RWM Insights

Yale’s Investor Keeps Playbook

An excerpt from an interview with Yale endowment CIO, David Swensen is outlined below. The entire article can be reviewed by following this link; http://biz.yahoo.com/wallstreet/090113/sb123180744823875647_id.html?.v=7

He isn’t a household name. But as the Yale University’s endowment’s chief investment officer for two decades, has earned a reputation as one of the world’s savviest and most successful investors. Yet even Yale hasn’t escaped the financial crisis.

The university estimated late last month that the endowment had lost 25% of its value since the end of June. That is expected to lead to budget cuts and puts Mr. Swensen in line for his first negative fiscal year since 1988. Other endowments that have set out to follow the strategy he has advocated are also suffering.

He spoke to The Wall Street Journal about the financial crisis, hedge funds, scandal-scarred money manager, and ill-fated efforts to mimic Yale’s investment strategy. Here are questions and his answers, edited for context and clarity.

WSJ: Does the poor performance of most assets last year suggest you need to tinker with the endowment’s portfolio to better withstand another year like 2008?

Mr. Swensen: I don’t think it makes sense for an institutional investor with as long an investment horizon as Yale’s to structure a portfolio to perform well in a period of financial crisis. That would require moving away from equity-oriented investments that have served institutions with long time horizons well.

Craig Karmin WallStreet Journal Tuesday January 13, 12:52 pm ET

Were the Experts Helpful?

The collapse in stock prices last year spared no one as share prices fell around the world. All 47 markets tracked by MSCI lost ground, with 23 countries experiencing losses in excess of 50% (total return measured in dollar terms). The US finished 7th, with a total return of −37.6%.

Among the ten largest firms in the S&P 500® Index at year-end 2007, there was a wide range of outcomes for 2008: Bank of America and General Electric significantly underperformed the market, with price declines of −65.9% and −56.3%, respectively; while Johnson & Johnson shares fell only 10.3% and Wal- Mart rose 17.9%. Other prominent firms experiencing dramatic losses included American International Group (−97.3%), Citigroup (−77.2%), Fannie Mae (−98.1%), Merrill Lynch (−77.6%), and Wachovia (−85.4%). Since all these firms are constituents of a market portfolio, the easiest way to outperform the market in 2008 was to avoid or underweight these big losers.

It seems plausible that last year’s financial meltdown was so extensive and so welladvertised that investment experts would have found it relatively easy to outperform the broad market by selecting the right stocks or sectors. But a review of several widely read sources of advice suggests that, in at least one respect, there was nothing unusual about 2008: it was just as hard as ever to outperform the market.

A few samples from the “where to invest now” articles we were reading a year ago:

