Summary of the book "Pioneering Portfolio Management" - By David F. Swensen

Key concepts in this book:

1. Endowments assist institutions in maintaining their autonomy.
2. Institutions must think about both the immediate and long future.
3. Three fundamental instruments should be part of your financial philosophy.
4. Different assets should be mixed in different proportions in your portfolio.
5. Traditional asset classes rely on rewards provided by the market.
6. Investing in alternative assets necessitates a high level of judgment.
7. A delicate mix of oversight and authority is required for good portfolio governance.

Who can benefit the most from this book:

• Investment beginners.
• University staff looking for a fresh perspective.
• Business managers looking for a new angle.

What am I getting out of it? Invest with more assurance.

How can your organization plan for the future while meeting today's financial obligations? The answer is to build a solid investment portfolio, which these blinks will show you how to do.

Endowment assets will be discussed, as well as how they might benefit your organization. You'll also learn a rudimentary grasp of the various asset classes in which your organization might invest, as well as how to combine them in your portfolio. This is your handbook for making your institution's funds work harder for you.

• You'll learn why asset allocation is both an art and a science.
• How to manage risk in your portfolio.
• And why endowments are so vital to colleges in this summary.

1. Endowments assist institutions in maintaining their autonomy.

You must first understand why investments, particularly endowments, are so crucial before you can manage your institutional investments. But first, what exactly do we mean when we say "endowment"?

An endowment is a term used to describe endowments made to a university by individuals or groups of individuals. For example, in the nineteenth century, alumni donated 96 acres of property to Yale University. What distinguishes an endowment is that it is provided with the expectation that only the interest will be spent, not the principal. This indicates that the endowment is intended to provide financial assistance to the university indefinitely, for as long as it exists. And it is for this reason that they are so important.

Endowments safeguard your institution's long-term strategic independence.

When your institution wants financial assistance, you are frequently forced to accept assistance from other sources. Many private American universities, for example, had little choice but to turn to the federal government for loans and grants in the 1970s. However, the difficulty with this approach to funding is that these outside financial backers usually have their own agenda for your organization, and their assistance often comes with conditions for how you use your money.

This means that the institution's executives may lose control over their own resource allocation plan. The federal money that was handed to universities, for example, came with the condition that they implement new restrictions in a variety of areas. It also meant that many colleges were required to conduct research in areas where the government desired information.

When donating to an endowment, the donor can specify which part of the university they want their money to go to. Many endowments, for example, exist only to provide financial assistance to students. However, because the endowment will be in place for decades, if not centuries, the donor's influence will eventually wane over time, and the university can use their endowments to ensure that they stay independent institutions free to conduct their own affairs without outside interference.

2. Institutions must think about both the immediate and long future.

There are two key priorities for endowment managers. The first aim is to maintain the endowment asset's long-term purchasing power. The second goal is to guarantee that the endowment provides the institution with a consistent and adequate cash flow each year. Unfortunately, these goals frequently clash with one another.

Because the endowment's objective is to fund the institution for as long as it exists, it's critical to preserve the asset's long-term worth. When it comes to universities, for example, it is assumed that they would never close their doors, therefore the endowment asset must be protected in perpetuity.

In this view, endowment management has an inherent tension: today's scholars, or other benefactors of the institution, should not profit more from the endowment asset than future generations of scholars. As a result, the asset's worth must be carefully preserved in the long run.

How does this happen? By implementing a high-return investing plan and embracing the considerable risk and market volatility that these high-return investments involve.

However, while this method balances the requirements of future generations with those of current beneficiaries, it can swiftly clash with the endowment manager's main responsibility, which is to provide the institution with sufficient and consistent financial support each year.

Let's imagine a university has opted to implement a strict endowment preservation plan. By this strategy, the manager decides to spend just the asset's annual returns, minus the cost of inflation. During the first year of this program, the asset generates a 10% return while inflation is only 4%. This ensures that a healthy 6% of the asset's value is dispersed throughout the institution's operations, while the remaining 4% is reinvested in the asset to accommodate for inflation. However, the market becomes more volatile the next year, with just a 2% real return on the asset and a greater rate of inflation of 7%. What is the role of the endowment manager? They have no choice except to refuse to share any of the returns that year and reinvest the entire 2% back into the asset. However, this implies that the institution is in jeopardy, and its activities for the year may have to be reduced. In this sense, future scholars now have a competitive advantage over current scholars.

3. Three fundamental instruments should be part of your financial philosophy.

What is your approach to investing? This highlights your thoughts and ideas on how to effectively earn a return on your investment to meet your institution's demands. How should you begin building your own set of investment principles? The answer is to think about three key tools that will assist you in managing your portfolio.

Asset allocation is the first of these instruments, and it should form the foundation of your budding portfolio.

