Book Review: Unconventional Success by David F. Swensen

David Swensen is no stranger to the institutional investment community. He has famously managed the Yale University endowment fund since 1985, achieving annualized returns of 17.8% per year over the last decade. His investment approach, commonly referred to as The Yale Model, is an application in the extreme of modern portfolio theory and was (and still is) an extremely unconventional approach to asset management. In his recent book Unconventional Success: A Fundamental Approach to Personal Investment, Swensen outlines how his unique investment approach can be implemented by the small individual investor and delivers a scathing critique of the for-profit mutual fund industry. The books is divided into three parts, although the bulk of the substance is concentrated in the first and third sections.

Part One: Asset Allocation

Swensen divides the investment universe into core and non-core asset classes. According to Swensen, core asset classes should comprise the vast majority of your investment portfolio. The attributes of a core asset classes include:

• Rely fundamentally on market-generated returns - Core asset class returns derive directly from the fundamental nature of the asset class itself and not on superior investment accumen. Truely gifted investment managers are rare and should not be relied upon. Swensen strongly endorses index funds and ETFs.
• Contribute basic, valuable, differentiable characteristics to a portfolio – Core asset classes promise substantial expected returns relative to their risk characterisitcs as well as offer protection against inflation and financial crises.
• Derive from broad, deep investable markets – Core asset classes possess enough liquidity to ensure an efficient pricing mechanism and guarantee that long-term asset prices do not deviate much from intrinsic economic value.

The six core asset classes identified by Swensen are domestic equities, foreign developed-market equities, emerging market equities, real estate, U.S. Treasury Bonds, and U.S. Treasury Inflation-protected Securities (TIPS). All other asset classes are deemed to be non-core asset classes and thus should not be owned by most investors. Popular non-core asset classes include commodities, corporate bonds, high-yield corporate bonds (or junk bonds), hedge funds, and foreign government bonds. Swensen goes into intimate detail on each non-core asset class and describes his logic for excluding them from his investment approach. He also gives a generic starting point to help construct your portfolio using the six core asset classes.

Part Two: Market Timing

In part two, Swensen examines investors’ bad behaviour chasing performance during the internet bubble. Needless to say, performance-chasing by the investing public reached a fevered pitch in the late 90’s, contributing to the ultimate destruction of billions upon billions of dollars of wealth. Mutual fund companies don’t escape their fair share of the blame, however. Swensen tracks the pattern of mutual fund advertising, revealing it to convey exactly the wrong message to investors, showing uncanny bad timing in touting asset classes just as they are about to fall and eschewing others just as they are about to rise. Investors tempted to constantly change in and out of various asset classes in response to short-term market events will get a lot out of this section.

Part Three: Security Selection

This section is a scathing review by Swensen of the for-profit mutual fund industry. It is, according to Swensen, a complete and total failure, full of greedy for-profit entities who consistently put their own profits ahead of the best interests of their investors. Swensen outlines many obvious sources of mutual-fund failure such as 12b-1 fees, high management fees, asset bloat, sales loads, portfolio churn and the link but also pays close attention to some hidden causes of poor mutual-fund performance such as the shameful practice of accepting soft-dollar kickbacks, the pay-to-play system, stale-price trading, market timing, and other odius practices which line the profits of mutual fund companies at investors’ expense. Some of these issues I knew about, some I was aware of but didn’t know many details, and others I had no idea even existed. Swensen describes these abuses with just moral outrage you can’t help but feel a growing sense of anger at how investors, and perhaps you yourself, have been so throughly fleeced in the past without even knowing it. Swensen passionately argues in favor of low-cost, broadly diversified index funds and ETFs.

Unconventional Success: A Fundamental Approach to Personal Investment is a well-written, persuasive treatise in favor of modern portfolio theory and deserves a place in every investor’s investment library. While my portfolio more or less corresponds with Swensen’s teachings already, I did pick up a few interesting ideas from this book I may end up implementing. For instance, I’m toying with the idea of upping my REIT allocation to 20% from its current 10%, perhaps by eliminating my Large-cap value allocation. The information in this book just might motivate you to make equally significant tweaks to your portfolio.

Buy Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen from Amazon.