Not a day goes by that I don't get an email from an investment firm promoting the attraction and growing popularity of alternatives—offering research, white papers, news clippings and other sources demonstrating the value of alternatives as a serious and important investment strategy for today's environment.
When David Swensen made his bold bet on alternatives in 1985, the strategies were far outside the mainstream of how college endowments and other large institutions invested their money. Despite the fringe status of the strategies, Swensen saw their validity and attractiveness and made it the centerpiece of the Yale Endowment. Fourteen years later he eloquently explained his thinking and his process in the excellent and thought-provoking “Pioneering Portfolio Management.” By the time the book was published, he was already famous—and with over $500 billion invested worldwide, alternatives were no longer a secret.
Swensen's recommendations to readers were noteworthy for pretty much ignoring the single most popular subject on investors’ minds then and now: performance. He wrote: “In selecting partners, due diligence efforts center on assessing the competence and character of the individuals responsible for portfolio decisions. Developing partnerships with extraordinary people represents the single most important element of alternative investment success.”
Swensen knew that as alternative investment strategies became more popular it would become harder for investors to generate attractive returns without either taking on excessive risk or finding those few managers who possessed the right combination of talent and temperament (while still taking on new investors); of course he was urging his readers to focus on the latter.
The public perception of what is popularly known as “the Yale Model” focuses exclusively on the specific asset classes in which Yale chose to invest. Character and competence are squishy and subjective attributes that don't lend themselves to being quantified; while performance and correlation are clear, well-defined and easily quantifiable. Understandably that became the common basis for evaluating Swensen—but that focus led investors to discount the most important and valuable aspects of the Yale Endowment's approach.
In his foreword to “Pioneering,” Charles Ellis anticipated this unfortunate outcome: “Public interest naturally centers on David Swensen's fine results—observers conventionally citing the unconventional structure of the portfolio and the superior returns realized, but usually overlooking the complementary strength of the long- and short-term controls used to avoid, minimize, and manage risk.”
It has been just under 30 years since Swensen began his tenure running the Yale Endowment. In preparing for this column I pulled “Pioneering” off my shelf to reacquaint myself with his arguments—and ended up rereading much of this wonderful book. What was notable to me in the second reading was not so much that he was an early mover into alternatives (which he was), but that he was exceptional in so many important ways that have little to do with alternatives as such and everything to do with intelligent investing. Swensen's observations from 1999 are a perfect counterpoint to Wall Street's growing push to convince investors that now is the time to invest in alternatives.
According to Morningstar, in the 12 months ending Oct. 31, investors added $24 billion to actively managed alternative strategy funds, small in terms of the $353 billion added to all long-term strategies (including index funds), but more than a third of the $73 billion (net) that went to all active funds. John Rekenthaler noted that active managers have never been in worse repute—and so it appears that, at least for now, they are casting their lot with alternatives as the way to shore up both their tarnished reputation and their assets under management.
A recent report from McKinsey & Co. estimated that alternative investments will contribute up to 40% of the global asset management industry's revenues by 2020. The report concludes that the demand for alternatives is driven by powerful structural forces leading investors to seek consistent and uncorrelated risk-adjusted returns. They also report that investors are increasingly disillusioned by traditional asset classes.
Whenever I come across investors who tell me they just want consistent growth, irrelevant to their sophistication in other areas, it is clear they are unsophisticated about the nature and/or history of investing. So to read from a reputable source that this a major objective of large institutional investors (who should know better) it must mean those objectives are being driven by incentives that have little to do with investing and more to do with the politics and governance problems inherent in institutions.
Swensen addresses this quandary: “Active management strategies demand uninstitutional behavior from institutions, creating a paradox that few can 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.” And on the issue of consistent returns he could not be clearer: “The most attractive investment opportunities fail to provide returns in a steady, predictable fashion.”
A recent BlackRock report, “10 Myths Surrounding Alternative Investments,” offers the following assertion: “Although many still think of alternative investments as exotic investments reserved for ultra-high-net worth individuals and sophisticated institutions, the reality is that alternatives have become mainstream.” The unstated but clear message of the report is that it is an advantage to investors for the popularity of alternatives to increase.
Swensen's view of alternatives is more realistic: “Absolute return investing, a relatively new asset class, consists of inefficiency-exploiting marketable securities positions exhibiting little or no correlation to traditional stock and bond investments.” He adds: “The fundamental notion of absolute return investing rests on identification and successful exploitation of inefficiencies in pricing marketable securities.” Anyone with even a cursory understanding of how markets work knows that as more investors seek to exploit the same inefficiencies, those inefficiencies diminish and ultimately disappear.
In a recent article in The Wall Street Journal, Jonathan Clements identifies an additional reason people are drawn to alternatives, “Investors are desperate for something that will protect their portfolios the next time stocks sink.” Clements finds investors increasingly uncomfortable with their traditional choices; as a result they are open to finding a different path in their desire to invest their money with confidence.
Swensen pushes back on that kind of thinking. Even as he promotes the use of absolute return and other strategies that don't generally correlate with the swings of the traditional stock market, he doesn't offer them up as a panacea or a cure to market fluctuation. If anything he urges readers to take advantage of market volatility, drawing on his own experience in dealing with institutional bureaucracies: “Two important tenets of investment management—contrarian thinking and long-term orientation—create great difficulties for governance of endowment funds.” He notes: “The universality with which investors proclaim themselves long-term in orientation matches only the startling degree to which short-term thinking drives investor decisions.”
Unlike today's institutional and individual investors, Swensen understands that old fashioned stocks and bonds remain perfectly legitimate investment vehicles. He writes that “thoughtfully structured combinations of marketable asset classes contain the potential to provide reasonable results for disciplined long-term investors.”
While Swensen was an early mover in alternatives, he knew that at some point the field would get crowded and he would once again be forced to fall back on his disciplined investment process for direction. “Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.”
After some three decades running the Yale Endowment, David Swensen likely has personal wealth that's hundreds of millions of dollars less than it would have been had he remained on Wall Street. In an investment world driven by money and the perverted incentives it creates, advice from a man who cannot be bought is not simply refreshing—it is valuable beyond measure.