A Conversation with David Swensen

A Conversation with David Swensen

Don Pollard

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from Stephen C. Freidheim Symposium on Global Economics and Stephen C. Freidheim Symposium on Global Economics

This is the keynote session of the Stephen C. Freidheim Symposium on Global Economics. 

This symposium focuses on the future of investment management in a world of low returns, the financial pressures felt by universities, states, and individuals around the world, and methods for adjusting to low returns on investments.

RUBIN: Here we are. Well, not surprisingly we have a full house. And if you’re an investor, there is nobody in the world you would rather sit with than David Swensen. So, David, we are delighted, honored, privileged, and grateful for you being with us. As you know, this is the Stephen C. Freidheim Symposium on Global Economics. (Laughs.) There’s Stephen right there. (Laughter.)

And what we’re going to do is I’m going to ask David a few questions, which he can respond to as a long-term investor, with all faces extremely complicated environment. And I’ll do that for about half an hour. And then the second half-hour we’ll take questions from all the members who are here. If you ask a question, stand up, identify yourself, identify your affiliation, and make your questions brief so we can get in as many as possible in the time that we have.

This session will be on the record. And afterwards, we will have I think a 15-minute or so coffee break. And then we’re going to have Governor Dannel Malloy of Connecticut, who will discuss pressures on pensions. And just—I’m not going to introduce David, because that’s—the CFR practice is not to read from people’s resumes. You all know who David is anyway. But besides which, he is the iconic held of the Yale endowment.

OK, David, let’s start with this: The markets have been up for about eight years, or thereabouts. There are all sorts of risks out there. Richard Haass was quoted in Nick Kristof’s column the other day as saying he thought there was a 50 percent chance we would have some sort of military engagement with North Korea. And we have a whole host of other risks that we can think about.

When you, as a long-term investor at Yale, think about your portfolio, do you take into consideration these—the possibility, at least, and whatever the probabilities you may think are—the possibility of a major downturn, given the circumstance I just cited? Or do you take the view that you’re a long-term investor and if things go down, they’ll come back up, and you don’t take that into consideration?

SWENSEN: You have to think about what’s going on in the tails of the distribution. I think that’s incredibly important. We spend too much time in finance class, in business schools or in colleges, thinking about normal distributions. And we know—we know the distribution isn’t normal. If securities returns were normally distributed, the crash in 1987 wouldn’t have happened. It was a 25-standard-deviation event. That’s an impossibility.

And when you look at defining moments for portfolio management, they come in 1987, they come in 1998, they come in 2008-2009. And if you ignore that, you’re not going to be able to manage your portfolio effectively. But when you start out, you were talking about fundamental risks in this world. And when you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling, and makes me wonder if we’re not setting ourselves up for an ’87 or a ’98, or a 2008-2009.

RUBIN: But then I think the question, David, is this—and this is what I think myself; I’m very focused on it. I agree with what you just said. But then do you have—does that enter—since you’re not a market timer, but a long-term investor, does that enter into your asset allocation at Yale? Should it enter into my asset allocation? I’m a long-term investor. Or should you just take the view these things are going to happen, they’re pretty much unpredictable in terms of timing and duration and magnitude, and so we accept them and figure that if it goes down, it’ll go back up? Which do you do?

SWENSEN: So we’re absolutely not market timers, but I would talk about market timing as kind of a short-term swing in the portfolio to take advantage of some knowledge that you have or some belief that you have about where markets are headed in the short term. But I think we have to take strategic positions in the portfolio. One of the most important metrics that we look at is the percentage of the portfolio that’s in what we call uncorrelated assets. And that’s a combination of absolute return, cash, and short-term bonds. And those are the assets that would protect the endowment in the—in the event of a market crisis.

Prior to the downturn in 2008, we were probably about 30 percent in uncorrelated assets. By the time 2009-2010 rolled around, we were probably around 15 percent. And the reason for the dramatic decline is these are the sources of liquidity in times of stress. And so today we’ve rebuilt that. It actually works out quite nicely from a cyclical perspective, if you’ve got a rebound afterwards. Instead of being 70 percent in risk assets, you’re 85 percent in risk assets. But over the years subsequent to the crisis, we’ve rebuilt our uncorrelated assets position to an excess of 30 percent. And we’re currently targeting about 32 ½ percent, which is somewhat above the long-term goal.

RUBIN: And is the uncorrelated, David, something that you think has a beta of close to zero?

SWENSEN: Yes.

RUBIN: OK.

SWENSEN: We worked very hard to engineer absolute return to have as little correlation to market as possible.

