Book summary “Unconventional success”: summary

Introduction

You face a daunting financial landscape filled with conflicted brokers, high-fee mutual funds, and seductive market trends that promise quick wealth. Navigating these pitfalls alone often leads to disastrous returns that lag far behind major market benchmarks.

You can achieve superior investment results by building a diversified, equity-oriented portfolio and avoiding the high costs and conflicts of for-profit mutual funds.

David F. Swensen guides you through the principles of sound investing by examining foundational asset allocation, essential market instruments, and the structural failures of the mutual fund industry. The book details how to construct a balanced portfolio, avoid performance-chasing traps, and utilize alternative investment vehicles.

You will find answers to several critical questions:

• How do you divide your capital among core asset classes?
• Why do actively managed mutual funds consistently fail to beat simple index strategies?
• How do high fees and taxes erode your long-term wealth?
• What role should non-core assets play in your personal financial strategy?

1. Foundations of Portfolio Return

Capital markets provide three distinct tools for investors to generate returns: asset allocation, market timing, and security selection. Asset allocation is the long-term decision regarding the proportion of assets in particular classes. Market timing refers to active or passive deviations from these targets. Security selection involves constructing portfolios within asset classes through active management bets or passive market replication.

Your investment results are overwhelmingly determined by asset allocation rather than market timing or security selection.

Studies of institutional portfolios conclude that roughly 90 percent or even 100 percent of the variability of returns stems from asset allocation. Security selection and market timing determine only about 10 percent of return variability. Because security selection involves active bets and transaction costs, it acts as a negative-sum game.

Sources of Return

Long-term investors should maintain a pronounced equity bias because equities consistently outperform bonds and cash over extended holding periods. Equity investors accept higher risk as a residual interest and receive a historical risk premium. Over the 78-year period from 1926 to 2003, U.S. stocks significantly outperformed government bonds and Treasury bills.

Roger Ibbotson's survey of returns from 1926 to 2003 shows that one dollar invested in large-company stocks expanded 2,285 times, bonds produced a 61 multiple, and cash an 18 multiple, while small stocks multiplied 10,954 times. U.S. stocks generated a 10.4 percent annual compound return over this period, compared to 5.4 percent for government bonds and 3.7 percent for Treasury bills, yielding a 5.0 percentage point historical risk premium. Jeremy Siegel's study reports an 8.3 percent compound return for U.S. stocks from 1802 to 2001.

Fundamental Investment Principles

Harry Markowitz called diversification one of the economic world's rare free lunches. Diversification provides a free lunch by reducing risk without diminishing returns, helping investors stay the course during market downturns. Concentrated portfolios suffer catastrophic losses that drive investors to abandon them at the worst possible times.

From the peak of small company stock prices in November 1928 to the trough in 1932, small stock investors suffered an excruciating 90 percent collapse in value. Small stocks also fell nearly 60 percent from December 1968 to December 1974.

2. Core Asset Classes

Sensible portfolios rely on six core asset classes that provide broad market exposure, equity orientation, and tax sensitivity.

Core asset classes must provide differentiable portfolio characteristics, rely on market-generated returns rather than active management, and trade in broad, deep, investable markets. You need reasonable certainty that portfolio constituents will fulfill their missions without relying on the skill or luck of active managers. Furthermore, market breadth, depth, and investability assure abundant choices, substantial volume, and reliable access.

Domestic and Foreign Equities

Historically, U.S. stocks have provided superior returns compared to bonds, with Jeremy Siegel recording 8.3 percent per annum over two hundred years and Roger Ibbotson recording 10.4 percent over seventy-eight years, yielding an equity risk premium of 3.4 to 5.0 percent. However, research by Philippe Jorion and William Goetzmann demonstrates survivorship bias.

Philippe Jorion and William Goetzmann examined thirty-nine stock markets over a seventy-five-year period and found that major disruptions afflicted nearly all of them except the United States.

