Author Topic: David Swensen: Investing and inefficient markets  (Read 3727 times)

grantmeaname

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David Swensen: Investing and inefficient markets
« on: December 02, 2012, 11:17:51 AM »
Institutional Investing and Inefficient Markets

In the last few weeks, I've been working on the Yale Financial Markets course available on Open Yale with some other hirsute learners. We have a good textbook and a good mass market book for the course, but the really valuable stuff we've read have been the selections from other works. One of my favorites has been Stocks for the Long Run, a good read for Mustachians about how stocks outperform debt over the long term; combined with textbook readings explaining things like who buys mortgages from consumer banks, the course has been really valuable.

But the best thing we've read is a chapter from Pioneering Portfolio Management, by David Swensen, manager of the Yale endowment. The chapter is on "alternative asset classes", things that Yale holds in its endowment other than (funds of) stocks and bonds. Yale works and invests some in private equity and venture capital, to name the most important two. Swensen is a cautious supporter of weak-form EMH, which states that most assets are priced pretty efficiently in general. So how does the man beat the market? Well, that's the point of the book.

Swensen includes a fantastic table that's the best question he can think of to measure efficiency or inefficiency of markets: how much better do the "good" managers do than the "bad" managers? (His thought process on that is here in his lecture for the Yale course; CTRL+F your way to the third use of the word "measure".) Here's the table:

The last two columns on the right are stocks here and abroad. He shows that domestic equities are so efficiently priced that even if skill in picking them can exist, two thirds of annual returns lie within 1.3% of the mean return. To be willing to pay a 1% expense ratio premium for an actively managed mutual fund, then, you have to be pretty damn sure that you can pick someone who's at least a percentage point better at generating returns than an index fund -- and the quartile evidence suggests that 75% of managers aren't. (The number is really probably slightly worse: this is before the trading fees, which are not disclosed as part of your expense.) For real estate (at least real estate available available to institutional investors) and international stocks, the efficiency of the market is not dramatically less: two thirds of managers perform with 2.5% and 2.1% of the median manager, respectively. In other words, it's an investing environment in which for those three classes there is very little or no opportunity for "skill" to give you better returns. The individual investor looking for advice can stop here: active management just does not work for these asset classes--it's not compelling. (Swensen doesn't include bonds, but they are likely priced even more efficiently than stocks.)

As a Mustachian who wanders wide-eyed through the advanced and crazy world of finance, you may be interested in the rest of the story for personal edification. So, how does this affect institutional investors? Swensen says that for these asset classes, there's so little to be gained by "picking right" that they don't even try. Identifying the top quartile hedge funds and venture capital opportunities does much more good than identifying even the top percentile of stocks or real estate. (I'm not enthralled with the idea that one can pick the best hedge fund or mutual fund manager, of course, but apparently Swensen is able to do it year in and year out; his ability to do so is how Yale's endowment generates outsize returns.) Here's the crux of the issue, though: on a risk-adjusted basis, venture capital and private equity don't outperform the efficiently-priced opportunities in the stock market and commercial real estate investment. The fields are only worth investing in if you're confident that you can pick the best 20% (venture capital) or even 10% (private equity) of opportunities (Swensen explains this more clearly in the text than I do here).

So why invest in inefficiently priced assets at all? Like a local financial planner explained to me in a recent job interview, "We know that mutual funds lost to index funds 80% of the time. We take great pride here in being able to pick the other 20%." But doesn't every financial analyst and small institutional investor think that? In the end, don't 80% of them lose? Aren't Fidelity and Blackrock the only real winners? I think to invest in things like venture capital, institutional investors must fall prey to the same thinking. (And remember, some institutional investors are nonprofit boards of directors and pension funds--not everyone is even gifted with expertise in finance at all!)

In summary, for the institutional investor who can't beat most other institutional investors at picking winning investment options, there's no reason to even venture into private equity, venture capital, and similar sectors of Wall Street. For the institutional or individual investor investing in stocks, real estate, and bonds, the assets are so efficiently priced that nearly no mutual fund manager is capable of earning his fee through his performance.
« Last Edit: December 02, 2012, 11:40:58 AM by grantmeaname »

KingCoin

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Re: David Swensen: Investing and inefficient markets
« Reply #1 on: December 02, 2012, 04:32:56 PM »
Here's the crux of the issue, though: on a risk-adjusted basis, venture capital and private equity don't outperform the efficiently-priced opportunities in the stock market and commercial real estate investment

Does this continue to be true? The period studied from 1980-1997 was very different from the period 1998-2012.

