The value of portfolio simplicity

07Aug07

What has been the upshot of investor desire for alpha and the alternative investment vehicles that try to produce alpha?

In light of recent capital market stress the question is entirely relevant. An article by Greg Ip and Jon E. Hilsenrath at WSJ.com in part argues that the desire of institutional investors to “look like Yale” has been a contributing factor to how it is we got where we are today. An extended excerpt from the article explains:

The subprime and LBO booms required willing lenders. The stock-market collapse and low interest rates of 2001 to 2004 nurtured a class of investors and products to fill that role. Managers of pension and endowment funds long had divided their assets among domestic stocks, bonds and cash. The funds saw their performance suffer when the stock market and then bond yields tumbled.

A few endowments, most notably at Yale and Harvard, had for years been spreading their investments more broadly, going into hedge funds, real estate, foreign stocks, even timberland. The goal was holdings that wouldn’t suffer in sync with stocks in a bear market. Sure enough, in 2000 and 2001, even as stocks tumbled, Harvard Management Co. earned returns of 32.2% and -2.7% respectively. Yale’s returns were 41% and 9.2%.

Other institutions wanted their money managed the same way, seeding a flood of hedge funds that bought other untraditional investments such as credit derivatives. University endowments poured roughly $40 billion into hedge funds between 2000 and 2006, according to Hedge Fund Intelligence, a newsletter. “I call it the ‘Let’s all look like Yale effect,'” says Jeremy Grantham, chairman of Boston money manager GMO LLC.

We (and others) trace back this trend to a book, “Pioneering Portfolio Management” by David Swensen the CIO of the Yale University endowment. In his book he lays out the process by which Yale invested its portfolio. This includes an extensive discussion of alternative investments including: hedge funds, private equity, venture capital and timberland. One could argue that this helped make it acceptable for other endowments and pension funds to wholeheartedly embrace an alternative investment-centric approach to portfolio management.

(For those interested in reading more on the performance of endowment portfolios should check out any number of posts by Mebane Faber at World Beta. He has written a number of posts on how individuals might replicate endowment portfolios with ETFs.)

It is interesting is that when Swensen wrote a book geared towards individual investors he skirted the discussion of alternative investments. Instead he recommends a low cost, index-centric portfolio for individual investors. There are any number of reasons why Swensen made these recommendations. To a certain degree it may be that this simple approach is one that if followed has the lowest likelihood of doing a portfolio harm.

Moves into hedge fund-like vehicles clearly carries some risk. Shefali Anand also at WSJ.com reports that the performance of long-short equity mutual funds since the market peak has been disappointing.

Lately, investors have embraced an array of new mutual funds — with names such as “long-short” and “market-neutral” — designed to work whether the market goes up or down.

The recent volatility has put these funds to the test, and many are missing their mark.

This disappointing performance has not been uniform, but it does emphasize the fact that once when ventures beyond plain-vanilla, indexed vehicles, performance depends on managerial skill. That is not the case with “lazy portfolios.” These are broadly diversified portfolios, periodically rebalanced, that are made up of index funds (often ETFs). The goal is to provide investors with a low-cost, low-stress approach to portfolio management.

Paul B. Farrell at Marketwatch.com has been a proponent of this approach and periodically writes on the topic. Here he notes five benefits of this approach in light of recent market volatility. Prominent investment blogger Charles Kirk at the Kirk Report has also written extensively on “lazy portfolios” and has amassed an archive of posts dedicated to the topic. The archive is well worth a visit and you can find any number of examples of “lazy portfolios”, the vast majority of which are exclusively composed of ETFs.

Not only do “lazy portfolios” avoid the risk of overtrading and investment fads they also have the benefit of low expenses. In a recent post we discussed the extraordinarily, at least by historical standards, low expense ratio one can generate using broadly diversified, indexed ETFs. Investment expenses are unique in that they are the only variable that investors can truly control. Whether it be via the expense ratio of a fund or your own trading, this is a variable that is controllable. Gross returns, on the other hand, are entirely controlled by the market’s whims. Investors should always focus on net returns, both after expenses and taxes.

As one can see from the length of this post the topic of portfolio simplicity is, in fact, not a simple one at all. The focus of the financial media and the investment blogosophere is on market-moving news and trading ideas. The idea of simple, boring, “lazy portfolios” is in direct contrast. That is one reason why alternative investments, like mutual funds that utilize hedge fund techniques, have become popular. These funds satisfy our desire to generate alpha and provide some excitement along the way.

Every one is free to manage their money however they see fit. Individual investors need to keep in mind that portfolio management need not be exciting. It need only be effective and grounded in reality. Portfolio simplicity and “lazy portfolios” satisfy these requirements for the vast majority of individual investors.

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