Foreign developed equities offer long-term returns comparable to U.S. stocks while providing critical portfolio diversification due to regional economic drivers and currency exposure. Over the thirty-four years following the 1970 inception of the MSCI EAFE Index, non-U.S. developed markets returned 10.0 percent per annum compared to 11.3 percent for the S&P 500.

In the 1980s, Japan dominated world markets by returning 28.4 percent per annum, but in the 1990s its market declined by 0.9 percent per annum following an economic collapse.

Bonds and Real Estate

U.S. Treasury bonds provide unmatched portfolio diversification against financial crises and deflation, functioning as an essential safe haven despite offering lower expected returns than equities. Because Treasury bonds carry the full-faith-and-credit backing of the U.S. government, they have zero default risk and offer powerful portfolio insurance during market panics.

In the stock market collapse of October 1987, when the U.S. market plummeted over 20 percent in a single day, Treasury bonds staged an impressive rally.

Real estate combines bond-like rental cash flows with equity-like residual values, providing inflation protection and strong diversification, but individual investors face extreme wealth destruction from predatory private REIT fee structures. Publicly traded REITs offer low cost and high liquidity, such as Vanguard's REIT Index Fund charging 0.27 percent, whereas private real estate investment programs extract exorbitant up-front, acquisition, and management fees.

Wells Capital consumed up to 16.0 percent of investor capital in organization, offering, and acquisition fees on a $3 billion offering, leaving only 84.0 percent actually invested in real estate.

3. Portfolio Construction

Effective portfolio construction combines scientific asset allocation with personal discipline and systematic rebalancing.

Portfolio construction requires both the science of applying investment principles and the art of incorporating personal preferences. The science encompasses combining core asset classes efficiently and cost-effectively. The art involves using common-sense judgment to integrate individual characteristics into the asset-allocation process.

The Science of Portfolio Structure

Effective diversification requires every asset class to be large enough to matter but small enough not to dominate. Each asset class in a diversified portfolio should receive a weighting of at least 5 or 10 percent to matter, and no more than 25 or 30 percent so that it does not matter too much.

Portfolios must be dominated by high-expected-return equities while incorporating specific inflation and deflation hedges. High-expected-return assets drive results, while U.S. Treasury Inflation-Protected Securities and real estate protect against inflation, and standard U.S. Treasury bonds guard against deflation and market crises.

A reference portfolio allocates 70 percent of assets in high-expected-return vehicles, 15 percent of assets in TIPS, 20 percent of assets in real estate, 30 percent of assets in U.S. government obligations, and 15 percent of assets in standard U.S. Treasury bonds.

The Art of Personalization

As an investor's time horizon shortens, risk exposure should be reduced by shifting from a risky portfolio to riskless cash. You hold a diversified, equity-oriented portfolio when your horizon is long. As the horizon contracts toward short-term needs, you systematically move portions of the risky portfolio into cash or short-term instruments while keeping the composition of the risky portfolio intact.

• For terms of one to two years or less, favor bank deposits, money-market funds, or short-term bond funds.
• For terms of eight to ten years or more, use an equity-oriented, diversified asset allocation.
• For intermediate horizons between two and eight years, combine risky long-term assets with less risky short-term investments.

Rebalancing ensures portfolio characteristics match targeted allocations by systematically selling appreciated assets and buying depreciated ones. Market forces naturally cause asset proportions to drift. Without systematic rebalancing, your actual portfolio risk and return profile diverges from the desired targets.

• Direct fresh flows of funds to underweight asset classes to move allocations closer to target without creating tax consequences.
• Employ tax-deferred accounts to conduct rebalancing activity and eliminate current tax liabilities.
• Use losses generated from security sales to offset gains realized elsewhere, enabling tax-free rebalancing.

4. Non-Core Asset Classes

Non-core asset classes fail at least one of three fundamental criteria required for core inclusion. An asset class must provide a basic, valuable, and differentiable characteristic, rely fundamentally on markets rather than active management for returns, and be represented in a broad, deep investable market. Non-core alternatives violate these rules and introduce credit risk, illiquidity, callability, or severe dependence on active management.

