The Asset Allocation Paradox

Question

I've had this problem stuck in my head for a while and I'd like some help with it. In David Swensen's Unconventional Success, the argument is made that asset allocation is the best way to get a good return in the long run for the individual, and that no-load mutual funds are the way to go.

If you study Yale's investment portfolio, however, there is a paradox. They publish their allocation annually, but for each category (Absolute Return, Domestic Equities, etc...), they hire outside managers. Now I understand that Yale has far more resources than any of us, so naturally they don't need to buy a S&P ETF to get exposure to domestic equities. Consider this line of reasoning:

1. Asset allocation is the best way to get solid returns in the long run.
2. For each category, Yale will hire the best hedge funds/investors to manage their money.
3. These best investors will produce great returns, which will bolster Yale's portfolio.
4. Due to Yale's diversification via asset allocation, they will not be hit too hard even if a single area does poorly, because all the other areas will keep them up.

Ignoring the case where every category does poorly due to something like a global recession, Yale has a terrific strategy for long term growth. My question is this:

They believe that asset allocation is the best way to produce long term growth while mitigating risk. If this is a fact, why aren't the investment managers (IM's) they hire also involved in asset allocation? If an IM's goal is to make money while managing risk (which is the goal of hedge funds), and asset allocation is the best way to do this, then why on earth would an IM concentrate his/her money in a single area?

Assuming that investors select an investment strategy to produce the greatest returns at a manageable level of risk, why don't all investors simply employ asset allocation if it truly is the best way to achieve the goal?

Answer 1

Asset Allocation serves many purposes, not just mitigating risk via a diversification of asset classes, but also allowing you to take a level of risk that is appropriate for a given investor at a given time by how much is allocated to which asset classes.

A younger investor with a longer timeframe, may wish to take a lot more risk, investing heavily in equities, and perhaps managed funds that are of the 'aggressive growth' variety, seeking better than market returns.

Someone a little older may wish to pull back a bit, especially after a bull market has brought them substantial gains, and begin to 'take money off the table' perhaps by starting to establish some fixed income positions, or pulling back to slightly less risky index, 'value' or 'balanced' funds.

An investor who is near or in retirement will generally want even less risk, going to a much more balanced approach with half or more of their investments in fixed income, and the remainder often in income producing 'blue chip' type stocks, or 'income funds'. This allows them to protect a good amount of their wealth from potential loss at a time when they have to be able to depend on it for a majority of their income.

An institution such as Yale has very different concerns, and may always be in a more aggressive 'long term' mode since 'retirement' is not a factor for them. They are willing to invest mostly in very aggressive ways, using diversification to protect them from one of those choices 'tanking' but still overall taking a pretty high level of risk, much more so than might be appropriate for an individual who will generally need to seek safety and to preserve gains as they get older. For example look at the PDF that @JLDugger linked, and observe the overall risk level that Yale is taking, and in addition observe the large allocations they make to things like private equity with a 27%+ risk level compared to their very small amount of fixed income with a 10% risk level. Yale has a very long time horizon and invests in a way that is atypical of the needs and concerns of an individual investor. They also have as you pointed out, the economy of scale (with something like #17B in assets?) to afford to hire proven experts, and their own internal PHD level experts to watch over the whole thing, all of which very few individual investors have.

For either class of investor, diversification, is a means to mitigate risk by not having all your eggs in one basket. Via having multiple different investments (such as picking multiple individual stocks, or aggressive funds with different approaches, or just an index fund to get multiple stocks) you are protected from being wiped out as might happen if a single choice might fail. For example imagine what would have happened if you had in 2005 put all your money into a single stock with a company that had been showing record profits such as Lehman Brothers, and left it there until 2008 when the stock tanked. or even faster collapses such as Enron, etc that all 'looked great' up until shortly after they failed utterly. Being allocated across multiple asset classes provides some diversification all on it's own, but you can also be diversified within a class.

Yale uses the diversification across several asset classes to have lower risk than being invested in a single asset class such as private equity. But their allocation places much more of their funds in high risk classes and much less of their funds in the lowest risk classes such as fixed income.

Answer 2

I recommend you take a look at this lecture (really, the whole series is enlightening), from Swenson. He identifies 3 sources of returns: diversification, timing and selection. He appears to discard timing and selection as impossible.

A student kinda calls him out on this. Diversification reduces risk, not increase returns. It turns out they did time the market, by shorting .com's before the bubble, and real estate just before the downturn. In 1990, Yale started a "Absolute Return" unit and allocated like 15 percent to it, mostly by selling US equities, that specializes in these sorts of hedging moves.

As for why you might employ managers for specific areas, consider that the expense ratio Wall Street charges you or me still represent a very nice salary when applied to the billions in Yale's portfolio. So they hire internally to reduce expenses, and I'm sure they're kept busy. They also need people to sell off assets to maintain ratios, and figuring out which ones to sell might take specialized knowledge. Finally, in some areas, you functionally cannot invest without management. For example, Yale has a substantial allocation in private equity, and by definition that doesn't trade on the open market.

The other thing you should consider is that for all its diversification, Yale lost 25 percent of their portfolio in 2009. For a technique that's supposed to reduce volatility, they seem to have a large range of returns over the past five years.