RUBIN: When you advise Yale—many of us are involved with institutions that have endowments. When you advise Yale as to how they should think about returns going forward, A, what do you advise them? And two, in that advice you take into account or you don’t take into account the possibility, again, of a major downturn?

SWENSEN: So for most of the 32 years that I’ve been at Yale, the standard assumption for endowment returns for the operating budget was 8 ¼ nominal. And that turned out to be a pretty decent working assumption. I think our 32-year rate of return is something like 13 ½, so we’ve generated a substantial cushion over the budgetary assumption for more than three decades.

What I’ve been talking to the provost about for the past 12 or 18 months is, for the first time in this very long period, reducing the expected return assumption in the budget to 5 percent nominal. And—

RUBIN: (Inaudible)—problem with that. (Laughs.)

SWENSEN: —I think I’m making—I think I’m making progress. (Laughter.) But places like Yale have an enormous amount of inertia, and it’s very difficult to make those kind of changes, particularly since it’s not a very popular change. (Laughter.) And I think, to some extent, we’re victims of our own success, because they’ll say, oh, you’re just Chicken Little; the sky is falling, the sky is falling. But, of course, you know, the returns have been generated in a pretty smooth fashion with that one exception in 2008-2009.

In terms of how we think about the possibility of a financial crisis, we really work hard to have a stable flow of resources through the operating budget. When I started in 1985, the endowments contribution to the budget was $45 million, Bob, and the budget was 450 million (dollars).

RUBIN: Probably more now. (Laughs.)

SWENSEN: It’s a little bit more now. It’s a little bit more now. It was 10 percent of revenues at the time. And if you have a fluctuation in 10 percent revenues, it can be hard to deal with, but not impossible. This year’s contribution to the operating budget is going to be $1.3 billion, and that’s 35 percent of revenues. And if you take out the medical school, which has a different business model, we’re providing between 60 and 65 percent of the funds for Yale College and for the graduate school and the professional schools.

And if you have a fluctuation in a number that’s 65 percent of your budget, it’s much more difficult to accommodate. So we’ve engineered the spending rule so there’s a very substantial amount of stability. Eighty percent of the spending in a given year is the same as what we spent the previous year, grown by inflation. And only 20 percent is sensitive to endowment values.

And we believe that if we had another disruption of markets like 2008-2009, we could provide year-over-year increases in spending to the budget. But when you have that high a weight on the previous year’s spending, you’re introducing volatility into the purchasing power of the endowment. But I think that’s the right thing, because providing that stable flow of resources is incredibly important.

RUBIN: We do the same thing at Harvard, David, but I think, if I remember correctly, our numbers are 70/30 instead of 80/20. But it’s the same idea.

Let me ask you another question. The United States—when you think of investing for, say, a 10-year period or whatever it may be, longer run, and you look at the immense political dysfunction at the present time, then you have to have some judgment what you think is going to happen in terms of our political system. And, you know, who knows is the answer. But at least you have to be troubled by it, whatever your views may be.

Does that prospect, or the possibility, at least—whatever the probability—whatever the odds may be, the possibility of political dysfunction which prevents us from dealing with our—with the great predominance of our challenges, our policy challenges, does that affect at all how you think about investing in this country?

SWENSEN: You know—

RUBIN: Or maybe you just have a faith this is going to come back and you don’t worry about it.

SWENSEN: The types of questions that you need to ask with respect to where you’re investing are the bedrock for putting together your asset allocation. And when I look around the world, there are places that we just won’t invest; Russia. If the rule of law is not followed, then you know whether or not you own anything. And if you don’t know whether or not you own it, then why would you put—why would you put your funds there?

And as we look around the world, in spite of the problems that we face in the United States, this is one of the best environments in which to invest. I think that the breadth of emerging markets that we were interested in 20 years ago has narrowed dramatically, which I think is incredibly unfortunate. You would have hoped that you’d have 20 years of progress instead of enormous amounts of backsliding in many of the markets that we once found attractive.

And there are some very interesting things going in Japan, one of the places I’m most optimistic about. It seems like capitalism might actually be taking root, making progress there. And, you know, selectively in Europe we’re seeing some opportunities. But the United States is still, I think, the market in which we’re most comfortable, our current political problems notwithstanding.

RUBIN: How do you feel about China?

SWENSEN: China is an area that makes me incredibly nervous, but at the same time we’re heavily committed there. And I have had great relationships with a handful of managers in China that have produced extraordinary returns. But the party’s commitment to capitalism doesn’t seem as steadfast as I might have thought five or 10 years ago. And that makes me nervous.

RUBIN: Does the party conference that just ended in October, did that cause you to be more concerned or not?