  • For its annual “Where to Invest” issue, SmartMoney scoured the globe for appealing opportunities and identified a dozen companies “likely to increase profits in a world filled with trouble spots.”Outcome: From the recommendation date of November 2, 2007 through December 31, 2008, the average share price decline of the twelve named stocks was 52.4%, compared to a drop of 40.2% for the S&P 500® Index and 35.4% for the Dow Jones Industrial Average. Performance varied widely: Wells Fargo (WFC) shares declined 8.8%, while Genworth Financial (GNW) plummeted 88.9%.
    Pearlman, Russell. “Where to Invest 2008.” SmartMoney, January 2008.
  • A prominent money manager and self-described “contrarian” investor wrote in a January 2008 Forbes column: “You have to choose carefully here, since many financial stocks will not come back for a long time, if ever. . . . The safest plays are among the big banks.”Outcome: Prices for the seven financial stocks mentioned in the column, including Citigroup, Freddie Mac, and Wachovia, declined an average of 74.0% in 2008. Dreman, David. “Seize the Day.”
    Forbes, January 8, 2008. Wall Street Journal, New York Stock Exchange 2008 Trading Summary, January 2, 2009.
  • A money manager who applied detailed quantitative analysis to successfully predict the crash of 1987 was expecting a gain of 20% for the S&P 500® in 2008: “Our models show the S&P 500 is undervalued by 25%…Our indicators are extremely bullish.”Outcome: Disappointment.
    Tergesen, Anne. “What the Pros Are Saying.”
    Business Week, December 31, 2007.
  • A veteran market analyst favored “pockets of value,” including stocks which had been “excessively punished” in the subprime-related meltdown: Nordstrom, Tiffany, J. Crew, and his favorite, American International Group.Outcome: Company Price Change 2008
    American International Group (AIG) −97.3%
    J. Crew Group (JCW) −74.7%
    Nordstrom (JWN) −63.8%
    Tiffany & Co. (TIF) −48.7%
    Tergesen, Anne. “What the Pros Are Saying.” Business Week, December 31, 2007.
    Wall Street Journal, New York Stock Exchange 2008 Trading Summary, January 2, 2009.
  • Nvidia was featured in a “Company of the Year” cover story by Forbes, which reported that the firm’s sophisticated graphics chips, the brains inside popular products such as the Sony PS3 game console, were finding new applications in science and industry.Outcome: Nvidia shares fell 76.3% in 2008.
    Caulfield, Brian. “Shoot to Kill.” Forbes, January 7, 2008. Wall Street Journal, New York Stock Exchange 2008 Trading Summary, January 2, 2009.
  • A successful former hedge fund manager and globetrotting author argued correctly a year ago that a recession in the US was already underway. He was bullish on commodities (“the commodities bull market still has years to go”) and China (“there are gigantic opportunities in China and gigantic changes taking place there.”)Outcome: The Dow Jones-AIG Commodity Index declined 37% in 2008, the worst year since its inception in 1998, and total return for the S&P GSCI® Index was −46.49%. China ranked 26th among 47 world stock markets tracked by MSCI, with a total return of −50.83%. In fairness to the forecaster, he was making a long-term recommendation, not a prediction for the next twelve months. Investors who overweighted their portfolios in 2008 with commodities or Chinese stocks are hoping he’s right.
    Barclays Global Investors. Ishares.com, accessed January 7, 2009. Cui, Carolyn. “Commodities: Great—Then Ugly.” Wall Street Journal, January 2, 2009. O’Keefe, Brian. “Hog Wild for China.” Fortune, December 24, 2007.
  • The cover of Fortune’s Investment Guide 2008 issue offered a teaser: “Five Must-Have Foreign Stocks.” With thousands of stocks to choose from throughout the world, imagine how rewarding it could be to identify a handful of the best-positioned companies. After consulting with “top foreign fund managers and analysts,” Fortune settled on the following picks:
    • Bank of Ireland, IRE (“dirt cheap,” 7% dividend yield).
    • The iShares Brazil Index, EWZ (“only Egypt has done better over the past five years”).
    • Mobile Telesystems, MBT (“more cell phone subscribers than AT&T”).
    • Potash Corp. of Saskatchewan, POT (“earnings to soar more than 50%”).
    • GlaxoSmithKline, GSX (“strong cash flow, rich dividend yield”).
      Outcome: Bank of Ireland eliminated its dividend amid rising loan losses. Brazil finished 36th out of 47 world stock markets tracked by MSCI. Shares of Mobile Telesystems couldn’t escape the collapse in Russian stock prices. Potash Corp. shares fall along with fertilizer prices. GlaxoSmithKline performed relatively well. The average price decline in 2008 for the five recommendations was −59.5%, compared to a loss of 45.2% for the MSCI All-Country World Index.
      Bank of Ireland. Bankofireland.com, accessed January 7, 2009.
      MSCI. Mscibarra.com, accessed January 5, 2009.
      Rosenberg, Yuval. “Harvesting the Top Foreign Stocks.” Fortune, December 24, 2007.
      Wall Street Journal, New York Stock Exchange 2008 Trading Summary, January 2, 2009.

Our take: If stock picking didn’t work in 2008, when will it work?

Weston Wellington
Vice President, Dimensional Fund Advisors

Comment from Dennis Gogarty,
President of Raffa Wealth Management
2008 has been a year unlike anything most of us have seen in our lifetimes. Investors all around the world are faced with the realty that decisions must be made in the face of uncertainty. I suggest focusing on what we can control. Specifically, the level of risk we’ll allow in our portfolios and the expenses we’ll incur in achieving the asset allocation that matches this level of risk. The reality today, and always, is that we don’t know what’s going to happen next week, next quarter or next year. We do know, however, that risk and return are directly related and that expenses directly detract from bottom line results. When it comes to investing simple is good – design an allocation strategy based on risk and keep expenses to a minimum.

Black Monday

Stock prices sank sharply on Monday in the wake of Lehman Brothers’ bankruptcy
announcement over the weekend. Other firms perceived to have credit-related
worries sank sharply as well: shares of insurance giant AIG fell 60.8%, Washington
Mutual was down 26.7%, and Citigroup lost 15.1%. Among the thirty Dow Industrial
component issues, only Coca-Cola managed to eke out a gain, closing up 25
cents for the day.

