What is the best strategy for investing a long-term portfolio? To find an answer, look to the halls of academe. This is partly because much long-term investing follows theories that were born in universities. “Modern portfolio theory”, developed in US universities from the 1950s to the 1970s, turning many of its theorists into Nobel laureates, is now accepted as orthodoxy by the fund management community – even though it is coming under increasing attack.
The core of the theory is to diversify among different asset classes until it is not possible to increase returns without also increasing risks. It uses statistical methods to do this. A consequence of the theory is to look for returns that are not correlated to the market as these allow for greater diversification.
There is another reason to look to universities: they have arguably the longest time horizons of any investor. A university endowment is managed on the assumption that the university will live for ever. Further, the larger university foundations are massive, giving them wider opportunities than small investors.
Hence, David Swensen, chief investment officer of Yale University’s endowment, is close to the ideal long-term investor. A former academic economist who has been running the endowment for more than 20 years, he uses “a combination of academic theory and informed market judgment”. He was taught by some of the practitioners of modern portfolio theory.
Rather than the theory, however, it is Mr Swensen’s returns that have attracted attention. Over the 10 years to June 2006, Yale earned an annualised 17.2 per cent, after taking account of fees. This meant that the endowment grew by $9.2bn, compared to how it would have performed if it had merely had returns in line with the average for university endowments.
In its 2006 official report, the endowment was worth $18.5bn, and this has now increased to about $22.5bn, making it one of the biggest.
How did Mr Swensen do it? He diversified. He also homed in on another academic theory, which holds that public markets tend towards efficiency. In other words, all known information is constantly included in prices.
This implies that share prices will go on a “random walk”, shifting in response to new information. It also implies that it is exceptionally difficult for anybody to out-perform them. For most individual investors, the answer is not to attempt to beat the market, but to invest in index funds, which merely attempt to replicate the performance of an index, and charge much lower fees than active portfolio managers.
But for those with the resources – and the long-time horizon – of the Yale endowment, the theory suggests that illiquid markets offer the greatest opportunities. Because these markets are less liquid, they will also tend to be less efficient than the stock and bond markets – some assets will be overpriced, but there will also be bargains. So, if you have the resources to do the proper research, the theory dictates that it should be easier to outperform in these markets than in others.
Thus, Yale’s portfolio, arguably the closest approach that currently exists to an academic’s pure “long-term” portfolio, looks nothing like a traditional portfolio. Yale’s investment in fixed income securities is tiny – 2.5 per cent in cash and 3.8 per cent in bonds. But its investment in publicly traded equities is also minimal. Last year, it held 11.6 per cent in the US and 14.6 per cent in foreign equities. Hence, bonds, equities and cash, which make up 100 per cent of a traditional long-term portfolio, make up just less than a third of the Yale endowment. By contrast, when Mr Swensen took over in 1985, they accounted for more than three-quarters of it.
Where does the rest go? Mr Swensen has 23.3 per cent of the endowment in “absolute return” strategies, which take the returns available from cash as their benchmark. In theory, they should not be correlated to the equity market. Almost invariably operated by hedge funds, often using high-powered computer-driven techniques, such strategies have the common element of attempting to exploit market inefficiencies. “Event-driven” strategies attempt to profit from specific situations such as mergers, spin-offs or bankruptcy restructurings. Markets can often over- or underreact in these situations, creating an opportunity for profit.
Other “value-driven” or “market-neutral” strategies attempt to find underpriced securities, and make hedged bets on them. One popular variation would be to buy an undervalued stock and then balance it by taking a “short” position in another, similar stock. In a “short” position, a manager borrows a stock and then sells it to someone else. If the stock subsequently declines, the manager can realise a profit when buying back the stock and returning it to the lender.
These strategies are known as “market-neutral” because they do not depend on the overall market. Take a fund that has bet that General Motors is undervalued relative to Ford. If the market goes down, then it will gain more from the “short” on Ford than it loses from the “long” position in GM. If the market is up, it will gain more from the “long” on GM than the “short” on Ford. All that is necessary to make money is to be right as to which stock is undervalued. Hence, such strategies are not correlated to the market.
Mr Swensen also has 16.4 per cent in private equity – funds that use leverage to buy-out underperforming companies, take them private, and then aim to turn them round before selling them. Again, these profit from inefficiencies in the market.
Further, Yale has a colossal 27.8 per cent of its portfolio in “real assets,” a category that includes real estate, forestry and oil fields. Since Yale started its real assets portfolio in 1978, it has grown at an average of 17.4 per cent a year – well ahead of what could be achieved in the stock market.
Yale has been more radical than most but educational institutions as a whole are heavily invested in these types of alternative assets. On average, they only have about two-thirds of their portfolios in stocks, bonds and cash. Mr Swensen’s success has inspired a general move towards alternative assets. Many large pension schemes have increased their allocations to real assets, hedge funds and private equity, while the financial services industry is busily trying to find ways to make these assets available to retail investors.
There are, however, criticisms of such approaches to long-term investing. The most important is that Yale’s approach is quite impracticable for investors with shorter time horizons and less money to invest. Asset classes such as forestry or private equity carry hefty minimum investments to put them out of the reach of all but the wealthiest individuals.
Another criticism, put forward by Nassim Nicholas Taleb, a former trader whose book The Black Swan is an aggressive attack on the statistical assumptions underlying modern portfolio theory, arguing that it cannot cope with unforeseen events. Until Australia was discovered, for example, Europeans believed that all swans were white; then it was discovered that there were black swans.
In financial modelling, an event that had not been foreseen, such as the Russian default that precipitated the Long-Term Capital Management crisis of 1998, cannot be incorporated into risk models that are based on historic data. Therefore, Mr Taleb argues, risk management models based on looking at past data cannot guard against the greatest risks for the future. They cannot contend with “black swans”.
Some argue that the statistical models, with their precise quantification of levels of risk, can breed overconfidence and, hence, lead to the kind of excessive risk-taking that can cause a financial crisis.
Another line of attack comes from behavioural finance. This is a discipline that does away with traditional economists’ assumption that people’s decisions are rational. Instead, it substitutes findings from experimental psychology, or even borrows from the science of the brain, to see how people actually make decisions.
In practice, most of our decisions are not carefully considered and rational. Behavioural economists are busily identifying ways in which people make mistakes and then applying these insights to fund management.
A new breed of funds uses behavioural economics to identify mispricings in the market and then attempts to profit from them. For example, research shows that investors are “loss-averse”, that is they will take much greater risks to avoid a loss than they will to make a gain. This can move markets in predictable ways.
Other examples include “groupthink”, which can lead to booms and bubbles as everyone piles into the same assets. This research is also a critical underpinning for the notion of introducing “default” options in retirement plans.
But there is reason for hope. Optimists point out that by finding the inefficiencies created by human behaviour and exploiting them, behavioural economists are also making markets more efficient – at least in the long-term.