SWENSEN: My level of concern has been pretty constant—

RUBIN: OK. (Laughs.)

SWENSEN: —the past 12 or 18 months. (Laughter.)

RUBIN: So you already—you anticipated that. OK.

Let me ask another question, David. You were a pioneer, and with extraordinary results for Yale, in alternatives. And private equity certainly has been an extremely attractive place to be. On the other hand, vast amounts of money are now coming into private equity. Does that affect your view at all with respect to private equity? Or how would you think about private equity as a—as a cliff?

SWENSEN: So if we’re talking about private equity and focused on the leveraged buyout—

RUBIN: No, I actually was thinking more broadly; I mean, some of the leveraged buyouts, but some of these are funds—they usually tend to be smaller—where they are private equity, but they’re not really dependent on leverage as much as they are as the engagement with the companies and trying to make them better and that sort of thing.

SWENSEN: So that is what I love most in my portfolio. I think the private equity that you’re talking about, where you buy the company, you make the company better—

RUBIN: Yeah.

SWENSEN: —and then you sell the company is a superior form of capitalism. I’m really concerned about what’s going on in our public markets. I think short-termism is incredibly damaging. There’s this focus on quarter-to-quarter earnings. There’s this focus on whether you’re a penny short or a penny above the estimate.

And there’s this activist mentality that permeates the markets. It’s not just the companies where the activists take a position and then ask for cash back, whether it comes back through a dividend or comes back through a share buyback. It’s the possibility that the activist is going to go after the company that’s not currently under threat. And it’s a very naïve playbook that I think is destroying the quality of the companies and destroying the quality of the markets.

If you compare and contrast that with the—let’s say the buyout world, where you’ve got hands-on operators that are going to improve the quality of the companies, there’s no pressure for quarter-to-quarter performance. There’s no pressure to return cash at any cost. There’s an opportunity, with a five- to seven-year time horizon, to engage in intelligent capital investments that will improve the long-term prospects of the company.

The only problem is that you have to pay 20 percent of the profits.

RUBIN: (Laughs.)

SWENSEN: Right? And that’s the hurdle, right? You have to make 20 percent of the profits to the operator. If there were a fair deal structure, you wouldn’t want to put anything into the public securities markets. You’d want it all in private equity, because that is a better form of capitalism.

RUBIN: While I—since I’m an investor and not an owner of a private equity firm, I agree with you. (Laughter.) But from their perspective, I suppose, they would say that is capitalism. You want better returns, you have to pay the people that provide them, I guess.

SWENSEN: Oh, yeah. Yeah, I’d just rather pay them 20 percent over a fair hurdle, as opposed to 20 percent over zero.

RUBIN: Yeah, I would too, but they don’t want to do it that way. (Laughter.)

SWENSEN: Yeah, I know. I know.

RUBIN: What about the notion, David, that over time—a notion that I think is getting a lot of currency now, actually, that over time AI, machine learning, and all these kinds of things are going to replace the David Swensens of the world. And they will be—and I know all of us reject that. And we say, no, our judgement is what we want to rely on, but they have done an awful lot of back-testing on one thing or another, and they have a sort of an interesting case to make. Do you have any view of that?

SWENSEN: So, Bob, usually I’m not glad that I’m 63 years old—(laughter)—and nearer to the end of my career than the beginning of my career. But that question actually makes me glad of those two facts. (Laughter.) You know, I have never been a big fan of quantitative approaches to investment. And the fundamental reason is that I can’t understand what’s in the black box. And if I don’t know what’s in the black box, and there’s underperformance, I don’t know if the black box is broken or if it’s out of favor. And if it’s broken, you want to stop. And if it’s out of favor, you want to increase your exposure.

And so I’m an old-fashioned guy that wants to sit across the table from somebody who’s done the analysis and understand why they own the position. And then if it goes against them, I can have another conversation and try and figure out whether the thesis was wrong and we should exit, or whether the thesis is intact and we should increase the position. And I don’t understand any other way to invest.

RUBIN: David, there are vast amounts of—there’s a vast amount of liquidity around, looking for all kinds of—looking for wherever it can go to try to do as well as it can do. Are there areas you think are under focused on?

SWENSEN: So one area that I think is really interesting is Japan. I mentioned that earlier. And the resources have been in place there for decades. But the focus of corporate management has often been on things that have nothing to do with return on equality and nothing to do with profits—scale, employment, you know, things that matter but aren’t necessarily good for investors. And I think there’s been a sea change. And there are a handful of people that are kind of leading this charge to focus on corporate profitability, effective use of assets. And I think that there will be some really interesting opportunities that come out of that.

