Book Review: Pioneering Portfolio Management

This book by David F. Swensen, Chief Investment Officer and manager of Yale’s endowment, contains some of the driest prose I have ever encountered. However, the content is solid, comprehensive, well-informed, and backed up by Swensen’s years of success as well as his research into the history of a variety of markets.

Swensen reminded me that markets lacking liquidity and frequent pricing (like the real estate market) are fertile ground for inefficiencies that present lucrative investment opportunities.

He had the following to say about Wall Street Research:

Wall Street research suffers from a number of significant problems: it comes from conflicted sources, tends to represent consensus positions, and enjoys wide distribution...Reports circulate widely as investment banks attempt to gain the largest advantage possible. The wider the distribution of information, the less value it has, as the implications of the report become incorporated into security prices in short order.

I had also discussed this previously in Transcendental Generalization:

...I have learned not to trust analysts. It is not that they are stupid, but they are highly motivated to publicize their reports, which the market responds to quickly.

One of the most interesting things Swensen does is compare high-risk private funds (e.g. leveraged buyout funds) with lower-risk equity index funds. For an apples-to-apples comparison, he normalizes the amount of leverage, concluding that a similarly leveraged investment in the S&P 500 beats the performance of buyout funds by nearly 40% annually. This is despite a couple of biases in the data favoring buyout funds, and doesn’t include management fees that such funds charge. This suggests that superior returns are available to the average investor, and not just to the wealthy who can invest in leveraged buyouts.

The book is (naturally) written from the perspective of the institutional investor. Hence, it includes chapters on choosing, negotiating with, and managing people and companies to invest your money. However, there is also a wealth of guidance for investors managing their own money.

Swensen eloquently discredits the efficient-market hypothesis by referring to the work of a fellow Yale professor:

Yale economist Robert Shiller argues that markets exhibit excess volatility. That is, security prices tend to fluctuate more than necessary to respond to the fundamental factors, such as earnings and interest rates, that determine intrinsic value. In other words, "if price movements were rescaled down...so as to be less variable, then price would do a better job of forecasting fundamentals." Shiller's self-described "controversial claim" provides "evidence of a failure of the efficient markets model." Anyone attempting to understand October 1987's market crash from a fundamental perspective sees merit in Shiller's position.

He also makes what I consider to be a critical distinction between volatility and risk, a distinction that is frequently neglected by economists and investors:

Under some circumstances, following a significant decline in price, an asset actually becomes less risky, since it can be acquired more cheaply. The common-sense conclusion of bottom-fishing invstors contrasts with the statistician's conclusion that a dramatic drop in price increases observed (historical) volatility, implying a higher risk level for the asset.

Tags: Business, Reading

Updated at: 16 January 2006 12:01 AM

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