Monday, January 30, 2006

Review: Unconventional Success

It's unfortunate that investment books that have sensible advice rarely reach the right audience --- the sophisticated individual investor already knows most of what they have to offer, if they've even read one of the classics, such as A Random Walk Down Wall Street, while the naive investor is unlikely to read the book, since that's the reason why they are naive.

David Swensen comes from managing one of the most successful college endowment investment programs, the one at Yale University (one reason why I can't imagine donating money to a private university is that they have the resources to do well even without charging exorbitant fees, but they do so anyway). Large college endowments can do many things that individual investors cannot --- for instance, they can hold entire office buildings for many years in a diversified porfolio and have it still be only 10 to 20% of their assets. Most individual investors by contrast, can afford to own just their own homes, and for most such investors, that home comprises upwards of 50% of their assets (hence the phrase, "house rich, cash poor"). Bereft of such tools, Swensen does not offer much advice and insight that other, more pedestrain authors haven't already written.

Here are the interesting titbits in the book:
  • Core Asset classes include: Domestic Stocks, Foreign Stocks (divided into Developed Markets and Emerging Markets), Treasury Bonds, Tips, and Real Estate. Allocating your money amongst these classes will provide reasonably good opporunity for growth. Swensen does provide a sample allocation, but does not provide any data (or advise) about adjusting the allocation for your particular position in the life cycle.
  • Corporate bonds do not provide any diversity, and are much worse than Treasuries from an asset-allocation point of view.
  • Foreign bonds provide currency risk without the high returns of foreign equity. Since currency speculation is a zero-sum game, foreign bonds are best avoided.
  • Venture Capital provides surprisingly low returns, mostly because high management fees kill the returns from mediocre VCs, while excellent VCs have such high minimums that most individual investors are locked out.
  • Hedge funds also have a poor record, because survivorship bias means that only high performing ones are not shut down after a short time.
  • Tax-Exempt bonds are surprisingly dangerous for individual investors.
  • Rebalancing is important, since it enforces a "buy low sell high" discipline. When Swensen ran the Yale portfolio, they rebalanced every day! Obviously, due to transaction costs, this should not be attempted by individual investors.
  • Mutual funds are extremely poor in performance. In fact, honest mutual fund companies are so rare that Swensen names the one honest one. (It's Long Leaf Partners Funds, managed by SouthWestern Asset Management, a privately held company whose employees and management are co-invested in the funds to an incredibly high degree --- naturally, all of Long Leaf's funds are now closed to new investors!) All the others (Fidelity, Putnam, to just name a few) have been involved in so many financial scandals that their commitment to their "customers" (really, victims) is suspect. Page after page was devoted to various mutual fund scandals.
  • ETFs can vary in quality, so it really makes sense to do your research!
  • Vanguard and TIAA-Cref, the two non-profit companies that operate mostly indexed funds (and a few actively managed ones), are the only places where it makes sense to park your money long term. (If you don't already know this, you're probably not reading this blog anyway!)
All in all, a surprisingly small number of good bits from a distinguished author. He doesn't mention, for instance,I Bonds, which are an excellent vehicle for most individual investors, because he's not used to managing portfolios less than a few billion dollars. He doesn't mention basic tax trade-offs (Roth versus Regular IRAs and 401ks), or the SEPP 72(t) exception.

All in all, while I'm glad I read the book, the practical advice I got from Brad DeLong last year from a 15 minute conversation while he was at the Google campus did more for my portfolio. On the other hand, his comments about corporate bonds and municipal bonds were very much worth reading, so I'm glad I checked this book out of the Santa Clara County Library.

Economic theory teaches the law of one price, viz., that in freely competitive markets identical goods or services trade at identical prices. In the case of index-fund management, the portfolio management fees charged by various service providers should be identical, or nearly so. Otherwise, rational consumers transfer funds from high-cost providers to low-cost providers, thereby driving the greedy (or inefficient) fund-management companies to reduce prices or exit the business.

Economic theroy fails. In a 2002 study, Morningstar identified fifty-seven S&P 500 index funds that charged more than Vanguard's market-leading 0.18 percent annual fee. The average yearly expense ratio of the non-Vanguard index managers amounted to an over-the-top 0.82 percent...

Had the expensive index funds emanated from a disreputable bunch of bucket shops, investors might conclude that thee poor saps who chose the high-cost funds deserved the consequences of paying active-management fees for less than passive-management results. In fact, the roster of high-fee index fund managers include two of the investment management world's most venerable names --- Morgan Stanley Funds and Scudder Investments.

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