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Front Matter


(One of the top mistakes that individual investors make is investing all of their money in a local company or an employer's stock.You could get rich, but the risk will be very highjust ask former Enron and Bear Stearns employees.)


Summary

•Endowment assets under management are large and growing.•Endowments have several advantages over the investing public: They are tax-exempt, have long-term time horizons, and have few investment restrictions.•A large and strongly performing endowment gives the school a huge competitive advantage, and contributes substantial amounts to the school's operating budget.

•Poor management of the endowment can be detrimental to the operations and survival of a university.

•The biggest endowments, known as the Super Endowments, perform form better than the smaller endowments, and do so year in and year out in every asset class.

•The Super Endowments employ a less traditional asset allocation-more more real assets and alternatives, and fewer U.S. stocks and bonds.

•The Super Endowments utilize their active asset management capabilities (market timing and security selection), relationships, and pricing leverage to outperform the smaller endowments.


It really boils down to "don't put all your eggs in one basket," or in other words, diversification works.You can put together a bunch of risky assets (stocks, real estate, commodities) and as long as they don't all move together in a correlated fashion, the combined portfolio is less risky than the individual parts. Roger Gibson has some great examples of multiasset-class set-class investing in his academic papers and his book, Asset Allocation,


The mean variance optimization will tell you what the best allocation is for the past. We care about the best allocation in the fiitiare.


Assumptions that you may be using today as fact (stocks outperform bonds, small caps outperform large caps, etc), could prove to be unreliable in the future.


Correlations should be viewed as a tendency, not an absolute, and they are certainly something you cannot count on. A famous Wall Street saying is that in times of economic shocks, all correlations go to 1! (Meaning when it hits the fan, everything goes down together.)


Financial professionals love jargon. They like to refer to benchmark indexes and asset classes as beta.' All this means is that the investor buys something and gets paid for holding systematic risk.Asset



Then there is alpha. Alpha is the value added by a portfolio manager ager by active management (and is usually measured against some benchmark index, or beta). Think of the skill-based returns added by Warren Buffett versus the S&P 500, or the returns of PIMCO's Bill Gross versus the Lehman Aggregate Bond Index.


Alpha is a zero sum game, meaning for one person to win someone else has to lose. (Actually it is negative sum when you include transaction tion commissions and slippage.)


An inverse relationship exists between efficiency in asset pricing ing and appropriate degree of active management. Passive management strategies suit highly-efficient markets, such as U.S. Treasury bonds, where market returns drive results and active management adds less than nothing to returns. Active management ment strategies fit inefficient markets, such as private equity, where market returns contribute very little to ultimate results and investment selection provides the fundamental source of return.


The main purpose of the bond portfolio is to act as a hedge against financial accidents or unexpected deflation. Yale finds the assets unattractive due to the low historical and expected returns, as well as the high degree of market efficiency. Swensen argues against allocations to foreign bonds due to their low expected returns and foreign currency rency exposure.


Summary 

•The Yale University endowment has not always been in good shape, and the arrival of David Swensen helped propelYale into an investment ment powerhouse.

•Yale generates its exceptional return due to asset allocation and active management.

•Yale seeks wide diversification as an effective means of risk management

.•Most of Yale's portfolio is in equity-like asset classes. Bonds exist only as a hedge against deflation

•There is a large allocation to real assets and nontraditional asset classes for their return potential and diversifying power.

•Active management is practiced only in the less efficient markets, andYale generates most of its outperformance in private equity and real assets.

•Yale outperforms its current target Policy Portfolio by over 6% per annum.


Chapter 2




The Claymore/Clear Global Timber (CUT) exchange-traded traded fund (ETF) is the first ETF to launch focusing on the timber area, and it has a global allocation to companies involved in owning and leasing forest land, harvesting timber, selling wood and pulp-based products, and selling paper and packaging ing materials. The index weights the country allocations by the distribution of forest land across regions of the world. Barclay's quickly followed with the iShares S&P Global Timber & Forestry Index Fund (WOOD) ETE


Summary

•The Harvard endowment is the largest in the world

.•The seeds of an unconventional portfolio were planted in the 1970s and 1980s.

