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Yale strategy

David Swensen runs a fund of funds for the Yale endowment. But he claims to hate funds of funds so why hasn't he quit? He wrote a book called Unconventional Success but a better title is Unconventional Luck. If Swensen truly believes his comments on hedge funds then his returns were due to luck not skill. Alternatives are ESSENTIAL for Yale's portfolio but apparently not for yours. He loves alternatives for people as "clever" as he thinks he is but he says the unwashed masses should make do with index funds! Bear markets reveal how "smart" Swensen really is. It is worth noting that Swensen avoids several top performing strategies and best managers.

The so-called "endowment model" is too risky. Swensen's TRUE risk-adjusted performance has been poor. Almost all his "outperformance" has been due to leveraged beta NOT alpha. Swensen deserves some credit for seeing earlier than "peers" the need for alternatives so why backtrack and urge Joe Sixpack into "low cost" index funds? If simple asset allocation and "cheap" passive are all you need why does he have so many alternatives in the endowment portfolio? Why hasn't he handed all the endowment to passive funds instead of "pioneering" portfolio management?

Swensen says investors not as good as he thinks he is should not invest in hedge funds. He runs a fund of funds but thinks funds of funds run by ANYONE ELSE are bad! Many investors want what good hedge funds deliver and accept the RARE chance of fraud by bottom tier speculators that would never pass a thorough due diligence process. A large subset of investors like what a fund of funds provide and are prepared to pay the extra fees to take care of due diligence, portfolio construction and monitoring. It's CHEAPER than attempting to do it themselves.

If ever there were a strong candidate for mean reversion in performance it's Swensen. Skill persists but luck does not. I suspect Swensen's complaints have a lot to do with the inability to negotiate on fees, access and liquidity anymore. Demand is so much larger than supply in the QUALITY absolute return space and it is frustrating some people who once were able to enjoy limited partner power and side-letter favoritism. His earlier Pioneering Portfolio Management book is as insightful as lottery winners disclosing how they picked their numbers. Differentiating luck from skill can be difficult but not in Swensen's case.

Summarizing Unconventional Success: profit orientated mutual fund firms are bad whereas non-profit fund management firms are wonderful. The notion that not for profit fund managers must be superior is very bizarre. Incentives are the driver of any functioning economy and Swensen's beloved Vanguard and TIAA-CREF are in the BUSINESS of allocating capital to EARNINGS generating companies. As Swensen ought to have learnt from the funds he invests in, incentives are essential if you seek strong risk-adjusted returns. His inconsistent "logic" is a red flag.

Hedge funds charge an incentive fee and so attract the highest quality portfolio managers and traders; the better investors do, the better the managers do. The profit motive delivers superior products and choice to consumers in all business sectors and the financial world is no different. Unlike good hedge funds, neither Vanguard nor TIAA-CREF has made a cent in many years for the unfortunate investors in their "fabulous" flagship funds. Low cost long only can be VERY expensive. DO NOT INVEST in "passive" funds. The Yale endowment doesn't. Why should you?

Extending David Swensen's thesis perhaps we should restrict the purchase of ALL individual equities by anyone except him because Enron, WorldCom and many other 100% losing stocks lied to investors. Perhaps regulators should ban all collective investment vehicles because of the extra fees. People know if they do their homework and diversify they will make money. Either way, EVERY investor, big and small, institution or individual, needs a LARGE part of their portfolio in proper hedge funds. Just like David Swensen.

As for his infatuation with ETFs, Swensen gets half marks. They are sometimes a good vehicle for trading but certainly not for static long term investment as he advocates. Futures are usually superior to ETFs in transaction cost and liquidity terms. You can ALWAYS short futures not so with ETFs despite the claims. Bond and commodity ETFs are unproven and often poorly structured while interest rate and commodity futures have been around for many decades.

I'll take the S&P 500, FTSE, DAX, STOXX and TOPIX futures over QQQ, SPY etc every time. Ditto for JGB, treasury and crude oil futures. ETFs can be good when there is no associated liquid future; for example the REIT or sector ETFs. Also ETFs pay dividends but futures don't so you have to balance the better product against the dividends if they are high enough. You don't have to rollover ETFs but with futures you don't tie up as much cash for margin. It is a trade off but futures are usually the optimal vehicle.

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