Unconventional Success: Investing in Core and Non-Core Asset Classes

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One of the books I am currently reading is Unconventional Success: A Fundamental Approach to Personal Investment by David Swensen. He is a very successful institutional money manager, having guided the Yale University Endowment to over 16% annualized returns over 20 years. While he has already written a bestselling book about institutional fund management, Pioneering Portfolio Management, this newer book outlines his investment advice as tailored for individual investors. I’m not finished with it yet, but so far I am very impressed. This is one of the few people in the world who could easily say “Here’s how anyone can beat the market!”, but instead he presents a unique argument for building a portfolio using low-cost, diversified, passive components.

One of the ways he separates himself from others is his definition of “core” asset classes in which to invest. Briefly, core asset classes share three main characteristics:

  1. They rely on market-generated returns, not from active management skill (as it is a very rare attribute and hard to separate from luck).
  2. They add a valuable and differentiable characteristic to a portfolio.
  3. They come from broad, highly-liquid markets.

The six core asset classes he identifies are:

Domestic Equity
Foreign Developed Equity
Emerging Market Equity
Real Estate
U.S. Treasury Bonds
U.S. Treasury Inflation-Protected Securities (TIPS)

These are all pretty well-accepted asset classes. The surprise comes when he tells you where you shouldn’t invest. Here are the non-core asset classes which Swensen believes fail to satisfy one or more of the criteria above:

Domestic Corporate Bonds
High-Yield Corporate Bonds
Asset-Backed Securitiesl
(like GNMA mortgage-backed bonds)
Tax-Exempt Bonds
Foreign Bonds
Hedge Funds
Leveraged Buyouts
Venture Capital

Many of these asset classes are very popular! Take corporate bonds. While I can’t present the argument nearly as well here, the basic idea is that they don’t satisfy the “valuable and differentiable” requirement above. People buy corporate bonds over Treasury bonds because they can get a higher yield. But Swensen argues that the slight premium is not enough to compensate for the additional credit risk, lower liquidity, and callability of such bonds. One source of this imbalance is the fact that the interests of the bond issuer (the corporation) are inherently at odds with the bond investor. The corporation wants to minimize the cost of it’s debt, while the bond holder wants the opposite. Compare this with the situation of a stock holder, where both want the company share value to increase.

Possible Portfolio Changes? If you invest any bond mutual funds, you may want to find out what percentage of those funds are in corporate bonds and asset-backed securities. For example, the Vanguard Total Bond Index fund (VBMFX) holds almost 45% in mortgage-backed bonds and only 35% in Treasury bonds. Of course, many young folks don’t have any bonds at all, so this may be a low priority.

Personally, my small bond allocation is 100% in corporate bonds. I always thought that bond markets were very efficient in dealing with credit risk, and that duration and sensitivity to interest rates mattered more than the type of bond. I will have to do more reading on this topic, but it may be more prudent to switch to Treasury bonds/TIPS and instead take any additional risk by adding more equities exposure.

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  1. May I just say: David Swenson is da man! Not only does he have a great mind, but he left Wall St. superstardom for the relatively low-paying Yale gig–and brought them billions and billions and billions.

    Indeed, he himself has said something along the lines of “How much money does one person need? I am paid well–very well–and I still get to see all my son’s Little League games.” Yale truly has a treasure there.

    With regard to his second book (his first being written for institutions): he is a closet Bogle-head for the individual investor (although I bet he likes Dimensional even better). The real trick, especially for the individual, is locating those new and under-exploited asset classes that made Yale rich. (Hard to believe that private equity, etc. was so unheard of when he took over!)

    I am not a celebrity hound by any means, but I have my signed copies of Swensen’s books up on the shelf next to my pc of me and Stormin’ Norman…

  2. “People buy corporate bonds over Treasury bonds because they can get a higher yield. But Swensen argues that the slight premium is not enough to compensate for the additional credit risk, lower liquidity, and callability of such bonds.”

    Larry Swedroe makes a similar convincing argument for Short Term Treasuries + TIPS in his writings.

    Last week is a good example of why. Last week when equities took a plunge across the board Treasuries performed the best in the “flight to quality”. Bonds (of similar duration) holding corporates and riskier bonds did worse.

    For example, here are the 1 week returns from last week of Various vanguard funds:

    0.39% VFICX Intermediate Term Investment Grade
    0.40% VBIIX Intermediate Term Bond Index
    1.10% VFITX Intermediate Term Treasury

    The high yield bond fund got clobbered.

    So while riskier bonds (e.g. corporates) may indeed perform better in some cases, it seems that the additional risk of these bonds shows up at just the wrong time, i.e. during a market fall like last week when we need the “safety” of bonds the most to soften the blow.