The fields are only worth investing in if you're confident that you can pick the best 20% (venture capital) or even 10% (private equity) of opportunities (Swensen explains this more clearly in the text than I do here).

Swensen has a massive advantage in alternative investments due the size and structure of the money he manages. Even if Joe Mustachian is able to identify top alternative investment managers, most won't accept his investment (even if he meets minimum investment and net worth criteria). Yale and other endowments like those at Harvard and Princeton which have seen very similar returns have the following advantages:
1) Prestige - Funds like to have prestigious and rigorous investors as a signaler of quality.
2) Size - Funds prefer big chunk investments.
3) Long Investment Horizon - Endowments are willing to stick out the rough times.
4) Locked Up Capital - Endowments don't have to pull investments to when faced with redemptions by skittish investors.
This gives top endowments a veritable pick of the litter when it comes to investment opportunities and ultimately an advantage that can't be replicated by most.

I also read Swensen's "Unconventional Success" that targets more mainstreet type investors. He basically just argues for a balanced portfolio of assets (stocks, bonds, real estate) sans alternatives.

grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #2 on: December 02, 2012, 05:04:46 PM »
Does this continue to be true? The period studied from 1980-1997 was very different from the period 1998-2012.
Good question. Somebody should get ahold of the fourth edition (mine is the first), and see if Swensen updated his table. Google Books omits that page.

Quote
Swensen has a massive advantage in alternative investments due the size and structure of the money he manages. Even if Joe Mustachian is able to identify top alternative investment managers, most won't accept his investment (even if he meets minimum investment and net worth criteria). Yale and other endowments like those at Harvard and Princeton which have seen very similar returns have the following advantages:
1) Prestige - Funds like to have prestigious and rigorous investors as a signaler of quality.
2) Size - Funds prefer big chunk investments.
3) Long Investment Horizon - Endowments are willing to stick out the rough times.
4) Locked Up Capital - Endowments don't have to pull investments to when faced with redemptions by skittish investors.
This gives top endowments a veritable pick of the litter when it comes to investment opportunities and ultimately an advantage that can't be replicated by most.
I entirely agree, and those are some good insights about the advantages of being a big institutional investor. That section, and the bit you quoted, was meant to apply to institutional investors only. Looks like my final conclusion from that reading of Pioneering Portfolio Management is compatible with the thesis of Unconventional Success, though.

arebelspy

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Re: David Swensen: Investing and inefficient markets
« Reply #3 on: December 02, 2012, 06:51:42 PM »
Interesting.

I would agree with basically everything posted.

I do think that one runs into issues when cherry picking dates.  I don't know that it was done here, but why such a random timeframe.  Even if we assume it was current (1997) when the book came out, why 17 years, from 1980?

And even if it wasn't cherry picked, it was a specific time period where a different one may show something different.

Note: this is only in regards to comparing between asset classes, not arguing that the markets are in fact inefficient.

There have been times where gold outperformed stocks and many more times in the last few decades where the opposite was true.  I expect leveraged real estate to perform very will in the next decade or two due to (relatively) low prices combined with historically low interest rates.  Over a long time period, I expect equities to outperform real estate.  But tends are cyclical, and real estate is down.

So I do think one may be able to make more broad predictions, with the caveat that they may be wrong, and/or adding risk.
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grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #4 on: December 02, 2012, 07:12:43 PM »
I do think that one runs into issues when cherry picking dates.  I don't know that it was done here, but why such a random timeframe.  Even if we assume it was current (1997) when the book came out, why 17 years, from 1980?

And even if it wasn't cherry picked, it was a specific time period where a different one may show something different.

The trend is qualitatively clear enough (and quantitatively dramatic enough) that I'm not very worried about bias from the period used (and your suspicion is correct; I've got the 1998 book). Since 1980 is a round number, I'm guessing that's when one of his research tools started collecting data, but I may be overly generous with that assumption. As Swensen emphasized in the chapter, Private Equity/Venture Capital are still equity stakes in companies, so they don't really represent a different asset class than stocks. They don't behave differently from stocks in response to macroeconomic trends--I can find the paragraph if you want, but if I'm remembering correctly he shows a really tight correlation between the asset classes over the period.

