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Pioneering Portfolio Management: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning, David F. Swensen

Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment
by David F. Swensen,  published 2009

Every investment strategy, process, and philosophy has its “day in the sun.” Prior to the establishment of the SEC, the early 20th century speculators such as Bernard Baruch, Jesse Livermore, and Joseph Kennedy found financial success through government connections, trading on inside information, operating investment pools, and plain, shrewd speculation.  John Maynard Keynes – one of the most influential economists of the 20th century and the architect of the post World War II Bretton Woods System – was also a very successful investor and speculator.  At one point, Keynes (successfully) speculated in his personal account while investing on behalf of various investment trusts and the King's College Endowment Fund.  Benjamin Graham, through Graham-Newman Corporation, achieved similar success through a thoroughly different strategy – by buying and holding securities selling at less than intrinsic value, or sometimes even less than cash value (what folks call a “deep value” strategy today; see our review of “The Intelligent Investor”), although Graham-Newman also engaged in arbitrage and hedging strategies when the times warranted (see its 1946 letter to shareholders).

Warren Buffett, on the other hand, took advantage of everything he learned under Benjamin Graham at Columbia and Graham-Newman Corporation.  But perhaps more importantly, Buffett recognized that the investment paradigm has shifted by the 1950s, as an ideological shift among public policy makers compelled the Federal Reserve and the US government to adopt financial and economic intervention policies that, for the first time, greatly tampered the boom/bust cycles that characterized the US investment environment prior to World War II (Benjamin also discussed this investment paradigm shift in the 1962 edition of “Security Analysis”).  Such policies also increased transparency by mandating better disclosure of corporate financial data, which in turn elevated the security analysis profession to one that is based more on investing for the long-run rather than short-term speculation. Under the partial influence of Philip Fisher (author of “Common Stocks and Uncommon Profits,” published in 1958), Buffett took this investment philosophy to heart.  Many of his latter individual investments – such as American Express, Coca-Cola, and Freddie Mac were made solely on their “franchise value” and long-term earnings power.  Combined with an unprecedented bull market in US stocks (especially small caps), the relatively inefficient markets at that time, his unique investment intelligence and temperament, and in his later years, his exclusive access to invest in superior private businesses and other deals (what private equity investors label as “deal flow”), Buffett arguably became the single most successful investor in modern history.

Other investors who made their mark have also done so by bringing to bear a new, unique, and valuable investment process.  George Soros, for example, was able to implement his “Theory of Reflexivity” to the newly floating foreign exchange market starting in the 1970s – culminating with his fund's spectacular gains in the aftermath of the 1985 Plaza Accord and in 1992 when the UK government took the Pound Sterling off the ERM.  Jim Simons of Renaissance Technologies inspired a whole generation of “quants” through his successful implementation of a quantitative/automated trading platform that was made possible by the increased availability and adoption of computing power for investment purposes.

Long-time subscribers should understand why I am so interested in the perpetual endowment space – and why I believe David Swensen (Chief Investment Officer at the Yale University Endowment) ranks in the top echelons of all-time great investors – right up there with Keynes, Graham, Buffett, Soros, and Simons.  Swensen's genius does not manifest itself in specific investment ideas or new investment platforms, but in having the vision to invest (unconventionally) in more inefficient markets and creating an investment process that ensures long-term success with accompanying investment discipline.  In other words, Swensen has left a great legacy in the form of a flexible but disciplined investment process at Yale – one that will still be in place long after he is gone.  The vast majority of past great investors were never able to create lasting investment institutions.  Certainly, Keynes, Graham, and Soros could not and it remains to be seen whether Buffett or Simons could do so once they leave their respective institutions.

Published in January 2009, the second edition of “Pioneering Portfolio Management” is a timely refresher on the institutional endowment investment “model” and various asset classes that have become more “mainstream” since the publication of the first edition in 2000.  This book – along with “Foundation & Endowment Investing: Philosophies and Strategies of Top Investors and Institutions” by Lawrence Kochard (CIO of the Georgetown University Endowment) and Cathleen Rittereiser – is no doubt “the bible” of the endowment investing world.  That said, “Pioneering Portfolio Management” does have something for everyone – including high net worth and accredited investors interested in adopting a long-term investment process that has worked in all kinds of market cycles.

All the important topics, such as liquidity and asset-liability management, investment philosophy, asset allocation, the characteristics of the most popular asset classes (traditional and “alternative”), and the all-important investment process are covered.  There is even a great (timely) appendix discussing why many fixed income asset classes – such as foreign government bonds, junk bonds and asset-backed securities – are unattractive in the long-run.  The book begins with an introduction in “the world of endowment management” – outlining the vast array of challenging investment issues (such as a investment timeline measured in centuries) as well as operational and agency issues.

Chapter 4 deals with a topic that is close to all investors' hearts – the concept of having a prudent and appropriate investment philosophy that aligns with one's investment temperament and long-term spending goals.  All the sub-topics that every investors needs to deal with – such as the roles of asset allocation, security selection, and market-timing in driving one's portfolio returns, as well as their perils – are covered in this chapter.

The next two chapters discuss how to derive the initial asset allocation and the management of that allocation.  Specifically, Swensen discusses the pitfalls of mean-variance optimization when attempting to create an “effective investment portfolio” (an issue which should be familiar to endowment professionals and consultants alike), reasonable return/risk/correlation assumptions of various asset classes, the importance of qualitative and quantitative assessments when simulating portfolios, rebalancing, the use of leverage, and securities lending.  Swensen then goes on to discuss the characteristics and drivers of both traditional and alternative asset classes in the next two chapters, including the relationship between stock prices and inflation, the trickiness of emerging market investing, the challenges behind short-selling, and the secular increase in the institutional ownership of timberland.  Coming on the heels of the largest LBO craze in history, Swensen's six-page – sometimes scathing – discussion on the performance and risk characteristics of LBOs is also very timely.  While Yale has experienced great success in its buyout portfolio – primarily through investing in managers that implement operationally oriented strategies – the historically performance of the median buyout fund suggests otherwise.  Quoting Swensen: “While the value added by operationally oriented buyout partnerships may, in certain instances, overcome the burden imposed by the typical buyout fund's generous fee structure, in aggregate buyout investments fail to match public market alternatives.  After adjusting for the higher level of risk and the greater degree of illiquidity in buyout transactions, publicly traded equity strategies gain a clear advantage.”  The message is clear: Deal flow is all-important; and buyer beware.

Finally, Swensen details how various asset classes should be managed (e.g. passive or active) and the all-important investment process of a large endowment in the last two chapters.  Specifically, Swensen discusses the importance of “the people” – as well as the size, client base, and the entrepreneurial attitude of an investment organization when picking investment managers.  Having a sound process for selecting managers is very important in actively-managed strategies, especially within distressed debt, hedge funds, private real estate, and private equity strategies. Swensen ends the book with an emphasis on the need to create an appropriate operating environment and organization structure that pushes the day-to-day investment responsibilities to the investment professionals, with the trustees simply providing guidance similar to a Board of Directors at a corporation.  The need to have a strong investment committee and investment staff – both of which are needed to drive the portfolio management process in a disciplined and rigorous manner – is also emphasized, as all these will combine to help an endowment achieve peer-beating returns in an economically efficient manner.  This book should be on the bookshelf of every investor – endowment CIO and individual investor alike!


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