Non-core asset classes such as corporate bonds, hedge funds, and private equity introduce excessive fees and structural flaws.

Corporate and Municipal Debt

Corporate debt investors face limited upside capped by maturity or early calls and unlimited downside in the event of default or credit deterioration. Furthermore, corporate managements act primarily in the interest of equity holders, often transferring wealth away from bondholders through leverage and recapitalizations. S&P 500 debt-equity ratio rose from 0.46 in 1983 to 1.37 in 2003. Moody's recorded 5,955 debt issues downgraded versus 3,412 upgraded for the two decades ending June 30, 2003. Over the last decade, $4.5 trillion of debt deteriorated in quality compared to $3.4 trillion improved. At December 31, 2003, investment-grade corporate bonds reached $1.8 trillion in market value.

WorldCom senior debt was rated single A by Moody's in April 2002, downgraded to junk in May, defaulted on $23 billion in July, and filed for the largest bankruptcy in history with over $100 billion in assets, causing senior notes to fall from 82.34 to 12.50.

Alternative Investments

Hedge funds depend entirely on active management skill to generate returns above cash, yet their rich fee structures and survivorship biases obscure the difficulty of achieving net excess returns. At December 31, 2003, an estimated 6,000 hedge fund firms controlled $800 billion in equity capital. Investors face a 2.5 percent total fee drag, combining a 1 percent management fee and a 20 percent profits interest on top-quartile returns. Long Term Capital Management reported net returns of 32.4 percent per year through October 1997 before its near-collapse, followed by a -91.8 percent return from October 1997 to its October 1998 demise.

Leveraged-buyout funds historically deliver risk-adjusted returns inferior to public equities due to excessive debt risks, high fee loads, and misaligned incentives in large funds. At December 31, 2003, the U.S. leveraged-buyout industry controlled $230 billion in capital. Cambridge Associates data showed a pooled mean return of 11.5 percent for 304 buyout funds compared to 12.2 percent for the S&P 500 over the twenty years ending June 30, 2003. Buyout funds over $1 billion produced an annual return of 6.0 percent, versus 17.8 percent for funds under $1 billion.

Aggregate venture capital returns match public equities while carrying much higher risk, and top-tier franchise firms are closed to new investors. At December 31, 2003, the U.S. venture capital industry controlled $135 billion in capital across more than 1,300 partnerships. A sample of nearly 950 venture funds earned a 19.6 percent rate of return over the twenty-year period ending December 31, 2000, compared to 20.2 percent for the S&P 500. Benchmark Capital invested $6.7 million in Pierre Omidyar's eBay in 1997 at a $20 million valuation, which grew into a holding worth billions after the company's September 1998 IPO and subsequent market rise.

5. Chasing Performance

Chasing past performance destroys your wealth by buying at market peaks and selling during market troughs.

Because you buy based on recent stellar returns, you expose the maximum amount of assets to the highest level of risk just before a trend reverses. When the market collapses, you panic and withdraw your capital, locking in severe losses and suffering from asymmetric tax burdens on capital gains distributions.

The Kinetics Internet fund produced an annual return of 119.4 percent for the three years ending December 31, 1999. The top ten performing technology mutual funds for that same period produced an average annual return of over 78 percent, but the following three years brought a loss of 79 percent of the initial stake, destroying billions of dollars through poor timing. Net investment losses consumed 72 percent of investor capital over the six-year period from 1997 to 2002 for top ten tech funds.

Performance Chasing and Morningstar Ratings

Morningstar assigns star ratings based purely on historical performance and a flawed risk metric, causing you to pour massive capital into top-rated funds just as they peak. Four-star and five-star mutual funds garnered an average of 106 percent of net cash flows between 1999 and 2003. Recognizing that its broad categories and old risk metrics were broken—such as previously deeming any fund outperforming T-bills as riskless—Morningstar instituted changes in July 2002 to restrict ratings to narrow niche categories and alter its risk penalty calculation.