•Like Yale, Harvard seeks wide diversification, and focuses on equity-like asset classes.

•Real assets and alternatives have a large allocation in the portfolio. Timber investments, which provide stable, less correlated returns, is an area where Harvard has developed an expertise.

•Harvard has had very strong returns, outperforming its peers and the asset class benchmarks.

•Harvard has outperformed the target Policy Portfolio by over 5% per annum

.•Once run like an internal hedge fund, Harvard is morphing into the Yale style of outsourcing its endowment management.


Ivy portfolio


Ivy portfolio


Because


The result is an even 20% allocation to the five asset classes. We can this portfolio the Ivy Portfolio as it is very simple but still reflects the general allocations of the top endowments without hedge funds and private vate equity. Namely, a preference toward equity assets, real assets to protect against inflation, and a small bond allocation to insure against deflation risk. (We expand the Ivy Portfolio later to include more granular asset classes, but this exercise is mainly to approximate historical performance.)


Originally developed by Stanford Professor William Sharpe, it is simply the return of an investment (R) minus cash sitting in T-bills (otherwise known as the risk-free rate, Rf), divided by the volatility of the investment ((T). Cash will have a Sharpe Ratio of zero. S=(R-Rf)/6 A good rule of thumb for Sharpe Ratios is that asset classes, over the long term, have Sharpes around 0.2 to 0.3. A "dummy" 60/40 allocation to stocks/bonds is around .4. The Ivy Portfolio allocation is around 0.6.


Some alternative metrics include:•Sortino Ratio: uses only the volatility of negative asset returns in the denominator (similar to Ziemba's downside symmetric Sharpe Ratio).•Sterling Ratio: uses the average maximum drawdown in the denominator.•MAR (or Calmar) Ratio: uses maximum drawdown in the denominator.•Ulcer Index: Measures the length and severity of drawdowns (one of our favorites).


The Ivy Portfolio is a well diversified "all-weather" portfolio that should hold up in various economic environments.


The best review of commodities' role in a portfolio is the white paper by Ibbotson Associates (commissioned by PIMCO) titled, "Strategic Asset Allocation and Commodities." As usual, we will link to this paper (and many other important papers on commodities) on the Ivy Portfolio web site. How much to include in the portfolio? The Ibbotson study suggests a significant amount.


Jack Meyer gives this advice to the individual investor in a 2004 Business Week interview: "First, get diversified. Come up with a portfolio lio that covers a lot of asset classes. Second, you want to keep your fees low. That means avoiding the most hyped but expensive funds, in favor of low-cost index funds. And finally, invest for the long term. Investors should simply have index funds to keep their fees low and their taxes down." (Symonds, 2004)


In short: diversify, avoid fees and taxes, index, and take a long-term view. This section details how to construct a Policy Portfolio based on the Ivy Portfolio allocation.


Eric Crittenden, the portfolio manager at Blackstar observes, "Our interpretation of these findings is to conclude that the stock market is simply an extension of what we see every day in business. A small minority of businesses are well run and blessed with successful ideas. Some businesses are modestly profitable. Many businesses struggle to break even and a large percentage end up being failures. To us it seems the 80/20 rule applies to the stock market: 80% of the gains are a function tion of 20% of the stocks."


The takeaway is that 64% of all stocks underperformed the Russell 3000 index during their lifetime and 36% of all stocks outperformed the Russell 3000 index during their lifetime. If most stocks are underperforming performing the index in which they are members, then a relatively few stocks must be responsible for a majority of the gains.