The only secular change I can think of since 1998 is an increase in the efficiency of private equity as the field matures, but I would imagine that it's still similar in the big picture sense that the main asset classes are all efficiently priced or near enough.

arebelspy

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Re: David Swensen: Investing and inefficient markets
« Reply #5 on: December 02, 2012, 07:28:40 PM »
Thanks.  Just confirms my preferred methods of equity investment (total return, index funds, and/or something like Vanguard's Wellington/Wellesley).

Funny that the least stressful method generates the highest returns as well (simply due to the lowest fees), aside from being able to pick the outperformers above and beyond their fees.
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sheepstache

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Re: David Swensen: Investing and inefficient markets
« Reply #6 on: December 02, 2012, 08:19:07 PM »
And you know the thing is a lot of people use outperformance to judge whether managers can beat the market, even Schiller in the chapter on investment managers.  Maybe it's so obvious that they never even discuss it, but it's worth pointing out that some outperformance is explained by sheer random luck.  Get 100 people in a room who all claim to be better at flipping pennies, meaning, say, that they're saying they'll flip heads more than half the time.  Well many of them are going to do that.  That's a terribly crude analogy because you could say the likelihood of doing better or worse than the market isn't 50/50, but you see what I mean.  Again, Schiller says it must be possible to beat the market because some managers do, but, again, of those 100 people flipping pennies, some are going to get heads 10 times in a row, 20 even 30 times in a row, that's not an impossibility, but that doesn't mean it makes sense to look back and conclude, oh, it must be possible for some people to be better penny flippers than others.
</rant>
Comparing managers to each other is an interesting way of looking at it.  In science I guess it would be questioning whether p value is high enough that the difference is significant, which most people would agree it is not.  Although as he also sort of explains it could also just mean everybody is closet indexing.

Hamster

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Re: David Swensen: Investing and inefficient markets
« Reply #7 on: December 03, 2012, 12:37:14 AM »
Get 100 people in a room who all claim to be better at flipping pennies, meaning, say, that they're saying they'll flip heads more than half the time.  Well many of them are going to do that... of those 100 people flipping pennies, some are going to get heads 10 times in a row, 20 even 30 times in a row, that's not an impossibility...

[nitpick]
Not impossible, but 2^30=1,073,741,824. About one in a billion attempts will get heads 30 times in a row.
so it's not likely to happen to those 100 coin flippers. Even 10 heads in a row averages 1 in 1024 attempts. [/nitpick]

That said, your point stands; just the magnitude is at issue.

sheepstache

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Re: David Swensen: Investing and inefficient markets
« Reply #8 on: December 03, 2012, 05:57:06 AM »
Get 100 people in a room who all claim to be better at flipping pennies, meaning, say, that they're saying they'll flip heads more than half the time.  Well many of them are going to do that... of those 100 people flipping pennies, some are going to get heads 10 times in a row, 20 even 30 times in a row, that's not an impossibility...

[nitpick]
Not impossible, but 2^30=1,073,741,824. About one in a billion attempts will get heads 30 times in a row.
so it's not likely to happen to those 100 coin flippers. Even 10 heads in a row averages 1 in 1024 attempts. [/nitpick]

That said, your point stands; just the magnitude is at issue.

It's true.  Figured it matched my complete lack of quantifying an actual market example but that people would still get the point, as you did :)

grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #9 on: December 03, 2012, 11:46:55 AM »
Winning 25 of the 30 coin flips would still be pretty impressive, though. Surely it would get you a $50k bonus.

sheepstache

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Re: David Swensen: Investing and inefficient markets
« Reply #10 on: December 03, 2012, 12:22:18 PM »
Winning 25 of the 30 coin flips would still be pretty impressive, though. Surely it would get you a $50k bonus.

Sure, there's just no reason for it to have happened to you rather than one of the others, which makes it difficult for the people trying to make money by betting on you.

grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #11 on: December 03, 2012, 01:46:14 PM »
Yeah. I just figured that by writing a couple hundred posts in support of the efficient market hypothesis I had by this point made sarcasm tags obsolete.

sheepstache

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Re: David Swensen: Investing and inefficient markets
« Reply #12 on: December 03, 2012, 01:54:21 PM »
Yeah. I just figured that by writing a couple hundred posts in support of the efficient market hypothesis I had by this point made sarcasm tags obsolete.

