The ferocious assault on the working practices of the mutual fund business made in the book Unconventional Success: A Fundamental Approach to Personal Investment by the chief investment officer of Yale University, David Swensen, which I mentioned last week, raises some interesting questions about the way that investors need to behave when choosing funds. While there is no doubting the savagery of Swensen's attack, or his devastating use of evidence, it would be wrong to give the impression that what he has to say is all negative - far from it.
In fact, much of what he writes is a lucid exposition of how private investors should go about thinking about the business of investment, starting from first principles and applying them in a disciplined way. There is, it has to be said, something rather lofty about the way that Swensen dismisses many of the things that ordinary investors, in all their innocence, seem to do and think. But it is probably naive to expect anything else from such a successful, high-minded pillar of the East Coast Brahmin class.
Stripped to its essentials, the advice to private investors he gives could not be simpler or more straightforward. It goes something like this. Don't think for a moment that you can do as well as the real professionals. That way only danger and disappointment lies. Stick instead to applying a few easy principles, using passively managed funds (preferably run by not-for-profit organisations) to create a balanced portfolio of what he calls core investment assets.
What are these core assets? They are the ones listed in the table, which shows Swensen's suggested starting portfolio for a typical US investor. I have added to these a list of the nearest UK equivalents, where possible - we do not yet have the equivalent of a Real Estate Investment Trust in this country (although the Treasury is considering authorising such a vehicle and there are commercial property funds aplenty being launched at this moment).
Note that there are some significant absentees from this list. They include corporate bonds, emerging market debt, high-yield bonds, asset-backed securities (such as mortgage-backed securities, very popular in the United States, but not over here), overseas bonds, hedge funds and venture capital.
All these assets fail one or more of Swensen's key tests of what constitutes a core asset - namely that it should add something distinctive to a portfolio that you don't already have in there, that it should be an asset class that does not require active management to generate returns, and that it should be easy to buy and sell in a liquid market.
A further important criterion is that the people who are selling you an asset, or managing it for you, should have a clear identity of interest with you, the investor. Swensen's argument is that, where that alignment of interest does not exist, in a profit-making industry it is all too likely to find your provider making money from you, rather than for you (which is one of the things that tends to happen in the fund business).
In the case of the last two types of asset, hedge funds and venture capital, Swensen's argument is that the private investor effectively has no chance to make money from them. Most of the benefits of hedge funds and venture capital, for example, go to a small group of dedicated professional investors. Corporate bonds, to take another example, offer little in the way of the diversification benefits that you can obtain from a much safer government bond.
In general, Swensen concludes: "Non-core assets provide investors with a broad range of superficially appealing but ultimately performance-damaging investment alternatives." He adds: "Trendy investors often pursue the cocktail-party-chatter benefits of commitments to the promise, seldom fulfilled, of actively managed alternatives." These assets are the ones that tend to be most heavily sold, for example on the basis of temptingly high yields, and feature disproportionately in "investment-related media coverage". (To which I reply: "Not here, they don't.")
The fundamental point, consistent with financial theory, that runs through this whole argument is that investors should concentrate on the decisions that are going to make a difference to their final wealth, and leave aside those that sound tempting, but are riskier than they at first appear. A sensible investor's portfolio will have a relatively high equity content, as this is the only way to achieve real (inflation-beating) growth in the long term. It must also be diversified, to guard against the risk of bad outcomes (such as inflation and recession).
Of the main sources of market returns, the first and overwhelmingly most important is asset allocation - where and how you divide your money between the various core assets. The other two, market timing and individual security selection, are too unreliable and too difficult to be of any value to the private investor.
A wise investor will therefore spend most of his time on the asset allocation decision, which means also rebalancing his portfolio every three or six months to retain his target percentage levels.
In Swensen's world (and mine, for that matter), this is not something that should be too difficult to do, though it would clearly put large parts of the financial services industry out of business if everyone were to follow this advice. Where I part company with his analysis is in thinking that the next step - going on from a core asset portfolio to make a few sensible active management decisions for yourself as well (as the best professionals do) - is somehow beyond most investors.
I have greater faith in the common sense and ability of intelligent private investors than that. The biggest drawback is that so many people seem to need the comfort of so-called "expert" advice in order to make these decisions (something that the whole panoply of regulation seeks to enforce on you).
However, Swensen is surely right to say that the first question you should always ask yourself is: "How does my expert adviser/fund provider make his money?" If their interests are not aligned with yours, don't go near them.Reuse content