In the end, it is important to keep in mind that:•Capitalism is a dynamic process, and many businesses fail.•Observing the long-term total returns for all stocks shows a very non-normal distribution that consists of a small minority of huge winners, a majority of below average performers, and a significant number of complete failures.•If you are going to pick stocks, realize that the blind odds of picking ing a winner more accurately than the index are against you.•Almost half of stocks have a negative rate of return over their lifetimes, times, and one in five loses almost all of its value.•Indexing is the best way to ensure that you will own the big winners. Momentum works.


Summary

•The Super Endowments on average have returned 4% to 6% more per year than any one asset class.

•An investor can replicate the asset class exposure (without alternatives) of the Super Endowments with liquid indexes.

•An investor can create an all-weather Policy Portfolio with either no-load mutual funds or ETFs.

•The Ivy Portfolio can be constructed with any number of ETFs, and we provide sample portfolios with 5 to 20 asset classes

.•While the exact percentages should be tailored to the individual's situation, the key is an allocation to stocks, bonds, and real assets in line with the endowment percentages.

•A diversified, passive, indexed approach achieves good results, but trails the Super Endowments by about 4% per year for similar volatility.

•Having the discipline to rebalance is important. Tax harvesting could improve the tax efficiency of the portfolio.


Basically, unless you are an endowment or can pick the top 20% of private equity funds, you are better off buying a stock index and not dealing with all of the headaches of limited partnerships.


•Private equity is a difficult asset class for the individual to access-high high investment minimums, closed funds, and lengthy lockups detract from the appeal of private equity.

•Private equity can be lucrative for those able to invest with the top managers.

•Endowments dominate private equity with returns approximately 14% greater than the average investor.

•The average returns of private equity are equity-like with correlations similar to domestic and foreign stocks.

•The difference between top and bottom quartile performers is huge, with most of the returns generated by the top investors

.•The listed ETFs may replicate the median returns of the asset class, but it is too early to tell if they add any value

.•An investor could allocate some of the portfolio to these ETFs with the knowledge that it could simply perform like leveraged U.S. and foreign stocks.


Summary 

•Hedge fund managers pursue active strategies that attempt to generate erate alpha. Because of the fee structure, rewards for being a top manager are enormous.

•In 2007, there were over 10,000 funds managing about $2 trillion.•Some benefits to investing in hedge funds include higher absolute and risk-adjusted returns, low correlation to traditional investments, and fewer constraints on the portfolio.

•Some potential drawbacks include accreditation requirements, lack of liquidity, manager selection, fraud, taxes, transparency, and top funds closed to new investors.

•Funds of funds can eliminate a lot of the portfolio construction and due diligence hassles but layer on extra fees.

•The United States is starting to see more hedge-like mutual funds and ETFs.

•The foreign listed hedge fund space is large and growing fast, currently around 50 funds with $20 billion in assets.

•An investor can access the foreign listed space, but caution is warranted due to legal and tax implications.


We use the monthly equivalent of Siegel's 200-day SMA-the 10-month SMA. Because we were privy to Siegel's results before conducting ducting the test, this query on U.S. stocks should be seen as in-sample. (That just means we already got a peek at the data. Out-of-sample testing is a better indicator of a system's robustness).' The system is as follows: Buy Rule: Buy when monthly price > 10-month SMA. Sell Rule: Sell and move to cash when monthly price < 10-month month SMA. (For those unfamiliar with moving averages, stockcharts.com is a good web site that allows users to graph moving averages on asset classes and funds. More important, they account for dividends in their total return calculations.) Beyond that, keep in mind:•All entry and exit prices are on the day of the signal at the close. The model is only updated once a month on the last day of the month. Anything going on during the rest of the month is ignored.•All data series are total return series including dividends, updated monthly.•Cash returns are estimated with 90-day Treasury bills, and margin rates (for leveraged models to be discussed later) are estimated with the broker call rate.•Taxes, commissions, and slippage are excluded (see "practical considerations" siderations" section later in the chapter). That's it. The rules are simple, but for some people they are hard to follow. Why is that? For the same reason people have a hard time dieting, or training for marathons, or cleaning out the garage: self control trol and discipline.