The S&P 500® Index fell 4.71%, its largest one-day percentage
loss since September 17, 2001 when the Index fell 4.92% following a four-day
trading suspension. Ranked by magnitude of one-day losses for the S&P
500® Index, Monday’s decline ranks fourteenth among all trading sessions
since January 1950. Although some market breaks are still fixed in our memory,
others have faded from view. We suspect few non-professionals can recall
what the news background was when stock prices plunged on October 27, 1997;
January 8, 1988; or September 11, 1986.

Rank Date S&P
500®Close
Change
vs. Prev Close
1October 19, 1987224.84-20.47%
2October 26, 1987227.67-8.28%
3October 27, 1997876.99-6.87%
4August 31, 1998957.28-6.80%
5January 8, 1988243.40-6.77%
6May 28, 196255.50-6.68%
7September 26, 195542.61-6.62%
8October 13, 1989333.65-3.12%
9April 14, 20001,356.56-5.83%
10June 26, 195018.11-5.38%
11October 16, 1987282.70-5.16%
12September 17, 20011,038.77-4.92%
13September 11, 1986235.18-4.81%
14September 15, 20081,192.70-4.71%

The S&P data are provided by Standard & Poor’s Index Services Group.

Financial journalists will undoubtedly be scribbling energetically in the
coming weeks to offer anxious investors an explanation for “what it all means.” A
sample appears in the most recent issue of Forbes, where three prominent
investment professionals offer their views of the future: one is quite bullish,
one is quite bearish, and the third is cautious but hopeful. Each offers
compelling evidence to make their case. Forbes editors helpfully
place each column on consecutive pages, making it easy for readers to determine
which pundit is promoting views most similar to their own. The only investors
likely to improve their portfolio results by reading such observations are
those who were not properly diversified to begin with and become motivated
to take action. The world is an uncertain place, and sharp fluctuations in
asset prices reflect that uncertainty.

History offers abundant evidence that market economies are resilient. The
world will find a way to manage its financial affairs without the advice
of Lehman Brothers, and the residential mortgage loan will survive even if
Fannie Mae does not. The key issue for investors is to make sure their financial
future does not get derailed by events at a handful of firms, and that their
portfolios are properly positioned to capture all the rewards the markets
have to offer when the next up cycle begins. Recent events have provided
an unusually harsh lesson of the importance of diversification. In a matter
of days, shareholders of three financial giants—Fannie Mae, Freddie
Mac, and Lehman Brothers Holdings—have seen their shares plunge into
the penny-stock category. A fourth, American International Group, is scrambling
for survival. For well-diversified investors, the financial damage associated
with these four firms has been minor; in aggregate, they represented less
than 1% of a diversified US equity portfolio on May 31, 2008, and even less
for a global strategy.1 Four
or five years from now, these investors may have a difficult time remembering
what happened and when.

However, for those with concentrated positions, especially employees with
large holdings of company stock, these events are a financial tornado inflicting
potentially irreparable damage. One business owner cited by the Wall
Street Journal
recently purchased 25,000 shares of Freddie Mac at roughly
$5 and lost most of his investment in a matter of days. Ironically, he claimed
to be through with day-trading strategies, and was seeking a profitable long-term
investment. Elsewhere, the Wall Street Journal estimated that the
24,000 employees of Lehman Brothers have seen $10 billion in personal wealth
evaporate as the value of Lehman shares collapsed. Many long-time employees
of Fannie Mae or Freddie Mac have experienced similarly catastrophic losses.
When times are good, the risk of a concentrated portfolio often appears extremely
remote. In March 2006, Fannie Mae was once characterized by Money magazine
as “America’s Safest Stock,” with a bulletproof business model that was “as
close as you’ll get to an invincible earnings machine.”

Events of 2008 demonstrate the importance of getting a few big issues right – namely
diversification and balance.  We expect that patience will prove critical
as well.

1Weights
for the US Core Equity
1 Portfolio
as of May 31, 2008 are used.

Bajaj, Vikas, Bajaj and Tara Bernard. “Worker Assets Shrink at Fannie and
Freddie.” New York Times, August 29, 2008.

Birger, Jon Birger. “The Rock.” Money, December 2001.

Dreman, David. Dreman. “Get Ready for Rising Prices.” Forbes, September
29, 2008.

Fisher, Ken Fisher. “The Unbubble.” Forbes, September 29, 2008.

Karmin, Craig Karmin. “Small Fannie, Freddie Holders Take Issue With Washington.” Wall
Street Journal,
September 12, 2008.

