David Swensen Advises Index Funds

Yale’s chief investment officer says most individual investors should choose low-cost funds.


David Swensen is the chief investment officer of Yale University’s $19.4 billion fund. He is also the author of an excellent book, Unconventional Success: A Fundamental Approach to Personal Investment.

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Swensen is credited with changing the way endowments invest by using private equity and hedge funds to boost returns. Given these views, it is particularly noteworthy that, at recent session of the John C. Bogle Legacy Forum, Swensen is quoted saying that unless an investor has access to “incredibly high-qualified professionals,” they “should be 100 percent passive—that includes almost all individual investors and most institutional investors”. In an NPR interview, he affirms these views, stating: “When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.”

His qualification is unfortunate. The reality is that most individual investors will be encouraged to believe they, with the assistance of their brokers and advisers, can find incredibly high-qualified professionals. They are likely to be very disappointed.

Reliance on alternative investments is dangerous. Clearly, Swensen has access to “incredibly high-qualified professionals.” So do the chief investment officers of Harvard, Princeton, and Stanford. Yet, according to one article, for the one-year period ending June 30, 2009, Yale’s endowment was down 24.6 percent, Harvard’s lost 27.3 percent, Princeton’s lost 24 percent, and Stanford’s lost 27 percent. The article notes the median loss was only 19.14 percent for foundations and endowments, according to WilshireTrust Universe. Did the investment skill of these well-qualified professionals go on sabbatical during that year?

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An easier way to achieve Swensen-like returns. While Swensen’s returns are impressive, they are not transparent. Endowments have minimal tax reporting disclosure, providing little insight into how Swensen’s fund achieves its returns. But individual investors don’t need access to alternative investments in order to obtain Swensen-like returns. A study of the 20-year performance of the Yale University endowment from July 1, 1985 to June 30, 2005 came to an interesting conclusion. An all stock, passively managed portfolio of 11 indexes, with 80 years of simulated risk and return data, beat the returns of the Yale endowment during this period. The funds in this portfolio are publicly traded. The risk and returns are completely transparent.

The odds of finding skilled fund managers is small. How difficult is it to identify incredibly high-qualified professionals? This is not an exercise for the faint of heart. One article notes the dismal performance of all the mutual fund managers in the database of the Center for Research in Security Prices. The average alpha, which is the return of a portfolio beyond what can be explained by exposure to risk, was -1.5 percent. That’s a negative alpha.

Few individual investors believe they are average, so the fool’s errand of trying to pick an outperforming mutual fund manager still has many takers. The odds are pretty poor. Let’s say you study the Morningstar and Lipper data and assume that skilled managers can be randomly unlucky and unskilled managers can get lucky in any period of time. You would need a 40 percent accuracy rate in identifying skilled mangers, which is four times better than what could be expected by random chance, in order to have a 50 percent chance of achieving a positive alpha. Those aren’t good odds.

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Finding great managers doesn’t mean great returns. Big state pension plans have access to the best managers in the world. Yet a comprehensive study of the performance of a large number of these plans indicated that all but one of them underperformed a comparable index portfolio.

Don’t try to pick incredibly high-qualified professionals. You are likely to fail. Instead, invest in a globally diversified portfolio of low management fee index funds, in an asset allocation appropriate for you.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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