The 10-month SMA is not the optimum parameter for any of the statistics, but it is evident that there is very broad parameter stability across the various moving average lengths.


Almost anybody can make up a list of rules that are 80% as good as what we taught our people. What they couldn't do is give them the confidence to stick to those rules even when things arc going bad. -RICHARD DENNIS


A down year two years in a row increases average returns about 4% but only happens about 10% of the time. Three negative ative years in a row result in median returns of about 30% a year. While this occurs somewhat infrequently, the results are very positive.


Many pundits also show how missing the ten best days of the market ket can decimate your returns, and use that as proof that market timing ing doesn't work. What they don't understand is that the vast majority (roughly 70%) of both the best and worst days occur when the market is below the ten-month simple moving average. The simple reason is because the market is more volatile.


Summary

•Do not lose.•Do not lose.

•Investing in asset classes yields rewards, but the risks can be significant.

•Most asset classes have experienced large drawdowns that can require years to recover from.

•Evolution by natural selection has resulted in numerous behavioral biases that interfere with investing success.

•Using a simple trend following approach can help to instill a disciplined ciplined investment process, while reducing volatility and risk of drawdowns.

•Historically the simple timing model has worked in virtually every market over long time frames.

•Applied to the Ivy Portfolio, the timing model results in equity-like like returns with bond-like volatility, and 36 years of consecutive positive returns.

•While still trailing the endowments, the timing model approaches the risk-adjusted returns of Harvard andYale.A leveraged version has similar returns as the endowments, albeit with stock-like volatility.

•A similar relative strength (or rotation) model could work for investors tors seeking higher absolute returns with manageable risk.


Mebane Faber is cofounding an online software project, called AlphaClone (www.alphaclone.com) to automate the 13F processes and intelligence described in this chapter.


Searching the SEC Database The SEC maintains the EDGAR database (www.sec.gov/edgar. shtnil),' and posts the electronic versions of 13F filings within a day after such filings are received. The data goes back to late 1999, although the archives in Washington, D.C., contain paper records that go back further. All an investor has to do to retrieve the holdings is to visit the web site, and search under "Company Name" for the desired fund or company. In our first case study, we use "Berkshire Hathaway" (CIK # 0001067983) resulting in a laundry list of filings. We are interested ested in only the 13F filings, and the user can narrow down the list by inputting the "Form Type" provided (13F). All of the quarterly 13F filings ings are now at your fingertips. Since the 13Fs are published within 45 days after quarter end, the filing for the quarter that ended December 31, 2008 would be available able around February 15, 2009.


The methodology we are going to use is as follows:

 1. Download all of the 13F quarterly filings. 

2. If there are more than 10 holdings, simply use the 10 largest holdings, ings, as the majority of a manager's performance should be driven by his largest holdings. 

3. Equal-weight the 10 holdings. 

4. Rebalance, add/delete holdings quarterly, and calculate performance ance as of the 20th of the month to allow for all filings to arrive.


Summary

•It is very simple to track holdings of institutional fund managers utilizing 13F filings submitted quarterly to the SEC.

•Following these fund managers can lead to new investment ideas

.•More importantly, results indicate that by tracking and rebalancing portfolios quarterly, an investor can replicate the long holdings of hedge funds without paying the high hedge fund fees.

•These excess returns can benefit from in-line volatility compared with the equity and hedge fund indices.

•Because value managers have long-term holding periods and low turnover, the 45-day delay in reported holdings should not be a significant issue

.•Case studies are presented examining three value investors, Berkshire Hathaway's Warren Buffett, Greenlight Capital's David Einhorn, and Blue Ridge Capital's John Griffin and back-tested results are presented sented for the portfolios since 2000.

•Additionally, more complex applications for investors could include constructing hedged portfolios, as well as portfolios that compile the holdings of multiple fund manager holdings. This "fund of funds" would add diversification to the 13F replication strategy.