David Swensen has been called Yale’s “Money Guru”—and rightly so. As the head of Yale University’s highly successful $16 billion endowment, he has created an amazing performance record. Over the last 10-years (through Yale’s 2010 fiscal year), for example, the endowment had an annualized return of 8.9% vs. 1.5% for a portfolio allocated 70% to U.S. equities and 30% to U.S. bonds.
Mr. Swensen is also the author of two highly influential books—Pioneering Portoflio Management: An Unconventional Approach to Institutional Investment (for Institutional Investors) and Unconventional Success: A Fundamental Approach to Personal Investment (geared toward individual investors)
By anyone’s standard, Mr. Swensen is one of the most credible voices on investing and portfolio management, which is why when he lambasted the mutual fund industry in a recent New York Times op-ed called, “The Mutual Fund Merry-Go Round,” I thought that his “call to arms” needed further discussion.
Marketing to Our Worst Instincts
Mr. Swensen’s op-ed piece begins with the argument that the marketing of mutual funds and brokerage services encourage investors to chase performance—jumping from one fund to another—in a futile attempt to time the market while hoping to ride on the coattails of the next star fund manager.
Mr. Swensen goes as far as to suggest that the well-known Morningstar star ratings encourage this behavior by promoting five star funds as a better choice for investors than funds with lower star ratings—despite the fact that the star ratings merely reflect past performance and that there is very little relationship between past performance and future performance:
“…the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high. Ill-advised buying and selling of funds costs the investing public a substantial sum.”
This type of rating system, according to Swensen, encourages investor behavior that inevitably leads to poor returns. And I agree.
It is certainly true that individual investors have a dismal track record (on average) of market timing (I’ve written many posts here at the Portfolioist backed by numerous academic studies proving why chasing market performance just doesn’t work). Still, investors tend to buy funds that have recently performed well and sell those that don’t, inevitably “buying high and selling low”—which is the polar opposite of what investors should be doing. Mr. Swensen even cites Morningstar’s own data regarding this type of bad investor behavior. Here is one example that I found: Morningstar reports that investors in the CGM Focus Fund (CGMFX) have an average return that lags the reported mutual fund return by 6% per year over the past three years.
He reports Morningstar’s finding that performance chasing in mutual funds cost investors an average of 1.6% per year (however, I found a recent summary of Morningstar research that puts the number at 2.0% per year for domestic equity mutual funds). Regardless, the bad timing penalty is substantially higher for more volatile funds.
The final piece of Mr. Swensen’s argument revolves around the fact that mutual fund companies heavily market their five-star funds with good recent performance and that that this further encourages the bad behavior of chasing performance.
Conflicts of Interest Hurt Investors
The second piece of Mr. Swensen’s argument is that the structure of the industry and its marketing practices are a result of an inherent conflict of interest between the companies that manage mutual funds and the individual investor:
The companies that manage for-profit mutual funds face a conflict of interest between producing profits for their owners and generating superior returns for their investors. Mr. Swensen claims that these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors, he asserts.
He further states that brokers and financial advisors encourage investors to trade often and to try to identify the ‘best’ funds as a means to boost brokerage and sales fees and to justify their services.
Mr. Swensen proposes that all mutual fund managers, brokers and advisors should be held to what is called a “fiduciary standard,” making them legally required to put a client’s interests ahead of their own. He implies that most investors have no idea whether they are being offered advice (implicitly or explicitly) by someone with their best interests in mind. Money Magazine recently provided a good overview of this issue.
Swensen’s Simple Investment Advice
Mr. Swensen’s advice for individual investors is pretty simple and straightforward:
1) Become financially “literate”
2) Invest in a well-diversified portfolio of low-cost funds
This is not a new position for Mr. Swensen. He has been making the case for simple, low-cost portfolios for decades, in every interview he has given and in every book he has written. Over the three years, (specifically, through August 18, 2011), MarketWatch reports that this Swensen’s simple portfolio has returned 2.7% per year vs. -0.55% for the S&P 500 Index. Over the past ten years, this portfolio has returned 6.6% per year vs. 2.2% for the S&P 500. (See the holdings and performance of Mr. Swensen’s portfolio).
Some Additional Food for Thought
There is little question that a trusted financial advisor who is legally bound to provide you with unbiased advice could lead you to make better financial decisions. The same argument could be made for hiring a professional nutritionist: he or she will simply tell you to start eating healthy and stop eating at McDonalds—regardless of how tasty the food looks in their commercials.
At the end of the day, McDonalds wants to sell more hamburgers and french fries just like a mutual fund company wants to sell more mutual fund shares. McDonalds is not in the business of helping you to plan a diet for your long-term health— and mutual fund companies are not in the business of helping you to make the best financial decisions.
We know that many American’s are in poor physical health due to poor dietary choices, and the same can be said for Americans’ financial health. In times of financial stress, such as in volatile markets, investors tend to make poor investment choices in volatile markets by chasing performance.
That said, do I think that McDonalds is responsible for this country’s high rate of obesity? No. Nor do I think that mutual fund companies are responsible for American’s bad investing habits. However, the similarities between physical health and financial health cannot be ignored. In my opinion, the answers to both problems are as simple as David Swensen’s highly successful investment strategies: educate yourself, stay invested, stay informed and don’t buy the hype.