One of the obvious areas of opportunity in an environment of extended valuations is short something. Recently we had to change an index that we use to measure the returns of short sellers, because the index stopped being published because there weren’t enough managers to populate the—populate the index. So it’s incredibly out of favors. Short sellers have suffered enormously. And I think that’s an area of opportunity.

RUBIN: Well, that’s interesting. I wouldn’t have thought of that one, David. How do you engage in that area? I presume Yale is not running a short book, in effect, so.

SWENSEN: No. Well, within the absence of return portfolio, a lot of the long/short managers or a lot of the other strategies have residual equity exposure. So you can offset that with dedicated short managers and have a portfolio in aggregate that’s uncorrelated. So rather than, you know, being lazy and having an absolute return portfolio that’s got a fair amount of equity exposure in it, using those dedicated short managers is a pretty effective tool.

RUBIN: This makes—yeah, it makes sense. Are there a lot of those people around?

SWENSEN: Not very many anymore.

RUBIN: That’s what I thought, OK. Yeah, that was my impression.

SWENSEN: The survivors are pretty impressive, because they’ve been through the ringer.

RUBIN: They’ve survived a difficult environment for that activity, yeah. (Laughs.) This may seem like an odd question, but I was thinking about it myself the other day. If you look back, say, 10 or 15 years ago, or 20—whatever you want to do; I don’t care—and you think about how you thought about investment then, and you think about how you think about investment now, is it any different conceptually or practically?

SWENSEN: You know, I think if you asked me that question 25 years ago, I would have had a reasonably long list of things that I thought were important in an investment management firm. Today, I would say that number one is the character and quality of the investment principles. Number two is the character and quality of the investment principles. Number three—(laughter)—you get the idea. And you have to go further down the list before you get to some of the nuts and bolts. And I’m absolutely convinced that there is nothing more important than being partners with great people.

RUBIN: I agree with that.

SWENSEN: In the investment world, if people are the way that you’re taught and—introductory econ—if they’re maximizers, they’re going to raise massive funds, charge high fees, and make a lot of money for themselves. I’m looking for somebody that’s got a screw loose and they define winning not by being as rich as they can be individually, but by producing great investment returns. And you do that—you can still make a great living, but instead of managing $20 billion, you probably manage $2 billion. And the other day we met with a manager, and they said their goal was to be in the IRR hall of fame. And I love that, because if they produce great returns, that’s going to benefit the university. But if they gather huge amounts of assets and charge high fees, that’s going to benefit them and not Yale.

RUBIN: Would you rather they be in the IRR hall of fame, or the MOIC hall of fame? (Laughter.) Multiple on invested capital.

SWENSEN: Oh. I like both. I’m greedy. (Laughs.)

RUBIN: Well, but, life—yeah, but life is choices. So, you know, people invest in different ways and it gives you different choices. If you had to pick one or the other, which would you chose?

SWENSEN: No, no, no, yeah, Bob, the point you make is really good. When we’re looking at records in the private equity world, by and large we say: What’s the point of doing this if you don’t get a net 2 times multiple? And you look at records for the many, many of the participants in the illiquid asset arena, and multiples are, you know, 1:4, or 1:5, something like that. So we really do focus on making sure that we’re making good multiples of the money we put to work in this arena.

RUBIN: My impression—this may be wrong—but my impression is that a lot of people who focus on IRR then disregard multiple on invested capital. And you get these wonderful IRRs, but you don’t get—

SWENSEN: Yeah, you didn’t make any money.

RUBIN: Yeah, exactly,

SWENSEN: You can’t eat IRR.

RUBIN: No.

SWENSEN: (Laughs.)

RUBIN: Let me ask another question, the congressional budget—right now, debt-to-GDP ratio in the United States is 77 percent, give or take. And the Congressional Budget Office estimates that in 30 years it will be 150 percent. And in 10 years it will be 91 percent. And if this tax cut goes through, which seems like a high probability, that will substantially worsen those numbers. Does that bother you at all?

SWENSEN: Enormously.

RUBIN: (Laughs.) Well, now that you’re bothered, what are you doing? (Laughter.) Tell me, or—and we’ll get you—we can get you some Excedrin, or something, but that wasn’t the point of my—(laughter)—that really wasn’t the point of my—it wasn’t the state of your emotional health that I was worried about. (Laughter.) but how do you think about that in terms of investing Yale’s portfolio?

SWENSEN: Yeah. You know, for most of the time that I’ve managed Yale’s portfolio, we’ve tried to be relentlessly bottom-up and focused solely on identifying anomalies in the pricing of individual securities. And that’s worked out really well. I think with the advent of the financial crisis in 2008, 2009, that changed, because we had to be concerned about whether or not the banking system in countries around the world, particularly in the United States, was going to survive. We had to think about whether the eurozone would continue to be a cohesive whole. And so we’ve been forced into this uncomfortable position of needing to understand some of these macro questions that we could have previously ignored without peril.

