This book outlines how institutions can approach endowment and investment management.
There is an examination of different asset classes and a description of various approaches to portfolio management.
You may be wondering if you should read the book. This book review will tell you what important lessons you can learn from this book so you can decide if it is worth your time.
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Lesson 1: Diversify your portfolio by mixing different assets in different proportions
When allocating assets, an investor must use both his or her judgment and rigorous quantitative analysis. Before you can start building your portfolio, you must first decide on your asset classes.
Too often, investors choose which assets to invest in based on how other investors allocate their assets.
By following the crowd in this manner, you will obtain a noncontroversial portfolio that will not be tailored to the specific needs of your institution.
How can you allocate your assets so that they truly benefit your organization? Institutional investors’ portfolios typically include domestic, foreign, and private equities, as well as real assets. The reason for this is that these assets typically provide returns comparable to equity investments.
Furthermore, institutional investors will need to consider how to mitigate the risks associated with certain asset classes. A well-diversified portfolio holds each asset class in an amount that balances its risks and potential gains.
How many asset classes should your portfolio contain?
Although investors disagree on the precise figure, there are some sound guidelines to follow. You should not allocate less than 5 to 10% of your fund to any one asset type. Why is this so? Because the allocation is insufficient to affect total returns.
Investing more than 25% of your portfolio in any one asset class is also a bad idea because it can lead to overconcentration. A typical institutional portfolio works well with six asset classes on average.
What should asset classes be called? There are distinctions between asset classes, such as debt versus equity, liquid versus illiquid, and sensitivity to inflation versus deflation.
However, not all assets can be divided into distinct categories. Fixed-income assets are frequently used by investors as a hedge against fiscal risks. Some fixed-income assets, however, are unable to play this role.
Below-grade investment bonds, unlike junk bonds, have equity-like risks despite being technically fixed-income assets from a legal standpoint. It is useful to compare how two assets respond to the same critical variable to determine whether they belong in the same class.
Unexpected inflation, for example, causes the value of traditional fixed-income assets to fall.
Inflation-indexed bonds, on the other hand, gain value when inflation occurs. As a result, they are classified differently.
Lesson 2: Traditional asset classes depend on market returns
When we define asset classes, we are attempting to group investments that are similar so that we can create a fairly uniform collection of investments. The goal of this section is to explain what we mean by traditional asset classes.
Traditional asset classes share several key characteristics.
To begin, they rely on market returns rather than active portfolio management returns. As a result, they frequently deliver substantial, consistent returns, giving their managers confidence that their portfolio is carrying out its institutional mission.
A traditional asset class trades in both broad and deep markets. This means that potential investors have a diverse set of options in well-established, resilient markets.
One type of traditional asset class is domestic equity.
Investing in domestic equity, also known as stocks, allows you to own a piece of a US corporation. Domestic equities will account for a sizable portion of institutional investors’ portfolios. This is a good thing.
Equities provide institutions with an expected return that corresponds to their needs for long-term portfolio growth.
According to studies, domestic equity has the best long-term performance record of any asset class. Over the last 200 years, earnings on American stocks have averaged more than 8%.
The primary benefit of stock ownership is that there is usually harmony between the interests of shareholders and the management of the company in which the stocks are held. The reason for this is that managers generally benefit from increased shareholder value.
When a company’s profitability improves, corporate executives typically receive financial incentives. For example, when a company’s profitability improves, shareholders benefit.
Domestic equity, in the form of American stocks, theoretically protects your portfolio against price inflation. As a result, any inflation should be reflected in higher stock prices, and the value of your portfolio should rise as well.
However, when it comes to incorporating inflation into equity prices, the stock market has a mixed record. In the early 1970s, for example, inflation reduced American purchasing power by 37%. Instead of increasing in value, stock prices fell by 22%. When adjusted for inflation, investors lost 51% of their money.
As a result, economists have concluded that stocks are an excellent long-term hedge against inflation, but offer little protection against rising prices in the short run.
Lesson 3: It takes excellent judgment to invest in alternative assets
If you are willing to accept some risk, alternative asset classes such as real estate and private equity can provide higher returns.
They also provide a certain level of return while reducing risk. When you include alternative asset classes in your portfolio, you become less reliant on marketable assets and domestic equity. As a result, your portfolio becomes more diverse.
Furthermore, alternative assets are frequently priced more efficiently than traditional assets, which means that investment managers with sound judgment and knowledge of specific markets can significantly increase the value of their portfolios.
To achieve this, you must actively manage your portfolio.
Consider one type of investment related to alternative asset classes: absolute return.
An absolute return strategy includes investing in marketable securities that take advantage of inefficiencies. Positions in these areas are unlikely to correlate with traditional stocks or bonds. This is a dangerous strategy. Absolute return managers, on the other hand, can mitigate this risk.
For example, they monitor current events and attempt to forecast their impact on financial markets. It could be anything from a corporate merger to a recent bankruptcy.
Because the legal and regulatory environment around the merged or bankrupted companies has temporarily changed, it is common for events like these to create opportunities for investors to buy attractive securities at a good price.
These changes are known to event-driven investors, and they understand how they will affect the valuation of the relevant securities.
Investors who are driven by events benefit from a lack of understanding about how financial events such as mergers and bankruptcy affect the value of their securities.
When uninformed investors learn of a merger or other financial event, they sell their securities in that company. When it comes to securities from bankrupt companies, investors are frequently willing to sell them almost at any price.
As a result, the market has a large supply of distressed securities that can be purchased cheaply and with attractive return prospects by astute event-driven investors.
Although event-driven investment strategies provide these opportunities, they cannot completely protect investors from market shifts.
In some cases, an investor may be in an unprofitable position if a merger that they assumed would take place does not take place.
Lesson 4: Portfolio governance requires a careful balance of oversight and autonomy
Good governance is required for the development of a solid and well-structured investment portfolio. This type of governance yields an institution-appropriate portfolio, and the process should result in effective market timing and meaningful relationships with investors.
One of the first decisions an institution must make is whether to use active or passive investment management policies for portfolios.
Choosing an active management strategy is not without risk. The institution, in particular, needs to identify active managers with the necessary skills, knowledge, and instincts.
Furthermore, active management generally necessitates the institution committing significant resources to its portfolio.
The outcome of attempting to pursue an active strategy without the necessary support and capabilities is frequently disappointing.
If a company lacks the resources to make active management work, it may opt for passive management. This reduces the risk of your portfolio and makes it a more hands-off, stripped-down venture.
In any case, regardless of which path an institution takes, its portfolio must be managed by two groups, not just one.
The first group you’ll need is an investment committee. This committee, similar to a board of directors, is in charge of the overall strategy of the portfolio.
The senior team carefully examines the investment recommendations made by the second group of managers, the investment team. They make decisions on issues such as asset allocation and spending policy.
They also make compelling arguments for these decisions in front of the committee. Investing personnel must be able to establish a solid intellectual foundation for their recommendations. Without this foundation, investment decisions may be haphazard or uninformed.
It is critical to think about how you want your investment management teams to approach governance. Investment departments present a unique challenge because one group, the investment committee, monitors the activities of another, the investment staff.
Group-based approaches can often encourage groupthink, which can be problematic. In this situation, group members engage in consensus-building too quickly, resulting in everyone reaching the same conclusions on every issue.
A good governance process takes this tendency toward groupthink into account and encourages independent thinking and contrarian attitudes among the investment team.
About the Author
David F. Swensen was an American investor, philanthropist, and endowment fund manager. He was Yale’s Chief Investment Officer for over three decades.
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