciaries increase the likelihood of avoiding or mitigating the most serious principal-agent conflicts.
Active Management Challenges
The third theme relates to the difficulties of managing investment portfolios to exploit asset mispricings. Both market timers and security selectors face intensely competitive environments in which the majority of participants fail. The efficiency of marketable security pricing poses formidable hurdles to investors pursuing active management strategies.
While illiquid markets provide a much greater range of mispriced assets, private investors fare little better than their marketable security counterparts as the extraordinary fee burden typical of private equity funds almost guarantees delivery of disappointing risk-adjusted results. Active management strategies, whether in public markets or private, generally fail to meet investor expectations.
In spite of the daunting obstacles to active management success, the overwhelming majority of market participants choose to play the loser’s game. Like the residents of Lake Wobegon who all believe their children to be above average, nearly all investors believe their active strategies will produce superior results. The harsh reality of the negative-sum game dictates that, in aggregate, active managers lose to the market by the amount it costs to play in the form of management fees, trading commissions, and dealer spread. Wall Street’s share of the pie defines the amount of performance drag experienced by the would-be market beaters.
The staff resources required to create portfolios with a reasonable chance of producing superior asset class returns place yet another obstacle in the path of institutions considering active management strategies. Promising investments come to light only after culling dozens of mediocre alternatives. Hiring and compensating the personnel needed to identify out-of-the-mainstream opportunities imposes a burden too great for many institutions to accept. The alternative of trying to pursue active strategies on-the-cheap exposes assets to material
danger. Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win.
Even with adequate numbers of high quaility personnel, active management strategies demand uninstitutional behavior from institutions, creating a paradox few successfully unravel. Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. Unless institutions maintain contrarian positions through difficult times, the resulting damage of buying high and selling low imposes severe financial and reputational costs on the institution.
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Even though the investment lessons in this book focus on the challenges and rewards of investing educational endowment funds, the ideas described in these pages address issues of value to all participants in financial markets. Perhaps most important, readers might develop an understanding of the extraordinary requirements for successful pursuit of active management strategies. Rigorous self-assessment leads to segregation of those with active management ability from those without, increasing chances for investment success by understanding which activities to avoid and which activities to pursue.
Beyond the pragmatic possibility of improving investment outcomes, students of finance might enjoy exploring the thought process underlying the management of a large institutional fund. Because fund managers operate in an environment that requires insights into tools ranging from the technical rigors of modern finance to the qualitative judgments of behavioral science, the funds management problem spans an improbably wide range of disciplines, providing material of interest to a broad group of market observers.