My first post will deal with some articles written by Aaron Pressman at BusinessWeek, criticising the 'magic formula' (as he calls it) of asset allocation described in David Swenson's book Unconventional Success (US). In the first ("Yale investing guru Swensen missed problems with his advice"), Pressman criticises the US model for poor performance during the financial crisis. While I don't disagree with his point that the portfolio described in US is very different from the Yale model, this is unavoidable due to two points:
1) The average investor simply can't invest in most high-quality alternative asset classes, as Yale does, due to SEC rules and the lack of a retail segment in these markets. Swensen's 'magic formula' as Mr.Pressman calls it ('suggestion' would be more accurate), is an approximation to allow for this (though I believe that Yale's reliance on alternative assets is much less important than the role of hard/'real' assets, as a driver of outsized returns).
2) Recognising that the 'average investor' will neccessarily have no special knowledge about the market, the US portfolio is entirely Beta-driven. This means it will, by defintion, have a different setup to a large institutionally portfolio managed full-time by one of the most famous and influential investment managers in the world, who, presumably, has quite an information edge, due to the budget, research staff, and other sources of information he can command.
Furthermore, I feel that Mr. Pressman has neglected to consider several major points in his article:
(a) He states that the US allocation (which lost 32% in the 12 months to March 2008) could be improved upon by "... a simple mix of say 70% U.S. stocks and 30% bonds, which lost only 25%. A 60/40 mix dropped 19%.", but he doesn't give any indication that he understands why this occurred. When you understand why it occurred, the reason for these varying performances becomes obvious. The reason that the 60/40 portfolio does best is because, in mid 2008, the markets rapidly went from predicting an inflationary to a deflationary scenario. Inflation-hedging 'hard' or 'real' assets (commodities, real estate, TIPS) looked hugely overpriced, and Treasury bonds went through the roof. The US portfolio is heavily weighted in hard assets (though not commodities), as an inflation hedge. What Mr. Pressman is saying essentially boils down to, the fact that, in deflationary times, bonds do super-duper, and stocks and hard assets do very poorly! This is not news, and leads on to my second point.
(b) Viewing the portfolio returns over timeframes of less than 10 years leads to misleading conclusions. In his second article ("Revisiting the debate over Yale's investing guru, David Swensen"), Mr.Pressman says,
If you invested $10,000 in the magic formula at the beginning of 2005, when the book came out, how much would you have 4-1/2 years later on May 31, 2009 with annual rebalancing? $10,275. That's worse than if you'd kept the whole sum in T-bills or a money market fund and virtually identical to the $10,268 you'd have investing a BENCHMARK EXAMPLE of 70% U.S. Stocks and 30% U.S. Treasuries.and from this draws the frankly hilarious conclusion that, "Running the results of the six-fund magic formula over longer periods doesn't help Swensen's case much." Well, 4 or 5 years is possibly medium-term, and definitely not long term. Run the portfolio over, say, 1966-1982, and see what happens to the benchmark example. In all seriousness, run the portfolio over at least 10 and preferably 20-40 years, and if you still get the same results, I might take it seriously. Of course, you won't get the same results, beacause what Yale and other endowments and institutions wisely learned from the 1970's was that it was disastrous not to have any inflation-hedges in a long-term portfolio. Most astute investors will be aware that bonds and stocks both act poorly in the face of inflation. The 1970's were just such a time. Rather worryingly, Mr. Pressman, states, "We’ve also just experienced a 30-year or so trend of declining long-term interest rates and inflation in the U.S. that gave a nice tailwind to certain assets. An asset mix constructed based on returns and volatility during that period might not work so well if the next 30 years see a very different interest rate backdrop.", implying, I think, that he believes an inflationary environment would make Swenson's portfolio even further underperform the 70/30 benchmark. As I hope I have made clear above, this statement simply doens't make any sense after a rational analysis of the US portfolio structure.
(c) Mr. Pressman states,
Finally, commenter 'Finn' [that's me!] makes reference to modern portfolio theory, the efficient frontier and the benefits of diversification. These are excellent theories but they're constructed on top of numerous simplifying assumptions about how the world works. I'd suggest taking a look at some of the more recent research about how MPT has failed of late.
Now, I'm not exactly the biggest fan of investment theory, and I wholeheartedly agree with Mr. Pressman that MPT should not be actually used for building portfolios (i.e. don't start plugging numbers in and taking the results as gospel). As a guide to thinking about portfolio construction, however, I find it helpful. It shows you an idealised conception of how the world should work (but doesn't!). That is why I mentoned MPT, as the theoretical underpinning of Mr. Swenson's model - diversification makes sense under conditions of ignorance (hence, the all-Beta portfolio). Using, for example Jeremy Siegel's Stocks for the Long Run, and the ABN Amro Global Investment Returns Yearbook data for stocks, bonds, cash, gold etc, we can see that, over very long periods, asset classes do have certain characteristics - cash (essentially a very short-term bond) yields, essentially, inflation-rate returns, as does gold (though with much more volatility). Long-term bonds do very poorly in times of inflation, and very well in times of deflation. Stocks are an excellent hedge for inflation over the long run, but actually (and, it looks like, irrationally) a very poor inflation hedge over the short term. This is how I use MPT - as a framework through which to think about these various correlations.
(d) Finally, Mr. Pressman makes the mistake of quoting NN Taleb to this Taleb fan, evidently unaware that (i) Taleb suggest putting 90% of your portfolio in T-bills and the balance in venture capital or options, (ii) more importantly, Taleb would absolutely abhore drawing firm conclusions about anything, including expected long-run portfolio performance, from inadequate past data (see 'Fooled by Randomness', 2nd ed. pp. 64-69, about the difference between noise and information), as Mr. Pressman does when he talks about performance over the past 1-5 years, as described above in (b).
In sum, Mr. Pressman be be right that the portfolio suggested in US did not do well over 2008-2009, but his analysis proves nothing about the long-term viability of the portfolio. Since it is the long-term performance we should care about, this to me suggests that these articles do not contribute very much.
