One of the investment world’s great heroes is David Swensen, the man who has managed Yale University’s endowment money since 1987. What makes him a hero? The fact that in all the years since he took over he has averaged a return of 16 per cent to 17 per cent a year with not one single down year.
That’s something almost nobody else can lay claim to: there are managers knocking about who can say they’ve made similar average returns but they have usually resulted from performance extremes — losing a lot some years but making much more in others.
The secret of Swensen’s success is, he says, relatively simple — diversification across asset classes. Instead of just investing most of the Yale portfolio in equities and bonds, his strategy (now known as the Yale Model) is to chop the money up into five or six equal parts and invest each in a separate asset class with as little correlation between them as possible. This means putting money into hedge funds, private equity, venture capital and property as well as into the big stock markets.
Why everyone is into diversification these days
When Swensen started doing this it was pioneering stuff. But these days it isn’t. We take it for granted that we should be diversifying into private equity and hedge funds. I have, for example, just had a newsletter from my own old college which includes an article by the bursar telling us that (inspired by Swensen) he has spent the past five years adopting a similar approach.
The bursar also says that the strategy has gone extremely well so far — over the past five years the college fund has significantly outperformed not only the FTSE All-Share index but also most comparable US educational endowments.
This is all good news of course (the more the college makes from its investment the fewer begging letters I hope they will send to their alumni), but I wonder if the bursar will be as smug 10 years from now.
Is the market about to turn against the diversifiers?
The market has been very much on the side of the diversifiers for the past five years. Equities have done well; property has been in the biggest bubble ever; the speed of the rise in the commodities market surprised even the most bullish of the bulls (myself included); and private-equity funds have been having the most splendid of times.
In short everything the Yale Model might have had you diversifying into has done well. One could say the success of the college has had less to do with diversification than with the fact that, thanks to the prevalence of cheap money around the world, everything has been going up. If everything is doing well, diversifying into everything can’t help but work. But what when all this stops?
It isn’t normal for everything to keep going up and we know that a great many markets are beginning to look a bit iffy. Commercial property yields are at rock bottom (in the City they are as low as 4 per cent) yet supply is still being expanded at speed; the residential property market has moved so far beyond any kind of common sense I barely dare comment on it any more; the blow-up at Amaranth a few weeks ago (where the hedge fund managed to lose $6 billion in a month thanks to a bad bet on natural gas) has sounded a warning about the level of borrowing such schemes use; and the private equity and venture capital businesses will suffer as interest rates rise.
Diversification or ‘diworsification’?
Owning lots of things that are all going up in value is fine. Owning lots that are of questionable long-term quality isn’t.
Fidelity fund star Peter Lynch calls holding too many different shares that you don’t understand “diworsification”. Holding too many asset classes may turn out to be just another version of the same thing.
First published in the Sunday Times 8/10/06