Asset allocation refers to deciding which asset classes will make up your portfolio and how much of your money will be invested in each. Foreign and domestic equities, fixed income, real assets, and private equities are among the asset types in which institutions often invest. According to economists Roger Ibbotson and Paul Kaplan's study from 2000, asset allocation policy decisions were by far the most important factor in determining investment return size.

Market timing is the second tool to examine. This is when you briefly deviate from your portfolio's long-term goals to take advantage of market changes. For example, your portfolio's goal might be to invest 50% of the fund in bonds and the remaining 50% inequities. However, if the fund manager examines market conditions and notices that equities are suddenly considerably cheaper, he or she may opt to shift the portfolio's composition to 60% stocks and 40% bonds. Market timing may have contributed to the increased return on investment as a result of this realignment.

Security selection is the final tool. This has to do with whether you want to establish an actively managed or passively managed portfolio.

Passive portfolios simply reflect market conditions, and their managers do not make active market bets. Active management, on the other hand, might be considered to be responsible for that fraction of the return on investment when a portfolio's composition differs from the actual market. When a market is efficient, such as tradable stock markets, actively managing securities frequently leads to lower overall investment performance. In extremely efficient markets, such as government bonds, where only market return affects your results and actively managing these instruments makes no difference, passive management is more appropriate. In less efficient markets, such as venture capital, real estate, or private equity, however, actively managing securities can provide big profits, so it makes sense to be more choosy about which specific assets you acquire.

4. Different assets should be mixed in different proportions in your portfolio.

Asset allocation is both an art and a science, and investors will need to use both their judgment and quantitative research. Choosing your asset classes is the first step in constructing your portfolio. All too often, investors base their asset allocation decisions on what assets and in what proportions are popular among other investors. Following the crowd will result in a noncontroversial portfolio, but it will not be personalized to match the needs of your organization.

So, what asset allocation will be most beneficial to your institution? Institutional portfolios, for example, require assets such as local, foreign, and private shares, as well as real assets. This is because these assets are anticipated to produce returns similar to those of stocks. Institutional investors will also have to think about ways to reduce the risks associated with certain asset classes. This is accomplished through portfolio diversity, in which each asset type is kept in a proportion that balances its risks and possible gains.

How many asset classes, on the other hand, should you include in your portfolio?

Investors disagree on the exact figure, but there are some good guidelines to follow. It's not a good idea to allocate less than 5 to 10% of your portfolio to any single asset class. Why? Because the allotment is insufficient to have an impact on the overall results. On the other hand, investing more than 25 to 30 per cent of one's portfolio in a single asset class is not a good idea because it increases the danger of overconcentration. In general, a typical institutional portfolio can be successfully managed with roughly six asset classes.

But how should asset types be defined? Differences between asset classes include debt versus equity, private versus public, liquid against illiquid, and inflation versus deflation sensitivity.

However, not all assets can be easily classified into discrete categories. Investors, for example, frequently employ fixed-income assets to hedge their bets against fiscal calamity. However, not all fixed-income investments can provide this function. Even though they are nominally fixed-income instruments, investment bonds with a lower credit rating, such as trash bonds, carry equity-like risk. With this in mind, comparing the responses of two assets to the same crucial variable can help decide whether they belong in the same class or not. In response to unexpected inflation, the price of traditional fixed-income assets, for example, falls. Inflation-indexed bonds, on the other hand, rise in value in reaction to the same variable. This shows that they belong to different classifications.

5. Traditional asset classes rely on rewards provided by the market.

When we define asset classes, we're seeking to group similar investments together to create a pretty uniform collection of investments. We'll look at what we mean when we talk about traditional asset types in this flash.

Traditional asset classifications include several distinguishing characteristics.

For starters, they mostly rely on market returns rather than returns created by active portfolio management. This means they frequently deliver substantial, consistent returns, giving portfolio managers confidence that their portfolio will meet its institutional goal.

Traditional asset classes trade in large and investable markets that are also deep. All of this means that potential investors are confronted with a wide selection of accessible options, all within well-established and resilient marketplaces.

Domestic equity is one form of the traditional asset class.

You hold a share of an American firm when you invest in domestic equity or stocks. Domestic equities will play a large position in most institutional investors' portfolios. This isn't a negative thing at all. Equity instruments offer a projected return that is in line with institutions' desire to see significant growth in their portfolios over time. Domestic stock, in fact, has the best long-term success record of any asset type, according to studies. Above a 200-year span, data collected on American equities shows annual earnings of over 8%.

One of the fundamental advantages of stock ownership is that the interests of shareholders, or those who own the stock, and the corporate managers, or those who run the company in which the stock is held, are usually aligned. This is because, in general, these executives benefit when shareholder value rises. When a company's profitability improves, for example, not only do shareholders benefit, but corporate executives often receive financial bonuses.