Following superb performance, technology funds jumped to an average rating of 4.7 stars with 90 percent holding five stars at the end of 1999, right before suffering huge losses in subsequent years.

Tax laws governing mutual funds are highly asymmetric, forcing you to pay taxes on realized capital gains while denying you the distribution of capital losses. For the top ten tech funds over the six-year period ending in 2002, capital gains distributions totaled $3.3 billion, forcing you to pay substantial taxes despite experiencing massive net investment losses. Overly active fund management further exposes 24 percent of your contributions to potential tax liability.

Contrarian Rebalancing

Sensible investors must act against market consensus by maintaining strict fidelity to asset-allocation targets and regularly rebalancing.

Avoiding consensus-driven fads requires disciplined, independent behavior. You should specify reasonable portfolio targets in advance and execute contrarian rebalancing by systematically buying out-of-favor assets and selling in-vogue assets.

Supremely rational investors take the step of acting against the consensus, rebalancing to long-term portfolio targets by buying the out-of-favor and selling the in-vogue, whereas typical investors suffer wealth destruction by chasing performance.

To protect your wealth from momentum players and flavor-of-the-month traps, you must follow specific rules:

• Carefully articulate reasonable portfolio targets
• Maintain close adherence to the chosen portfolio
• Regularly purchase out-of-favor assets
• Regularly sell in-favor assets

6. The Performance Deficit of Mutual Funds

Active management of marketable securities is a negative-sum game where active managers as a group must underperform the market by the cost of fees, commissions, and market impact. You lack the time, resources, and access to compete against sophisticated institutional investors. Mutual funds attempt to provide access but consistently fail to beat passive market-mimicking alternatives.

Active mutual funds operate as a negative-sum game where high fees, turnover, and taxes drag down investor returns.

Over ten to twenty-year periods, active mutual funds show pre-tax failure rates of 78 percent to 95 percent. After-tax failure rates rise even higher, reaching 86 percent to 96 percent.

Robert Arnott, Andrew Berkin, and Jia Ye examined mutual-fund returns for the twenty years ending December 31, 1998, and found that the average mutual fund underperformed the market by 2.1 percent per year pre-tax and by 2.8 percent per year after-tax. Their study also revealed a fifteen-year pre-tax annual return deficit of 4.2 percent and a ten-year pre-tax annual return deficit of 3.5 percent.

Fees and Agency Costs

A fundamental conflict of interest exists between mutual-fund managers who act as profit-seeking agents and investors who act as return-seeking principals. Mutual-fund organizations primarily exist to generate corporate profits through higher fees and asset accumulation. Size remains the enemy of performance, meaning asset-gathering managers win while you lose through bloated portfolios.

Within active equity management, higher fees correspond to lower returns, disproving the adage that you always get what you pay for. A study of 17,000 funds in the Standard & Poor's database demonstrated that in eight of nine domestic-equity categories, low-fee funds beat high-fee funds by margins ranging from 0.8 percent to 3.8 percent annually over a ten-year period. In 2002, median active management costs reached 2.35 percent, comprised of 1.5 percent management fees and 0.85 percent transaction costs.

Portfolio Turnover and Trading Costs

Frenetic portfolio turnover generates severe hidden trading costs and commissions that degrade active fund performance. In 2002, the weighted-average equity mutual-fund turnover reached 67 percent. Beyond visible commissions averaging 0.2 percent of assets, market impact costs extract an estimated additional 0.5 percent annually.

Aronson, Johnson & Ortiz estimated that for a hypothetical portfolio with 100 percent turnover, market impact costs range from 0.5 percent for the largest 500 securities up to 3.6 percent for the fifth quintile of smaller stocks.

High portfolio turnover in taxable accounts triggers realized capital gains that destroy a substantial portion of your wealth through avoidable tax liabilities. Managing taxable portfolios as if they were tax-exempt is highly irresponsible. Robert Jeffrey and Robert Arnott calculated that with a 35 percent capital gains tax rate and a 6 percent pre-tax growth rate, a 100 percent annual turnover rate reduces after-tax returns by more than two full percentage points.