It doesn’t mean that we’ve got, you know, answers to the questions. But they inform where it is that we’re more interested in placing funds and where it is that we’re less interesting placing funds, and they inform—they inform the asset allocation. And then, once that’s set up, which we review every year, then we go back to being relentlessly bottom-up, which is a much more comfortable place for us to be.

Did that duck your question artfully?

RUBIN: Yeah, you—well, it wasn’t so artful, but you did duck it. (Laughter.)

SWENSEN: That’s the best I can do, Bob.

RUBIN: Well, we’ll find something next year. But, no, but this is my final question. But it was sort of what I was getting at. I’m not equipped to do what you can do, which is make these bottom-up judgments. But it does strike me we live in a very complicated world.

And so my final question will be this—and maybe this is—I’m not going to phrase this exactly the right way, but it seems to me, but maybe I’m wrong, that when I think as an investor, which I do, about the world that we’re in, it seems to me to have a lot more uncertainty and complexity in many kinds of ways—geopolitically, economically, populism, all this sort of thing—than it did 15 or 20 years ago.

Now, my friend Larry Summers tells me that you always think that the present moment is more dangerous than other moments, and therefore you overstate that. And maybe Larry’s right, but maybe he’s wrong. So I’ll ask you what you think; not a choice, by the way, he necessarily acknowledges. (Laughter.) But I’ll ask you what you think. (Laughs.)

SWENSEN: So what Larry says resonates with me, because one of the things that I like to say is that we should never underestimate the resilience of this economy. But that—that said, it does feel as if this is a particularly fraught time.

RUBIN: That’s sort of my feeling.

Well, now we are entering the second half hour, when the better questions will be asked, because they’re going to come from you all. So who would like to start, if anyone?

Yes, ma’am. And if you would, state your affiliation. Make the question brief so we can get a bunch of them in. Thank you.

Q: Thank you. First of all, thanks so much for being here with us today. My name is Nili Gilbert. I’m a co-founder and portfolio manager at Matarin Capital. I also sit on the investment committee of the David Rockefeller Fund and chair the investment committee of Synergos Institute. My question is from the investment committee perspective.

When you talk about increasing allocation to uncorrelated assets, some challenges that investment committees can face there are when it comes to cash and short-term—cash and short-term fixed income that interest rates are low and rising. And when it comes to absolute-return strategies, many of them, especially if they’re very uncorrelated, have paled in comparison to high-beta strategies, even just a passive stock-market ETF.

So how would you counsel us—many of us here in the room, I think, are sitting on investment committees—to get around those headwinds as we’re speaking with our teams in thinking about making this switch?

SWENSEN: You know, it’s a great question, because this world of comparing returns to peers is all-pervasive. And I think it’s incredibly dysfunctional when it comes to making really good investment decisions. People are concerned about underperforming, and that causes them to want to put together portfolio allocations that look like other similar institutions.

And if you express concerns about market valuations by increasing your exposure to non-correlated alternatives, in a bull market you’re going to suffer poor relative performance. And there aren’t very many institutions that can maintain a position where, year after year after year, the numbers don’t look as good as those that are more invested in risk assets.

And so the advice that I would give would be to try and put together a portfolio that really works for your institution, and try and pay less attention to the returns that others with riskier portfolios might be generating, knowing that ultimately, if you’re making well-grounded decisions, that the numbers will come.

RUBIN: Of course, the problem, David, is—I’ve lived through this with an institution I’m involved with—when you have underperformers over the years, is it because they’re making more sensible decisions about risk or they’re just not making as good a decision about choices?

SWENSEN: Yeah. I mean, that’s a really, really, really important distinction. But it’s not so hard to parse, I think. You can use some, you know, reasonably basic analytical tools to figure out whether or not you’re being rewarded for the risks that you’re taking.

RUBIN: Yes, ma’am; sort of in the middle in the—no. Well, actually, I’ll come to her next. Right sort of in the middle back there; trying to get geographic dispersion.

Q: My name is Bhakti Mirchandani. I work at a hedge fund called 1 William Street.

You mentioned the damaging effects of short-termism for companies and for markets. And the way you’ve addressed that with Yale’s endowment is to invest largely in longer-term assets. But what about publicly traded companies? Unilever, for example, has stopped quarterly reporting. Other companies have stopped giving quarterly guidance, which is unique to the United States. But what steps would make you most optimistic about publicly traded companies and their investability from a long-termism perspective?