No, no, you don't understand, I wanted to think that, but with the number of people I've talked to who don't understand probability I just can't tell any more.

smedleyb

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Re: David Swensen: Investing and inefficient markets
« Reply #13 on: December 05, 2012, 11:31:41 AM »
Yeah. I just figured that by writing a couple hundred posts in support of the efficient market hypothesis I had by this point made sarcasm tags obsolete.

Grant, no need to complicate your defense of weak EMH.  Just say "John Paulson," and you win.

It's clear to these old eyes that the only consistent winners are predominantly -- for the reasons KingCoin gives -- insiders who are privy to the better deals, investments, opportunities, etc.  I don't think it's coincidence that guys like Tudor-Jones and Soros have either closed up shop or circled the wagons at their funds in light of the investigations at Galleon and now SAC capital.  Consistent outperformance is  a rarity, certainly, and apparently criminal, too! lol.

That said, I see dead people, uh......I mean inefficiencies everywhere -- in bonds, in some real estate markets, in the growing chorus of negativity we encounter in the mainstream press.  History itself is full of them (hindsight truly is 20/20).  The ability to repeatedly profit from said inefficiencies is another matter, but this is how I'm trying:

(a) avoiding long term bonds (which could be wrong for several more years before ultimately being right over the next 10-20).

(b) dabbling in some "distressed" real estate.

(c)  picking at some overseas markets (China) in my IRA as the press over-dramatizes the "multi-year market lows".  Personally, I like to buy'em when they hate'em.

Will this approach lead to outperformance?  Probably not.   



   

arebelspy

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Re: David Swensen: Investing and inefficient markets
« Reply #14 on: December 05, 2012, 01:36:19 PM »
Smedley, great to see you back!  :D

I basically agree with everything you said.  Inefficiencies may exist, but be tough to reliably and profitably exploit.  I think the three things you've named are potentially worth doing, much more so than short term day trading type exploits, IMO.

I'm curious if you'll share the revelation you had in your last post which led to you leaving (and if it still applies, or what has changed.)

EDIT: To clarify, someone posted this:
We doing quotes now? cool...

Warren Buffett openly recognizes the problem with technical analysis as evidenced by his statement, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” Legendary fund manager Peter Lynch adds, “Charts are great for predicting the past.” Most indicators are about as helpful as astrology

And you replied:
Arebelspy, while I do enjoy our back and forth banter, it's clear to me that we're both just talking past each other at this point.  That's not meant as a criticism against you, but it does suggest that this particular conversational well has run dry.  Let's just chalk it up to the complexity of the issues at hand, and nothing more.

KoalaBear, I would like to thank you as well for triggering a Eureka moment in my life. 

Seriously dude, thank you.

Then deleted your account.

I was thinking I'd never get the chance to ask you about it.
« Last Edit: December 05, 2012, 01:39:43 PM by arebelspy »
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grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #15 on: December 05, 2012, 03:34:28 PM »
It's amazing how similar our views on the markets have gotten. I'm with you on many of those.

smedleyb

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Re: David Swensen: Investing and inefficient markets
« Reply #16 on: December 05, 2012, 03:59:00 PM »
Arebelspy, my favorite mod!

Good to be back, for sure.

As far as the eureka moment, I guess it had more to do with the perceived futility on my part of attempting to demonstrate the usefulness/art of speculation to a predominantly buy and hold, invest for the long-haul type of crowd.  Being the stock chatterbox and financial DIY type of guy that I am, I found being told to buy Vanguard and focus on other things while the "experts" go to work on my retirement dollars to be a thoroughly unsatisfying answer.  Maybe the right answer, -- especially if you don't care about balance sheets, income statements, EPS growth rates, head and shoulder tops, etc -- but still an unsatisfying answer.

But looking back at the entirety of what was written, I feel pretty good about the things I said.  I think many of my predictions advocated over the summer turned out  to  be fairly prescient (pounding the table on Spain, especially the EWP; bullish on Facebook at $18-19; identifying SPX 1400 as a critical level weeks before it got there, and a level around which it's been trading ever since).  Granted I realize that to many these are just darts thrown at a board.  But to me they represent the fruits of years of observing the market in an attempt to locate it's inner rhythm (which many insist does not exist, even if I think it does).   Granted, there were failures too -- anticipating a European inspired domestic market sell off and attempting surgical shorts at SPX in August near the 1420 level, with a 1% stop, for instance.  But overall, I thought my predictions based on my technical and psychological observations proved to be more accurate than not, and I feel good about that. 


arebelspy

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Re: David Swensen: Investing and inefficient markets
« Reply #17 on: December 05, 2012, 05:16:28 PM »
Ah, yes, I agree with the futility of butting heads.  I still enjoy it though.  ;)

Even with more correct predictions than not though, we come back to the "can you reliably turn a profit on those predictions," and that adds an extra complication.

