Q&A with David Swensen
[January/February 2006]
By Christopher M. Wright
NAME: David F. Swensen
TITLE: Chief Investment Officer and Adjunct Professor, Yale University
BORN: 1954
EXPERIENCE: Dr. Swensen received his B.S. and B.A. degrees from the University of Wisconsin-River Falls and graduate degrees from Yale. His mentor during his Ph.D. days at Yale was Nobel laureate James Tobin (of Tobin’s q fame), who first introduced him to the idea of using a wide variety of asset classes to structure investment portfolios. From 1979 to 1982, Swensen worked at Salomon Brothers and, from 1982 to 1985, he was a senior vice president at Lehman Brothers. He then moved to Yale where the endowment fund has grown to $15.2 billion through his unconventional approach that underweights bonds and U.S. equities. Swensen is currently on the board of TIAA, the Brookings Institution and the Carnegie Institution. He has served as advisor to the New York Stock Exchange, the states of Connecticut and Massachusetts, and various foundations. He teaches economics, finance, and portfolio management at Yale and its business school. His two books are "Pioneering Portfolio Management—An Unconventional Approach to Institutional Investment" (Free Press, 2000) and "Unconventional Success—A Fundamental Approach to Personal Investment" (Free Press, 2005).
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When David Swensen talks, people listen. The author of "Unconventional Success" has compiled an enviable record of 16.1 percent average annual returns in his 20 years as chief investment officer of the Yale University endowment fund. Swensen was a pioneer investor in timber and private equity, and his moves are closely watched by other investment managers. Called an "icon in the world of big institutional money" by The Wall Street Journal, Swensen recently shared some insights with Portfolio and discussed his long experience in real estate investing.
Portfolio: You're known for being very competitive on the golf course. Did you learn anything in golf that helped you in portfolio management?
Swensen: Golf is a sport for perfectionists and investment work is as well.
Portfolio: Why did you leave Wall Street for the ivy-covered halls of Yale?
Swensen: I really love educational institutions. It's part of my family history. My father and grandfather were both college professors.
Portfolio: Your two books—the first for institutional investors, the second for individual investors—both devote considerable space to real estate as an asset class. Why is real estate at the core of what you do?
Swensen: In both books, I argue that real estate is an important part of portfolios. I think real estate historically has been one of the most reliable protectors against unanticipated inflation. That doesn't mean it's necessarily going to be true in the future, but at least in the past when real estate markets have been in equilibrium, the inflation protection real estate has provided has been substantial.
Portfolio: What is your view of REITs as an investment proposition?
Swensen: REITs have a number of fairly attractive attributes, not the least of which is liquidity. But one of the drawbacks of REITs is the frequent discrepancy between the price at which they trade and the value of their assets.
Portfolio: What percentage of the Yale portfolio is devoted to real estate, and how has the allocation changed over the 20 years you've been there?
Swensen: Real estate is part of what we call "real assets," which includes real estate, timber, and oil and gas. When I began at Yale 20 years ago, the allocation to real assets was less than 5 percent of the portfolio and now it amounts to 25 percent of total assets. There's been a pretty dramatic increase in both relative terms and absolute terms over that period.
Portfolio: Is the allocation significantly different if you back out oil and gas?
Swensen: We don't back out the sub-allocations for that class, but real estate's the largest of the three.
Portfolio: What real estate investment vehicles do you prefer—individual REIT stocks, mutual funds, exchange-traded funds (ETFs), direct real estate?
Swensen: From Yale's perspective, the core of our real estate portfolio is partnerships with individual real estate managers who take a value-added approach to investing—cleaning assets up, rehabilitating or repositioning them, and putting them back on the market. We will participate in the REIT market, particularly when REITs are trading at a discount, but we see no point in paying a premium to net asset value to own REIT securities.
Portfolio: Did you try to time the big run-up in REIT share prices that began in 2000?
Swensen: When we make asset allocation moves, it's not a question of trying to time markets. It's trying to put together a set of long-term targets that will serve the university well.
Portfolio: What about international real estate?