Domestic equity, in the form of American stocks, offers your portfolio protection against price inflation in the broader economy, at least in principle. This is because any inflation should be reflected in higher stock prices, resulting in an increase in the value of your portfolio. In actuality, the stock market has a mixed track record when it comes to absorbing inflation increases into the pricing of equities. Inflation, for example, caused a 37 per cent drop in American purchasing power in the early 1970s. However, rather than increasing in value, stock prices decreased by 22%. When adjusted for inflation, this meant that investors lost 51% of their money. With this in mind, economists have determined that while stocks are an excellent long-term inflation hedge, they don't necessarily provide adequate protection against rising prices in the short term.

6. Investing in alternative assets necessitates a high level of judgment.

Alternative asset classes, such as real estate and private equity, offer higher returns in exchange for a higher level of risk in your investment portfolio. Alternatively, they provide a lower level of risk in exchange for a specified level of return. You become less reliant on domestic equity and other marketable instruments when you include other asset classes in your portfolio. This results in a portfolio that is quite diverse.

Importantly, alternative assets are frequently priced more efficiently than traditional assets, allowing investment managers with superior judgment and market expertise to significantly increase the value of their portfolios. However, to achieve this, you must actively manage your portfolio.

Let's take a closer look at one sort of alternative asset class investment: absolute return.

Holding stakes in marketable securities that exploit inefficiencies is an absolute return investment strategy. These investments will not match your standard stock and bond holdings. This is, after all, a dangerous proposition. Absolute return managers, on the other hand, employ their expertise and knowledge to mitigate this risk. For example, they monitor current events and attempt to forecast how they may affect financial markets. These occurrences could include anything from a merger between two corporations to a company that has recently declared bankruptcy. Because the legal and regulatory landscape surrounding these combined or bankrupted corporations has temporarily changed, events like these often give opportunities to buy appealing shares at a favourable price. Event-driven investors are aware of these shifts and have a thorough knowledge of how they will impact the value of the underlying stocks.

Other investors lack the ability to discern how financial events such as mergers or bankruptcy affect the value of their shares, which creates opportunities for event-driven investors. When these uneducated investors learn of a merger or other financial event, they sell their shares in the firm in question. Many investors are eager to sell their stocks nearly at any price, especially when it comes to securities belonging to bankrupted corporations. When a large number of investors do this, it creates a large supply of distressed securities in the market, allowing savvy event-driven investors to acquire them inexpensively and with good return prospects.

Even with these advantages, however, event-driven investment methods cannot fully safeguard investors from market fluctuations. For example, there's a potential that a merger that investors were confident would happen doesn't actually happen, leaving the investor with an unproductive position.

7. A delicate mix of oversight and authority is required for good portfolio governance.

A robust governance procedure is required to build a sound and well-structured investment portfolio. Such governance results in a portfolio that is suitable for the institution's goals, and the process should encourage good market timing and crucial investment partnerships.

One of the first decisions that institutions must make about their portfolios is whether to pursue an active or passive investment management strategy.

Choosing an active management strategy is not without danger. In particular, the institution must be able to identify active managers with the necessary abilities, expertise, and instincts. Furthermore, active management strategies typically necessitate the institution committing significant resources to its portfolio. When institutions attempt to follow an active strategy without the necessary backing and competencies, the results are typically disappointing. If an organization lacks the resources essential to make active management successful, it may opt for a passive management approach. In fact, this will result in a much more hands-off, stripped-down portfolio, which is likely to be less risky.

Regardless of the path an institution chooses, its portfolio must be handled by two groups of individuals, not just one.

An investing committee is the first group you'll need. This committee functions similarly to a board of directors, with responsibility for the portfolio's overall strategy. The investment recommendations given by the second group of managers, the investment staff, are thoroughly evaluated by this senior team. This is the group that determines how to proceed in areas such as asset allocation and spending policy. They also make a compelling case to the committee for these actions. The investing team of the institution must be able to build a solid conceptual foundation for their suggestions. Investment decisions may become ad hoc or ignorant if this foundation is not in place.

You should consider how you want your investment management teams to think while creating your governance process. Investment departments utilize one set of individuals, the investment committee, to monitor the operations of another group, the investment staff. This presents a unique issue. The difficulty with this group-based strategy is that it can encourage groupthink all too often. This occurs when members of a group engage in too much consensus-building, resulting in everyone in the group fast reaching similar opinions on every issue. Within the investment department, good governance practices take into account this tendency toward groupthink and look for ways to encourage independent thought and contrarian views.

The key message in this summary is that institutional investments must strike a balance between meeting immediate needs and safeguarding the institution's future. By precisely measuring how much investment expertise your institution has and how many resources you can commit to investing, you can construct the right portfolio for your institution. This knowledge will aid you in deciding whether you want to manage your portfolio actively or passively.