SWENSEN: You know, I think it’s possible to take a long-term approach with publicly traded companies. We have some managers that are engaged in public-securities investing in markets around the world. And in each of our relationships, the managers invest with a long time horizon. I think it gives them an enormous advantage.

If you can invest with a three- to five-year horizon, which is a pretty, pretty difficult thing to do—it might sound like it’s an easy thing to do if market conditions are benign, but you throw a 2008 or a 2009 in there and you have to really work hard to remember that this is temporary and that you need to keep on looking out three to five years when you’re making these decisions.

Ultimately, that, I think, is an incredibly powerful advantage. And the people that are on the quarter-to-quarter timeframe, they’re going to lose almost certainly. And they’re definitely going to be losing to the managers that are using the three- to five-year horizon. So I do know that it’s possible to extend your time horizon and succeed.

One of the things that I think is fascinating, which is not very widely practiced—and there are only a handful of managers that I’ve come across that do this—is to essentially take a private-market approach in the public markets and take big concentrated positions in public companies, develop relationships with management, become partners with management, help them figure out intelligent intermediate and long-term strategies.

In one instance in which the university has a very long, successful history, the returns have been extraordinary. But it’s so at odds with what’s going on in the equity markets today that it’s a very, very unusual exception. And I don’t know how you put the genie back in the bottle, turn back the clock to an era where there was much less focus on the quarterly earnings report and much more focus on long-term performance.

RUBIN: Yes, sir.

Q: Hi. My name is Kabir Sehgal and I work at First Data Corporation. We’re a payments company.

Mr. Swensen, what do you think the government’s role is in regulating the fees that mutual funds charge Americans, or, for that matter, not just mutual funds but all active managers? Thank you.

SWENSEN: You know, I don’t—I don’t think the government really should have much of a role in regulating fees. As Bob said earlier, it’s a marketplace, and people can charge the fees that they want.

I think it’s really the responsibility of the investors to make sure that they’re not paying fees that are taking what should be handsome, incremental returns and causing them to disappear into the manager’s pockets. So it’s really our responsibility as institutional investors, if you’re an investor in mutual funds, it’s your responsibility as an individual to understand the relationship between the fees and the returns.

And, yeah, I wrote a book, “Unconventional Success,” that by and large excoriated the mutual fund industry for providing very poor after-fee, after-tax returns to individual investors. But one of the things that we’ve seen in the last 10 or 15 years is a very strong movement away from actively managed mutual funds, which by and large have done a terrible job. And I know there are exceptions. And unfortunately, there aren’t enough exceptions. There’s been a move away from these actively managed funds that aren’t performing to passive funds. And I think that that is a perfect example of investors taking responsibility, understanding the dynamics, and moving to an investment vehicle that is far more likely to provide appropriate returns or good returns for the investor.

RUBIN: Yes, sir.

Q: Thanks. Yves Istel of Rothschilds.

Could you comment from your three to five year or longer point of view how you see fixed income and interest rates? Are they part of or not part of your noncorrelated assets these days?

SWENSEN: Yes, so when I was trying not to answer Bob’s question about—(laughter)—interest rates, I realized I do have a better answer to that question.

RUBIN: Good, you have another shot at it. (Laughs.)

SWENSEN: If you looked at—if you looked at Yale’s bond portfolio 20 years ago, probably a market portfolio, market duration, it was all government bonds because I believed that there are better ways for Yale to take equity risk than to own corporate bonds. And, oh by the way, the corporate bond issuers are a lot smarter than the corporate bond buyers because the issuers get call provisions and the buyers don’t get put provisions. (Laughter.) Do I need to say anything more?

But as rate came down, we systematically reduced the duration of our bond portfolio. And today it’s probably nine months or a year. And so we don’t think there is any point in—hey, Marty. (Laughter.) My first boss from Salomon Brothers, laughing because I told him I would never make any interest rate bets. And here I am, describing an interest rate bet to a room full of people. (Laughter.) We don’t see any point of owning 30-year Treasurys if the yield is 2 ½ percent. And we would be willing to change that calculus if circumstances change. But, you know, for the time being, I think the right thing for the university is to have very short-duration portfolio.

Is that a better answer to your question, Bob?

RUBIN: It’s another answer. (Laughter.) Way in the back.

Q: Thank you. Peter Gleysteen, ‎Progow.

Given the Baby Boom’s ongoing retirement and need for steady, dependable income, yet they’re faced with investment choices from the asset management world that are mostly total return net asset value based, which is arguably price driven and therefore not only volatile but may be inherently speculative. The question is, do you see the possibility of big change, new investment products where the returns are actually tethered to fair value and the underlying cash generation of whatever the investment is?

