The passing last year of investment great David Swensen was very sad news. We are fortunate that he was a generous sharer of his insight. But we need to be careful to focus on the right lessons from his success.
Swensen achieved excellent investment outcomes over his 35-year stewardship of Yale’s Endowment. He generated returns of 13.1% per annum through 30 June 2020, significantly outperforming his peers and a traditional 60% stock/40% fixed income portfolio.
He rethought how institutions should invest. His most famous book is the hugely influential Pioneering Portfolio Management, An Unconventional Approach to Institutional Management.
At the heart of his approach was an emphasis on diversification into illiquid and alternative assets. He believed in asset allocation rather than stock selection. Allocating to alternatives provided the returns required alongside significant diversification from long-only equity exposure. And he recognised that the endowment’s long-term investment horizons so they could invest in private markets and benefit from an illiquidity premium.
So Yale endowment took large exposures to hedge funds, venture capital, leveraged buyouts, natural resources – and real estate.
Swensen was a pioneer. Witnessing his success, many others followed and over time allocations to real estate have increased.
Many see Yale’s allocation to alternatives, including real estate, as Swensen’s key insight. This is a mistake.
“When an unconventional asset class becomes conventional, the investment proposition can change fundamentally”
Yale’s Endowment did well in these sectors because they were immature and other institutions were not investing in them. As capital has flowed into real estate, competition for the best managers, strategies and assets increased. When an unconventional asset class becomes conventional, the investment proposition can change fundamentally.
To understand Swensen’s key lessons, we should listen to those who knew him well and worked with him closely. They do not see investment brilliance as the key to Swensen’s success. They did not believe it was what he invested in, but rather how he invested that set him apart. They stress organisational and cultural aspects of Swensen’s approach.
Charley Ellis, the author of many influential investment books, was a member of the Yale endowment investment committee. In his foreword to Pioneering Portfolio Management, he reveals the “salient ingredients of Swensen’s Secret Sauce”. These broadly fall into three categories.
- A process-driven approach to investment decision-making.
Ellis emphasises buy-in to an evidence-based decision-making process. To minimise errors, he says Swensen utilised “a carefully constructed, rigorously tested portfolio structure and decision-making process that are clearly defensive.”
Swensen is another example of great investors being as focused on the investment decision-making process as they are investment markets. He understood the importance of process over individual brilliance.
Appropriately constructed, an investment process can mitigate some of the human biases that can undermine good decision-making, including our tendency to follow the herd and do what others are doing.
Swensen states, “casually researched, consensus-oriented investment positions provide little prospect for producing superior results in the intensely competitive investment management world.
“Without a rigorous process, informed by thorough analysis and implemented with discipline, investment portfolios tend to follow the whims of fashion,” he adds.
Furthermore, a disciplined framework for decision-making tackles the principal-agent problem that characterises investment management and is prominent in real estate.
The incentives of those making the investment decisions do not always align with the client’s objectives. Swensen argues, “an effective investment process reduces the inevitable gap between the goals of an institution and the actions of the portfolio’s stewards”.
This points to the second ingredient of Swensen’s Secret Sauce.
- A client-centric purpose.
Swensen and his team were driven to deliver the best outcomes to their client. That was their purpose and it determined every action they took. Ellis says the team displayed “above and beyond” thoughtfulness about an institution’s best interests.
Putting the client’s outcomes at the heart of everything an investment management company does should go without saying. But it can be hard. For example, institutional investors tend to have some of the longest time horizons. Yet short-term underperformance can expose managers to career risk, sometimes in ways that are perplexing.
Take this example from Morgan Housel:
BlackRock CEO Larry Fink once told a story about having dinner with the manager of one of the world’s largest sovereign wealth funds.
The fund’s objectives, the manager said, were generational.
“So how do you measure performance?” Fink asked.
“Quarterly,” said the manager.
Ben Carson’s excellent book, Organizational Alpha, emphasises that there is little more important than remembering the time horizon of your goals. He says, “There is far too much emphasis on the short-term – geopolitical events, market timing and tactical trading – and not nearly enough emphasis on the long-term – policy decisions, asset allocation, structural investment framework, process and plan.”
He goes on to emphasise that when you make short-term decisions with long-term capital you tend to be reactive, instead of proactive with your investment decisions and there is a danger you repeatedly change strategy and chase past performance.
Being driven by a client-centric purpose and “extraordinarily thoughtful” about Yale University enabled Swensen’s team to avoid these errors.
- A collaborative culture characterised by integrity, trust and respect.
As someone who consistently acted with integrity and showed personal respect and affection for those close to him, David Swensen was somebody good people really wanted to work with. He was able to bring together a cohesive group of talented people to work collaboratively.
Ellis says, “The most remarkable reality about Yale’s Investment Office…is the rich culture of professional respect and personal affection that bonds so many talented and committed individuals into a superbly effective team whose collective efforts excel”.
Good investment decision-making is team activity. Free of politics, there was healthy debate and challenge. Trusted and respected, team members were happier, resulting in a low turnover in staff, aiding the consistency in approach.
Furthermore, the culture Swensen nurtured meant that third-party managers wanted to work with them. Managers prefer to work with clients they like and admire. This became a source of lasting competitive advantage.
No wonder one of Swensen’s former team members, Andrew Golden, who now runs the Princeton University endowment, is quoted as saying, “90% of good ideas on how to organise the office and develop a culture I’ve stolen from Yale”.
On Swensen’s Secret Sauce, Ben Carlson says, “Although it may seem odd to some that Ellis described so many non-investment-related reasons to define Swensen’s success over the years, it’s those intangibles that have made the biggest difference.”
Many of us have heard the famous Peter Drucker quote: “Culture eats strategy for breakfast.” Few of us have levered that insight as Swensen did. That is the example of his example we should follow.
