How David Swensen beats the market -- and why you can't

David Swensen is a generous man. Though he is one of the most successful money managers in the world, consistently delivering outsized returns for his investors, he takes home a paycheque that is the Wall Street equivalent of a vow of poverty.

Under Mr. Swensen's 20-year stewardship, Yale University's US$15-billion endowment has earned annual compound returns of 16.1%. Every dollar entrusted to him on June 30, 1984, had, by July 1, 2004, grown into nearly $20. According to an analysis by investment fund research firm Morningstar, there's not one Canadian mutual fund or institutional pooled fund that can match his record. Mr. Swensen also outperformed 99% of U.S.-based mutual funds. And he beat the S&P 500 and S&P/TSX Composite total returns of, respectively, 13.3% and 9.7%.

If he wanted to, Mr. Swensen could jump to a hedge fund and earn $50-million or $100-million a year, maybe more. Instead, the economics PhD and former student of Nobel-prize winner James Tobin stays at Yale, pulling down a measly US$1-million a year -- effectively donating to the university the difference between his market value and what he's actually paid. Maybe they should name the business school after him.

Financially gifted, personally modest and not looking to make a buck off of you: precisely the sort of fellow you'd trust if he gave you advice on how to manage your finances. And in his new book, Unconventional Success: A Fundamental Approach to Personal Investment (Free Press), Mr. Swensen does just that. His hot tip on how to run money just like he does? Don't.

"Individuals don't have access to the same quality of actively managed funds that Yale does," Mr. Swensen tells me over the phone early one morning from his New Haven, Conn., office. "And individuals tend to behave in ways that undermine the effects of active management."

Mr. Swensen speaks softly and slowly, carefully weighing every word before deciding to release it. It's an apt character trait for the new breed of money manager, a financial engineer whose game is calculated caution and mathematical risk reduction.

You and I cannot do what Mr. Swensen does because we're not smart enough, and we're not disciplined enough: We're almost certain to make classic mistakes such as chasing after fads, buying at the peak and selling during downturns. And when we aren't screwing ourselves, the mutual fund industry's high fees for sub-par returns will be more than happy to do so on our behalf.

To get the highest long-term returns possible, Mr. Swensen says you should be heavily weighted in the historically top-performing asset class, equities -- as he is. You should also reduce risk by diversifying within equities, and across a variety of other asset classes -- as he does. But unlike him, instead of trying to pick individual securities, you should invest with low-fee index mutual funds or exchange-traded index funds (ETFs).

His model portfolio (see accompanying table) was designed for American investors, but he says its principles can work just as well for Canadians.

A Canadian version of the Swensen portfolio would put 30% of your nest egg in the TSX index, using Barclays iUnits S&P/TSX 60 ETF, or TD's Canadian Index e-series mutual fund. These have management fees of 0.17% and 0.31%, respectively, whereas almost all other Canadian equity funds have management fees well in excess of 1%. Over time, those high fees will drill a hole in your retirement savings.

Put another 20% of your portfolio into U.S., world and emerging market equities by buying ultra low-fee ETFs, such as Vanguard Vipers. Invest 20% in Canadian real estate through Barclays iUnits real estate investment trust ETF.

To bring further diversification and risk-reduction to your portfolio, put 15% into a basket of Canadian government bonds and another 15% into "real-return" government bonds, which offer inflation protection. Keep your portfolio in balance by selling your winners and buying your losers. Repeat. Hold until retirement.

This isn't a particularly novel strategy. What's novel is finding an active manager, let alone one of the world's most successful active managers, arguing against active management.

Most managers do not beat the index. According to Standard and Poor's "Indices Versus Active Funds Scorecard," over the past five years, the S&P 500 beat 61.8% of large-cap American mutual funds, the S&P MidCap 400 outperformed 80.8% of mid-cap funds and the S&P SmallCap 600 outperformed 72.7% of small-cap funds. In Canada over the past three years, only 5.9% of Canadian equity funds outperformed the S&P/TSX Composite Index.

But Mr. Swensen has beaten the index. So why doesn't he recommend that, even if you can't manage money like him, you just go out and hire a money manager like him? Answer: It's a little like saying that if only the Leafs would draft players who scored more goals, they'd win more Stanley Cups.

"I've got 20 professionals here in New Haven devoting their careers to identifying high-quality active management opportunities," Mr. Swensen tells me. "An individual who devotes a couple of hours a week in the evening, at most, trying to compete with institutions that have armies of people out there? It just doesn't make sense."

Mr. Swensen also recommends that you stay away from hedge funds. Yet, once again, the paradox: Mr. Swensen has a quarter of Yale's portfolio in what are euphemistically known as absolute return strategies. He was one of the pioneers in the sector, and he isn't concerned that all of the new money rushing in will drive down returns. At least not his.

"The flood of capital into hedge funds isn't going to diminish the ability of good managers to find cheap stuff to buy and find expensive stuff to sell." If anything, all of these new "second-rate and third-rate managers," just might boost his returns.

"There's lots of money coming in doing stupid things," Mr. Swensen says. "If a flood of capital rushes in and bids up prices to unrealistically high levels, it gives a smart guy a chance to sell, and vice versa."

But while David Swensen may be able to find those opportunities, you would be wise not to try. History suggests that you run an extremely high risk of underperforming, and paying for the privilege.

Consider this snapshot of my own portfolio. From late August, 2004, to late August, 2005, my RRSP, which is mostly Canadian equities, was up 27%. That sounds like giant-killer performance -- but had I simply put all of my money into Barclays iunits S&P/TSX 60, and reinvested dividends, I'd have been up 30%.

This proves one of Mr. Swensen's biggest points: that the bulk of performance for most investors comes not from stock picking, but from asset allocation. I did well because I put most of my money in Canadian stocks, and the Canadian stock market had a raging bull of a year. All my active management did was slightly reduce my return.

But the Swensen analysis also says that my asset allocation, with so much in one asset class -- Canadian equities -- is high-risk. I got lucky this year. But I and everyone else who scored big from 2003 to 2005 would be advised to stop mistaking luck for talent.

"When you see markets perform above long-term historical levels, I think you would rationally expect that that would be offset by a period of underperformance," he told me. "I don't think I would base my investment expectations on trees growing to the skies."

But if you make a more modest, diversified, balanced bet, you stand a much better chance of reducing risk and increasing returns -- and growing something big to harvest at retirement time.

Tony Keller, a former editor of Financial Post Business magazine, is a visiting fellow at the University of Toronto Faculty of Law.