SWENSEN: You know, you raise a really important issue. I am terribly concerned about the retirement security of Americans. I think the Federal Reserve flow of funds data show that half of Americans have no savings—zero. And Social Security I don’t think is sufficient to support the retirements that most American citizens think that they’re going to have. The investment vehicles that are available for individuals are, aside from index funds, generally not suitable to allow the individuals to reach their retirement goals. And then what we’ve got available to individuals for the consumption phase—a set of fairly priced annuities would be a really nice start. Where are they going to find those? So it’s an area where we need to have innovation, where we need to have better government policies. And I don’t—I don’t see where any of those things are going to happen.

RUBIN: Yes, sir.

Q: Hi. I’m Jan Loeys with JPMorgan.

Did I hear you say that you have 32 percent now in uncorrelated assets?

SWENSEN: That’s correct.

Q: More than you had in ’08, when we were in recession?

SWENSEN: Slightly more, yeah.

Q: Do you think we’re in recession, or what scares you that you really want to have a recession-level of cash?

SWENSEN: Yeah. So I’m not worried about the economy so much. I have no idea what economic performance is going to be over the next five or 10 years. What I’m concerned about is valuation. I think when you look at pretty much any asset class anywhere in the world, it feels expensive. And the handful of areas that I talked about where I thought there were opportunities are kind of niche-y—short-selling, Japan, I think there’s some opportunities in China and India, although it’s hard to call either of those markets screamingly cheap either. So it’s really a question of valuation, not a question of economic fundamentals.

RUBIN: Other questions? Yes, sir.

Q: Hi, David. Ned Lamont, Connecticut, like you.

SWENSEN: How you doing?

Q: Talk about Connecticut state pension funds. About 35 percent funded. Talking about retirement security. Valuations are high. How is your asset decisions different in the public fund than they are in the endowment? (Laughter.)

SWENSEN: I’ll tell you, the public pension funds really scare me. We had a meeting with a group from California. And I was talking to them about the debates that we had for discount rates for Yale’s pension liabilities. And my position has been that it should be Treasurys plus 50 basis points, which is a 3 percent discount rate. And the discount rate that they were using was 7 ½ percent. And there is no way in the world that you can justify having a discount rate of 7 ½ percent. It doesn’t—it doesn’t make any sense. But that’s the norm in the world of state and local pensions, not the exception.

And so there are enormous liabilities out there, even when you use a dishonest discount rate. If you stated using an honest discount rate, those enormous liabilities would be magnified many-fold. And you’re obviously starting to see this when you look at the state budgets in Illinois and the state budgets in Connecticut. And that’s the tip of the iceberg. That we’re going to be seeing that problem repeated over and over and over again, because in essence our state and local politicians are lying to us about the magnitude of the problem. And the only way to address it is to tax people and have contributions made to obviate the underfunding.

But that’s not going to happen, because that’s not what politicians do. Maybe with the exception of Gina Raimondo in Rhode Island, who I think is an icon. She’s my hero. But as far as I see it, there is no other state in the country that’s honestly addressing the issue.

So it’s really not a question of investment. It’s a question of understanding what the liabilities are and making contributions to obviate the underfunding.

RUBIN: You know, David, it’s interesting you say that politicians don’t want to raise taxes, which is to put it mildly. But, you know, someday taxes are going to go up. The federal government is badly under-revenued. We’re about to make that substantially worse with tax cuts, which have a high probability of passing, I think. And the states—Jay Powell and I did—about 10 years ago we did a study for somebody—he did most of the work, I might add, but anyway—(laughter)—we did a study for somebody of the underfunding in the—in the pension fund. And it’s far worse today, and it was terrible then, particularly when you use realistic numbers. And these—you know, this can go on and go on until it can’t go on, and at some point we’re going to face a terrible problem in this country at both the federal and the state levels.

Q: Bob? Bob, wasn’t there a period when you were treasury secretary when the budget was actually in balance?

RUBIN: Well, now that you mention it—(laughter). Well, I didn’t bring this up, David did. (Laughter.) In 1998, for the first time in 30 years, the United States federal government had a budget surplus.

SWENSEN: Yeah. Yeah, yeah.

RUBIN: And then we demagogued, because we didn’t want to use it for tax cuts, and yet we couldn’t explain to people why paying down the debt was good. But demagogically we figured out to say save Social Security first; but nothing to do with anything, but it enabled us not to have tax cuts and use it to pay down the debt. So sometimes demagoguery in a good purpose is useful. (Laughter.)