  3. I read swenson’s book too, and he changed my thoughts on bonds as well…However, I still own the vanguard corporate hi-yield fund…why? because it’s very well managed and eeks out higher return…during bear markets it behaves poorly, so it doesn’t offer the diversification benefits of the treasuries, nevertheless, i still think it’s worth a small allocation if you have the room, because the find doesn’t perform like your typical hi-yield because of the management, and therefore reduces some of the inherit corporate bond risk…

  4. Re: Vanguard High Yield.

    Vguard HY is what’s known as “upper tier” high yield, i.e., the best of the junk (which is why that fund consistently underperforms its HY benchmark–the rare case where underperformance isn’t necessarily a *bad* thing; more a case of an imperfect benchmark).

    In other words, it is likely marginally “safer” than those HY funds focusing on the lowest end of the credit spectrum. HY *does* offer some diversification benefit.

    Frankly, were I an individual investor (i.e., w/o access to institutional-type asset classes), I don’t know *what* I would choose… Maybe I would look for some “all in one” fund that allocated across otherwise unobtainable asset classes (and, at the case of sounding like a shill for Dimensional, that service is what http://www.ifa.com provides). More of these should pop up in worker’ Defined Contribution plans in the near future.

    In my 401(k) account (a holdover from a previous life) I hold only Vanguard’s Global Equity and Wellington funds, which is about as diversified as one is going to get there. With enough assets, one might add, say, Utilities, Convertibles, HY, and a few other outliers, but true diversification is tough for a Vguard investor.

  5. I also found that part of Swensen’s book very enlightening.

    When the stock market was down around 5% last week, the High-Yield Corporate Fund was down about 3.2%. Those bonds didn’t do a good job of diversifying portfolios, at least during the most recent downturn.

    For my allocation, I need more bonds than I can fit in my tax-advantaged accounts, so I have some individual AAA-rated municipal bonds in my taxable account. It’s harder to price those accurately, but it appears they were up around the same 0.3 to 0.4 percent as the overall (non-junk) bond market. Again, Swensen’s analysis holds.

  6. Could someone post a good match for the first 5 asset classes with ETF’s.

  7. Glad you are finally getting around to reading “Unconventional Success”! I rank it as my favorite investing book.

    I too was struck by the fact that corporate bonds were such lousy investments. He makes a number of compelling points though.

    In regard to corporate bonds, I kind of mentally compare them to land line telephones. If you think about it, a land line can accomplish voice and data transfer, but it does neither particularly well. (For voice communication – you are tied to the location of your phone , and for data transfer it is much slower than competing products.) For this reason, most savvy people now just use a cell phone and some form of cable modem.

    Corportate bonds are the same way. They try to accomplish two things (safety and higher returns) and as a result accomplish neither particularly well. You would be better off splitting what you had allocated toward corporate bonds into a mixture of stocks and short term govt bonds getting the best of breed product for safety and returns.

    What is also interesting about “Unconventional Success” is that he suggests a target asset allocation later in the book, but doesn’t really provide a different allocation for younger/older investors. Perhaps that is a result of managing money for institutions, or perhaps he feels that a well diversified portfolio such as this is suitable for people of all ages. The fact that he speaks in terms of asset allocations instead of particular products makes the book a bit timeless as well. Superior product offerings will come about, but the core asset classes will likely not change.

    “Pioneering Portfolio Management” is also an excellent read by Swensen. Even if you never manage money for a multi-billion dollar institution, his insight into that world is a great read and can be understood by even the non-investor. Some Fascinating investing stories in there.

  8. i sold my fagix at 9.14 thank goodness – these corporate/junk bonds are getting demolished!

  9. Here is an example:
    From 1972-2006 we can compare 2 portfolios.

    100% Total US Market.
    Return: 11.24%
    Std. Dev: 17.20%
    Worst Year: -27.20% (1974)

    50% Small Cap Value
    50% Intermediate-Term Treasuries (5-year)
    Return: 12.01%
    Std. Dev: 11.00%
    Worst Year: -10.70% (1973)

    Or this one is also nice:
    50% Small Cap Value
    50% T-bills/Money Market
    Return: 10.97%
    Std. Dev: 9.96%
    Worst Year: -9.55% (1973)

    It also has the advantage that half your money is completely risk-free.

  10. I don’t know if Swensen would like DFA, actually. He never mentions the 3-factor model or even overweighting small/value stocks, and instead focuses on total-market returns.

    Here are few ETF ideas:

    Domestic Equity – VTI
    Foreign Developed Equity – EFA
    Emerging Market Equity – VWO
    Real Estate – VNQ
    U.S. Treasury Bonds – SHY, IEF
    U.S. Treasury Inflation-Protected Securities (TIPS) – TIP

  11. I’m afraid the correlation between equities and high-yield securities is not limited to our current downturn. There is a lot of academic research that suggests that high-yield bonds function a lot like equities — and for good reason. The typical reasons that a bond would have a high yield (e.g. too much total debt, too many other secured debt in front of it, uncertain operating environment, etc) tend to make the junk bondholder somewhat similar to that of a residual claimant.