Nevertheless, as always, I wish you and others trying to beat the market the best of luck.  Hopefully you will be one of the ones who can beat it over time.
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KingCoin

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Re: David Swensen: Investing and inefficient markets
« Reply #18 on: December 05, 2012, 05:16:59 PM »
As far as the eureka moment, I guess it had more to do with the perceived futility on my part of attempting to demonstrate the usefulness/art of speculation to a predominantly buy and hold, invest for the long-haul type of crowd. 

The reason you're faced with so much skepticism is the anecdotal nature of predictions and trading "wins". When you mention something like trading the 200 day moving average, it's hard not to wonder how such a simple strategy could beat the market when hedge funds have teams of PhD's and super computers trying to arbitrage any kind of predictable pattern.  Why not include a back-test of how this strategy has compared to a buy and hold strategy over the past 20 years along with an analysis of whether this strategy is robust across different periods and different moving averages? The numbers talk, hand waving walks. Getting a few calls right isn't a big enough sample size to be convincing of much of anything.

Invariably the market technicians will argue, "it's not just the 200 MA, it's also the secret sauce of my years of experience and gut feeling." Fine. So let's see your 10 year performance vs the S&P. What's your average return, volatility, and Sharpe ratio? How do these compare to the S&P? The proof is in the pudding, not some one off calls like "hey, Facebook is lookin' kind of cheap at $19".

If you really are consistently outperforming the market on a risk adjusted basis, get your trading results audited by PwC and you should have no trouble raising a ton of money and becoming a very wealthy fund manager. With the long term data on your side, you might even win over some Mustachians as investors :)

grantmeaname

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Re: David Swensen: Investing and inefficient markets
« Reply #19 on: December 05, 2012, 05:52:10 PM »
Hopefully the investor alley will return to its previous, high level of technical finance chatter. Most will ignore it, and at least half of us won't get any practical use out of the advice, but it is so interesting. And that's a very good thing.

smedleyb

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Re: David Swensen: Investing and inefficient markets
« Reply #20 on: December 05, 2012, 05:55:11 PM »
As far as the eureka moment, I guess it had more to do with the perceived futility on my part of attempting to demonstrate the usefulness/art of speculation to a predominantly buy and hold, invest for the long-haul type of crowd. 

The reason you're faced with so much skepticism is the anecdotal nature of predictions and trading "wins". When you mention something like trading the 200 day moving average, it's hard not to wonder how such a simple strategy could beat the market when hedge funds have teams of PhD's and super computers trying to arbitrage any kind of predictable pattern.  Why not include a back-test of how this strategy has compared to a buy and hold strategy over the past 20 years along with an analysis of whether this strategy is robust across different periods and different moving averages? The numbers talk, hand waving walks. Getting a few calls right isn't a big enough sample size to be convincing of much of anything.

Invariably the market technicians will argue, "it's not just the 200 MA, it's also the secret sauce of my years of experience and gut feeling." Fine. So let's see your 10 year performance vs the S&P. What's your average return, volatility, and Sharpe ratio? How do these compare to the S&P? The proof is in the pudding, not some one off calls like "hey, Facebook is lookin' kind of cheap at $19".

If you really are consistently outperforming the market on a risk adjusted basis, get your trading results audited by PwC and you should have no trouble raising a ton of money and becoming a very wealthy fund manager. With the long term data on your side, you might even win over some Mustachians as investors :)

My portfolio is up 20 fold since 1998; JDSU, QLGC and BRCD 98-2000, silver stocks 2005-2007 (PAAS, e.g.), cash 2007-2009, etc.  Do I outperform every year?  God no.  Is my trading account up nicely this year?  Hell yes. 

(p.s., FB at 19 = 50% Fibonacci retracement level vs. IPO price).

If I recall, I think econ Nobel laureate Meriwether at LTCM "back-tested" his method too.  Didn't stop him from vaporizing billions in the blink of an eye.  Twice. 

edit;  Meriwether was no Nobel laureate after all.  But two of his subordinates  "Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives"" were.





« Last Edit: December 05, 2012, 06:07:08 PM by smedleyb »