Swensen: We don't disclose sub-allocations, but we do have exposure to non-U.S. real estate. It's generally in the same format as our domestic exposure with a focus on entrepreneurial value-added partners that operate with private investment vehicles.
Portfolio: Your most recent book notes the wide disparity in the performance of investment managers and suggests that it's important to identify superior managers in inefficient markets. Have you been able to identify market-beating investment managers in real estate and, if so, what sets them apart from the rest?
Swensen: We've had a high level of success in identifying market-beating managers in all of our asset classes and real estate's no exception. The characteristics we look for in our managers are integrity, drive, energy, intelligence, and an edge in the market in which they operate.
Portfolio: Every money manager alive will tell you they fit that description.
Swensen: Our job is to identify those few who actually do. The due diligence we conduct involves spending time with prospective real estate managers, including time in our offices, in their offices, in social settings and on-site visits.
Portfolio: Your latest book warns retail investors away from active management.
Swensen: In the institutional book, I'm a big proponent of active management with the caveat that, if an institution is going to manage the portfolio actively, it must commit the resources to make those decisions intelligently. Individual investors have neither the time nor the resources to make high-quality active management decisions, so individuals need to take a passive approach to managing their portfolios.
Portfolio: That places you in very good company. John Bogle, Burton Malkiel and Jeremy Siegel have all extolled in this column the virtues of indexing for individual investors. Turning to another subject, it's been widely reported that your new book criticizes for-profit mutual funds for high fees and inconsistent returns. Less well known is your concern for the soul of the ETF industry.
Swensen: [Laughs]
Portfolio: ETFs might be going the same way as mutual funds, you say. Why aren't all ETFs on the side of the angels?
Swensen: Unfortunately, ETFs are beginning to be infected by the active management virus. Originally, the vast bulk of ETF offerings were index funds. They were a low-cost way for individuals to gain exposure to the core assets they should have in their investment portfolios. But once active management entered the ETF world,
individuals started having a harder time selecting appropriate securities.
I have exactly the same set of concerns about ETFs that I do about mutual funds. Active managers charge high fees that ultimately are not justified by performance; so people end up losing, at least by the amount of the fees. In taxable accounts, the high turnover you see in actively managed portfolios leads to undesirable tax consequences, generating a second way for people to lose.
Portfolio: Some firms like Barclays Global Investors say they are very successful with enhanced indexing. But if, as you say, semi-actively managed ETFs are the wrong way to go, what should individual investors who want diversified exposure to real estate do?
Swensen: Look for broad-based exposure to real estate securities that is provided at low cost. The most likely candidate would be an index fund of REIT securities.
Portfolio: Index mutual fund?
Swensen: It could be either in a traditional mutual fund format or an ETF format.
Portfolio: Why do you recommend mutual funds from not-for-profit fund management companies like Vanguard and TIAA-CREF? [Editor's note: Swensen is a trustee of TIAA.]
Swensen: In a for-profit organization, there's a tension between generating profits and fiduciary responsibility. The activities that lead to high profits—charging high management fees and gathering huge pools of assets—are the same activities that lead to poor investment returns. When you put the profit motive up against fiduciary responsibility, the profit motive almost invariably wins. Investors are far-better served in a not-for-profit environment. Vanguard and TIAA-CREF are the two large not-for-profits that provide investment management services to individuals.
Portfolio: A theme that recurs in your book is that, as asset classes get hot, money pours in, and returns fall due to increased competition for good deals. Many observers have noted that real estate is currently awash in capital, that money for new projects is easy to find. Do you worry that there will be too much money chasing too few good ideas in real estate, and how will we know when we get there?
Swensen: Sure, it's something to worry about, but you only know if you have been there after the fact. You have to be concerned about the flood of money coming into the real estate market and the extraordinary prices that are being paid for assets. The strategy that provides the most comfort in this kind of environment is staying out of the mainstream and purchasing assets that require some sort of repositioning or rehabilitation. It's a bonus if the managers are then able to offer the restructured assets to a market that seems willing to pay extraordinary prices for high-quality cash flows.
Christopher M. Wright (www.sinewaveinvestor.com) is a regular contributor to Portfolio.
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