  12. Domestic Equity

    S&P 500 = SPY or IVV. Russell 3000 = IWV. Total market = IYY or Vanguard’s VTI.

    Foreign Developed Equity

    iShares EFA or Vanguard’s brand new equivalent VEA.

    Emerging Market Equity

    IShares EEM or Vanguard’s VWO

    Real Estate

    Vanguard’s VNQ, or Ishares has several of them including ICF and IYR. iShares has an international REIT ETF, but I can’t find it.

    U.S. Treasury Bonds

    SHY, IEI, IEF depending on maturity. .

  13. Short term treasuries/corporate bonds protect you against interest rate increases.

    TIPS protect you against:
    1. unexpected inflation increases
    2. deflation because as a long bond they have a minimum floor in the coupon rate. If interest rates get so low CDs are doing the 2% rate again that 2.5% TIPS coupon rate looks pretty good.

    TIPS are also very uncorrelated against bonds, stocks, real estate and commodities so they are another asset class.

    The fixed income portion of a portfolio thats half TIPS and hald 2 year treasuries will outperform each individually.


  14. I am definitely leaning towards 50% TIPS/ 50% Treasury Bonds for my bond portfolio. Need to read more about buying TIPS on my own, but I have a feeling I’ll just pay a bit more for Vanguard’s mutual fund.

  15. Did a bit of checking; here’s the portfolio Swenson recommended in an article from Paul Farrell on CBS Marketwatch.

    15% Vanguard Inf. Protected Securities fund
    20% Vanguard REIT ETF
    15% Vanguard Short Term Treasury fund
    20% Vanguard Total International fund
    30% Vanguard Total Stock Market ETF

    Since some parts are relatively new ETFs, there isn’t much historical performance besides:

    2005: 8.06%
    2006: 17.72%

    It beat the S&P 500 both years. You could be EFA and EEM for foreign developed markets and foreign emerging markets. The vanguard fund has, IIRC, 5% in emerging markets.

    Here’s the article.

  16. Oops. AS you can see in the article, they calculated historical returns:

    1 yr/3 yr/5 yr return
    Yale portfolio 16.1% 16% 6.4%
    S&P 500 index 11.6% 12.9% -2.9%

  17. Jon, reader question:
    If you get a chance will address the scenerio (pros/cons) of pulling out equity in a home to add to their diversified portfolio of index funds. I believe that in the long term, a diversified portfolio of index funds would outperform home appreciation. Why would someone leave equity in their home? Error in my logic? Thanks

  18. That’s an interesting idea. I read a similar comment from Nassim Taleb — hold 90% treasuries and go 10% extremely risky. The only issue is tax efficiency — I’d have to identify mega high risk investments that are also somewhat tax efficient to split between retirement and taxable accounts.

    TIPS/treasuries/small cap value in retirement, emerging market in taxable? Don’t know if I have the guts to pull the trigger on that.

  19. Better yet – hold 75% short term treasuries. Use 5% to buy futures on the SP500 (buying your beta exposure). And aggressively invest the remaining 20%.

  20. Can somebody tell me about this —

    Which is better to buy: A, B, C shares if you have to purchase mutual funds.
    I have asked several people in the financial industry services and I have gotten an array of answers. Is it true that if somebody recommends B shares, I should run the other way.

    Just need some sound advice.

    Thank you.

  21. @Shak:
    Mutual funds that separate their shares out into A/B/C shares are typically not a good choice. The reason for the different shares is the difference in sales charges the fund hits you with when you invest.

    Typically, A shares impose a front-load, B/C shares back-load. Expense ratios generally run C > B > A, from highest to lowest.

    In all cases, you’re paying an exorbitant amount in expenses. If you can avoid these mutual funds, you should. If you can’t, I’d probably say Class A shares are the best option of a bad bunch.

    But really, try to go with a low-cost mutual fund provider like Vanguard.

  22. If I HAD to pick from A,B or C, A shares usually are cheaper over the long run. Of course, I’d pick a different company and avoid them altogether.

  23. This has not been updated in a while, but I just ran across it. Every year about this time I rebalance my portfolio and I am trying to do what a lot of people here are trying to do — implement Swenson’s approach. I saw an interview with him on Wealthtrack hosted by Consuelo Mack.

    In that interview he admitted he would lighten the Treasuries and allocate a little more to other classes. I have eliminated treasuries from my portfolio since I have concerns about the dollar, inflation, US debt.

    As part of inflation government securities, I added WIP – Goverment Inflation Protected Securities Ex-US ETF. I added DBC commodity ETF. I am straying from his advice but for the most part I am trying to implement what he recommends.

  24. Thank you so much for this post. I just started reading this book, too. He also has another great one I’m lining up to read: Pioneering Portfolio Management. I really like and appreciate your blog. Thank you for all you do.

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