Wednesday, March 27, 2013

One Size Doesn't Fit All At Least Not Forever

No sooner do I learn of the existence of a fail-safe one size fits all portfolio than I learn it no longer works as advertised. Robert Seawright, Chief Investment Officer of Madison Avenue Securities notes in an article entitled “Is the Yale Model Past It” this is really pretty common. Success breeds copycats. As more investors try to buy into the same model portfolio the returns tend to diminish. Also mean reversion, what I have termed “The Las Vegas Line” tends to catch up with even the most successful investors.

Casino Capitalism and The Las Vegas Line

David Swensen runs the endowment of Yale University. For over 20 years he generated an unbelievable average annualized return of 16.3%! His model has been copied by many other universities as well as individual investors. I recently learned about the existence of this genius from the book “I Will Teach You to Be Rich” by Ramit Sethi. By the way, this book is well worth reading. While it is particularly aimed at intelligent, educated, highly motivated singles in their 20s and early 30s, anyone interested in learning to improve their personal finance skills would benefit from considering the author’s ideas.

Here is Swensen’s Model Portfolio:

30% in Domestic Equities (U.S. stocks small, mid, and large cap)
15% in Developed World International Equities (countries such as Canada, England, Japan or Germany)
5% Emerging Market Equities (countries such as Brazil, Russia, India and China)
20% Real Estate Funds commonly called Real Estate Investment Trusts (REIT)
15% Government Bonds (good old boring U.S. Treasuries)
15% Treasury Inflation-Protected Securities (TIPS)

While it still looks like a pretty well diversified portfolio to me, Seawright observes that starting in 2008 things took a turn for the worse. In fiscal 2009 the Yale endowment lost 24.6% of its value, a little better than the S&P 500 but not as good as the average college endowment which lost only 18.6%.

Just how risky is Swensen’s portfolio? His research indicates that the typical Yale Model portfolio runs a 28% likelihood of losing half of its assets over the next 50 years and a 35% risk of a “spending disruption” (whatever that means) over the next five years. I would like to know how this compares to other model portfolios. We might all get a little green around the gills if the results of an academic study of the risks inherent in our portfolios were published in a scholarly journal.

According to Seawright, a portfolio invested 60% in an S&P 500 index fund and 40% in a Barclays Aggregate bond index fund would have gained 12.6% over the last three years and 2.8% over the last five years. Yale returned 11.83% over the last three years and 3.08% over the last five years.

For those of you interested in the more detailed comparison of the results published in this article:

“60/40 Index Portfolio = 42% Russell 3000 Index, 18% MSCI All Country World ex. US Index, 40% Barclays Aggregate Bond Index, rebalanced annually”

“60/40 Asset Class Portfolio = 9% S&P 500 Index, 12% DFA US large value index, 21% DFA US targeted value index, 6% DFA international large value index, 6% DFA international small value index, 6% DFA emerging market value index, 40% Ibbotson 5YR T-Note index, rebalanced annually”

Seawright notes that a variety of studies including Swensen’s own analysis have shown that his excellent returns came from management skill choosing its private equity exposure and an illiquidity risk that hammered a number of other university endowments. These are investments that can not be sold quickly on open markets when their value is headed South.

Sadly the author concludes the Yale Model is past its prime due to overcrowding. Once again it looks like simple is better than complex unless you are very smart and very lucky.

So, Please! Please! Please! Let’s be careful out there!

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