Karnitschnig, Matthew, Karnitschnig, Lian Leven, and Serena Ng. “AIG Faces
Cash Crisis As Stock Dives 61%.” Wall Street Journal, September
16, 2008.

Shilling, A. Gary Shilling. “Worse Is Yet to Come.” Forbes, September
29, 2008.

Smith, Randall, Smith and Susanne Craig. “The Lehman Stock Slide Hits Home.” Wall
Street Journal,
September 12, 2008.

Yahoo! Inc. Yahoo! Finance. In www.yahoo.com, accessed September
15, 2008.

Is It Different This Time?

As stock prices have slumped around the world over the past year, investors have been confronted with a barrage of grim news—falling home prices, rising costs for food and fuel, and worries over the fragile health of the banking system. Some have concluded that the current state of affairs bears little resemblance to the past and are questioning the wisdom of maintaining consistent exposure to equities at all.

We don’t know what the future for this business cycle looks like, but we do know that on many occasions in the past, investors were confronted with “unprecedented” events that tested their willingness to maintain a diversified approach. A few examples:
“On Wall Street, the most unnerving stock market reports since the Depression 1930s became daily more dismal.”
– Time, “The Economy: Crisis of Confidence,” June 1, 1970.

“Fed up with rising food prices, thousands of women took to the streets in protest. . . . [President Nixon] announced that ceilings were being imposed on prices of beef, pork and lamb.”
– Time, “Changing Farm Policy to Cut Food Prices,” April 9, 1973.

“The only way that the US can scrape through the next several years without major economic and social disruptions is to ease off dramatically on energy consumption.”
– Time, “The Arabs’ New Oil Squeeze: Dimouts, Slowdowns, Chills,” November 19, 1973.

“There have been multiplying signs that the long American romance with the big car may finally be ending. . . . Economists generally are agreed that the era of readily abundant fuel has ended for good.”
– Time, “The Painful Change to Thinking Small,” December 31, 1973.

“Investors have been frightened of an economy that seems out of control. . . . The stock market has scarcely been so shaky since 1929. . . . A Gallup poll published last month found that 46% of adults feared a depression similar to the classic one of the 1930s.”
– Time, “Seeking Relief from a Massive Migraine,” September 9, 1974.

“The woes of inflation and stagnation have touched nearly every American, but while some people are only slightly bruised, others feel as if they have gone ten rounds with George Foreman and are down for the count. . . . Pawnbrokers are gaining from once affluent people who have lost their jobs and are trying to get anything that they can out of jewelry or expensive cameras or appliances.”
– Time, “Who Is Hurting and Who Is Not,” October 14, 1974.

“Financial markets at home and abroad have been devastated in recent weeks as frantic traders and investors scrambled to come to grips with the anti-inflation policies of the Carter Administration and the Federal Reserve Board. . . . After a nervous September, Wall Street succumbed to despair, and the stock market was bloodied by what is being called the October massacre.”
John M. Lee, “Tumult in the Markets,” New York Times, November 6, 1978.

“Fortunes were conjured out of thin air by fresh-faced traders who created nothing more than paper.”
Walter Isaacson, “After the Fall,” Time, November 2, 1987.

“The next recession won’t look like any that has preceded it in recent decades. . . . We are so heavily indebted that a slump would quickly turn into a Latin American-style depression.”
Ashby Bladen, “Borrowing to the Bitter End,” Forbes, September 4, 1989.

“Chase Manhattan, the second largest US bank, is letting go 5,000 employees, or 12% of its work force, in a struggle to remain solvent. . . . The construction industry has creaked to a virtual halt after a decade of overbuilding. . . . From stock markets to supermarkets, high anxiety rules the day. . . . Now the specter of war, rapacious oil prices, and a far-reaching recession haunts political and business leaders everywhere. . . . The banks are basically pushing panic buttons everywhere.”
“I want to say we’re in a recession, but that’s not a strong enough word. In some regions, it’s a depression.”
John Greenwald, “All Shook Up,” Time, October 15, 1990. Final quotation attributed to William Hensler, chief executive, Wickes Lumber.

“Imagine every office building in Manhattan empty, a commercial ghost town. Now double it. That’s how much vacant office space—500 million square feet—there is in the United States today. Behind much of that empty office space stands the nation’s banking system. . . . The worry today is that the real estate recession, which is spreading nationally, could severely weaken the banking system, pulling down many smaller banks and a few big ones as well. . . . ‘Our real estate market is as bad as we’ve had since the 1930s,’ said Leo Spang, a Boston banker and president of the Real Estate Finance Association, a trade group.”
Steve Lohr, “Banking’s Real Estate Miseries,” New York Times, January 13, 1991.