Active funds frequently saddle new investors with large embedded unrealized capital gains liabilities. For the decade ending December 31, 2003, Fidelity's actively managed Magellan Fund averaged a hefty 4.7 percent in long-term capital gains distributions, whereas Vanguard's tax-efficient 500 Index Fund averaged only 0.6 percent.

7. Alternative Vehicles and Structures

Exchange-traded funds and not-for-profit structures offer low-cost, tax-efficient alternatives to for-profit mutual funds.

Exchange-Traded Funds

Exchange-traded funds combine the benefits of index funds with the ability to trade like stocks. The industry began on January 22, 1993, with State Street's SPDR tracking the S&P 500.

State Street's Spider grew from an initial capitalization of $6.6 million in 1993 to $43.8 billion by December 31, 2003. Total market value of all exchange-traded funds reached $157.4 billion on December 31, 2003.

ETFs achieve superior tax efficiency because in-kind redemption mechanisms minimize taxable capital gains distributions. Over the ten-year period ending December 31, 2002, regular open-end S&P 500 Index Funds averaged an annual capital gains distribution of 1.87 percent of assets, compared to 0.01 percent for the Spider ETF.

Out of 135 exchange-traded fund issues traded on U.S. exchanges as of January 2004, only 14 provided broadly diversified core asset exposure. Barclays charged 0.09 percent for a market-capitalization-weighted S&P 500 ETF, whereas Rydex charged 0.40 percent for an equal-weighted S&P 500 ETF.

Brokerage fees can severely erode returns on small ETF transactions. In August 2004, when the average price of SPY was $109, Merrill Lynch charged $206.79 for trading 100 shares and $687.53 for 500 shares. Ameritrade charged $10.99 for 100 or 1000 shares.

You should protect your portfolio by following simple rules:

• Evaluate every statement from a broker with unabashed skepticism.
• Avoid paying high levels of profitable-to-the-broker fees.
• Avoid executing large numbers of profitable-to-the-broker transactions.
• Avoid full-service brokerage firms and execute trades through low-cost, execution-only brokers.

Not-for-Profit Structures

Not-for-profit organizations like Vanguard and TIAA-CREF provide a safe harbor by focusing entirely on low-cost products. TIAA was founded in 1918, and started CREF in 1952 as the world's first variable annuity to combat post-World War II inflation.

Economic theory fails in index fund management as for-profit firms charge exorbitant fees for a commodity. A Morningstar study found non-Vanguard index managers charging an average yearly expense ratio of 0.82 percent, with Vanguard charging 0.18 percent for S&P 500 index funds.

High-cost index funds reached $57 billion in assets under management, with maximum fees stretching to 2.18 percent. Morgan Stanley conducted 29 prohibited sales contests between October 1999 and December 2002, offering rock concert tickets, NBA finals tickets, and racing school tuition to promote its own mutual funds.

10 Key Ideas

1. Your investment results are overwhelmingly determined by asset allocation rather than market timing or security selection.
2. Sensible portfolios rely on six core asset classes that provide broad market exposure, equity orientation, and tax sensitivity.
3. Effective diversification requires every asset class to be large enough to matter but small enough not to dominate.
4. Long-term investors should maintain a pronounced equity bias because equities consistently outperform bonds and cash over extended holding periods.
5. As an investor's time horizon shortens, risk exposure should be reduced by shifting from a risky portfolio to riskless cash.
6. Sensible investors must act against market consensus by maintaining strict fidelity to asset-allocation targets and regularly rebalancing.
7. Active mutual funds operate as a negative-sum game where high fees, turnover, and taxes drag down investor returns.
8. High portfolio turnover in taxable accounts triggers realized capital gains that destroy a substantial portion of your wealth through avoidable tax liabilities.
9. Exchange-traded funds combine the benefits of index funds with the ability to trade like stocks while offering superior tax efficiency.
10. Not-for-profit organizations like Vanguard and TIAA-CREF provide a safe harbor by focusing entirely on low-cost products.