“Falling real estate prices and the fragile state of the banking system make this recession unlike any other and extremely difficult to forecast.”
John R. Dorfman, “First Boston’s Bear, Carmine Grigoli, Refuses to Stop Growling Despite Stocks’ Big Rally,” Wall Street Journal, February 7, 1991. Quotation attributed to Carmine Grigoli, chief investment strategist, First Boston Corp.
“The nation’s top auditor said today that many more banks were effectively bankrupt than regulators had recognized. . . . ‘The bank insurance fund is nearly insolvent, and I cannot overemphasize how important it is to restore it as quickly as possible,’ Mr. Bowsher [Comptroller General] told the Senate Banking Committee.”
Stephen Labaton, “Bank Deposit Fund Nearly Insolvent, US Auditor Says,” New York Times, April 27, 1991.

“We’re going into one of those long periods where the market does nothing except consolidate this huge move up we’ve had. Dow 4000 is going to be with us for a long time.”
Daniel Kadlec, “Will Weary Legs End 20-Year Bull Ride?” USA Today, December 6, 1994. Quotation attributed to Seth Glickenhaus, senior partner, Glickenhaus & Co.

“This economic convulsion is unprecedented in the post-World War II era.”
Robert J. Samuelson, “A World Meltdown?” Newsweek September 7, 1998

“This time it is different. This time the market won’t be so quick to bounce back. . . . Who can look at the world right now and not conclude that things have changed dramatically?”
Joseph Nocera, “Requiem for the Bull,” Fortune, September 28, 1998.

“Wall Street stocks have plunged—Merrill Lynch down 59%, Morgan Stanley down 59%, and Lehman Brothers down 67%. . . . The real problem is with the risks that are unquantifiable.”
Bethany McLean, “Can the Brokerage Stocks Come Back?” Fortune, October 26, 1998.

“Investor nervousness pushed stock prices lower yesterday and sent signals of distress through the corporate bond market. . . . Many companies are overloaded with debt at a time of slowing economic growth. Among the stocks leading the decline yesterday were those of companies sensitive to the business cycle. . . . A Morgan Stanley index of 30 of these stocks plunged 4.7 percent yesterday, reflecting the worry that the economy may be headed for another recession.”
Jonathan Fuerbringer, “Negative News from Some Blue Chips Takes Heavy Toll,” New York Times, October 10, 2002. [Note: major US stock market indexes registered multi-year lows on October 9, 2002.]

Investing is like Dieting

This May, at the Berkshire Hathaway annual meeting, Warren Buffett boiled down what it means to be an intelligent investor into two startling sentences: “If a stock [I own] goes down 50%, I’d look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month.” Knowing he owns good businesses, Mr. Buffett wants prices to go down, not up, so he can buy even more shares more cheaply before they bounce back.

In the last long bear market, 1969 to 1982, stocks returned just 5.6% annually; after inflation, investors lost more than 2% a year. That mauling by the bear made stocks so inexpensive that over the ensuing 18 years they went up 18.5% a year, enough to turn $10,000 into more than $200,000. The renowned investor Benjamin Graham once wrote that “the investor’s chief problem — and even his worst enemy — is likely to be himself.” Equity markets are chaotic and the reason we expect the risk premium is that there are periods of extreme volatility.

For, as Mr. Buffett has also pointed out, investing is much like dieting: it is simple, but not easy. Everyone knows what it takes to lose weight. (Eat less, exercise more.) Nothing could be simpler, but few things are harder in a world full of chocolate cake and Cheetos. Likewise, investing is simple: diversify, buy and hold, rebalance and keep costs low. But simple isn’t easy in an environment that has seen extreme volatility as a result of skyrocketing oil prices, shaky lending practices and faltering investment banks. The real secret to being, or becoming, an intelligent investor is bolstering your self-control.

Nonprofits face unique challenges which greatly complicate matters.  Most long term reserves operate within an indefinite or uncertain time frame.  Furthermore, additional funds are often not available to buy additional securities as prices fall – as they are in 401k plans or other savings plans.  Accordingly, intelligent nonprofit investing must be matched with clear expectations and a thorough understanding of the organization’s cash flow requirements and tolerance for losses in the short term.  A well drafted investment policy should provide direction and minimize emotionally driven decision making.  A formal rebalancing policy should dictate the systematic process of selling high and buying lower.