Other questions? Yes, sir, way in the back.

Q: Andres Small from Partners Group.

I wanted to ask about your testing for character, because it seems like a very good hindsight. But how do you go forward? And politically, do you have a bias for long track records to be able to test that—i.e., hard for a new emerging manager to come up?

SWENSEN: You know, the testing for character is largely subjective. One of the things we try to do is to spend time with prospective managers in a social setting, so it’s not just sitting across one another at a conference table. But by the time I’m having a final meeting before deciding whether or not we’re going to move forward, I’m thinking to myself during the entire meeting: Is this an individual that I want to be my partner? And it’s subjective, it’s gut feel, but that’s the most important criterion as far as—as far as I’m concerned.

You know, I think—I think track records are really overrated. Some of Yale’s best investments have been with people that don’t have a track record. We took a couple of people out of proprietary trading at Goldman Sachs 25 years ago. If they had had a track record, it wouldn’t really matter because Goldman Sachs has a very different form of organization and a different way of giving resources to the people that are making investment decisions. But we didn’t even have those numbers. And it was really just a decision that this was a woman and this was a man that we thought were going to produce great returns, and they’ve done a really good job for the university.

Bob and I were talking about—at lunch about a student of mine who 12 years ago set up a fund in China having never managed a portfolio of Chinese equities. And we started out small with a $25 million contribution, but over the last 12 years this individual has added $1.3 billion of gains to the university from doing an extraordinary job in an incredibly inefficient environment.

And a number of years ago one of Julian Robertson’s colleagues split off. When we backed him, he had a 3x5 card that had an organization chart on it that said he was going to hire five people. And he turned out to be one of the most successful hedge fund managers of the past 20 years.

So it doesn’t mean we don’t like to look at track records. It’s a nice thing to have. But we would miss out on some incredible investment opportunities if we required three years of audited or five years of audited returns before backing somebody.

RUBIN: Yes, ma’am. You were very patient before. Thank you.

Q: And I’m not sure my questions—and there are a couple of them—are really good because I’m not a financial person. I’m Cathy Gay, and my firm is Catherine Gay Communications. It’s a communications strategies firm.

I’d like to know from you, Bob, why you think the tax reform is going to pass. Nothing he’s done so far has passed, so what will make this different?

And you said you’re not worried about the economy, or you can’t predict the economy. But I wonder if either of you think that after Trump and his cohorts leave Washington things can change maybe to a new normal, but sort of a more normal?

RUBIN: David?

SWENSEN: No, I think that—(laughter)—

RUBIN: No, I don’t want to—I don’t want to—

SWENSEN: My name’s not Bob. (Laughter.)

RUBIN: No, but that was only the first question addressed. The second question was, I think, for both of us, but predominantly for you, as I interpreted it. (Laughter.)

Look, who the heck knows? On the tax cuts, I’ll say this. I was on the phone last night with some people whose names you would recognize but I’m not going to use, because we agreed—who was very—I’m not licensed to practice politics, but these people are. And their judgment was that whatever you may think of the merits of the tax cut—now, I think it’s a—I think it’s a national tragedy, actually.

Q: Well, I certainly do, too. But—

RUBIN: Yeah, but you’re not in Congress. (Laughter.) But the—

Q: (Off mic.)

RUBIN: But all the political momentum amongst the congressional majorities is massively towards passing this thing. And it was their judgment, at least, that the probabilities were quite high this thing—high; actually more than quite high, probably—yeah, all right, quite, quite high that this thing will pass. (Laughter.)

In terms of the future of the political system, who the heck knows? Right now we are really mired—and this isn’t just a criticism of any individual or any—in both parties, the extremes are where the activity is. And the question is, will we come back to a system that can function in a moderately reasonable way where people are willing to work across policy and political lines? And I have an instinct, and it may be dead wrong: I think it’s going to be a long, messy process, but I—we’ve had a—we’ve had a resilient political system, we’re a dynamic society, and politics changes very, very quickly in America. So my instinct it will come back at some point, but there are no guarantees. I may be wrong. And it could be a long, messy process. But it is critical if we’re going to be successful, because while I agree with David—I’d rather invest here that any other place—the fact is we have enormously consequential policy challenges, and we’re addressing virtually—predominantly none of them. And that’s a bipartisan—not even attempting to.

Do you any view on any of that, David?

SWENSEN: I agree with you. (Laughter.)

RUBIN: David likes to duck questions he doesn’t want to answer, but that’s all right.

Yes, sir, right here.

Q: Hi. My name is—my name is Les from Alpine.

My question is on co-investments. I’d love your thoughts, because more endowments and more plan sponsors are relying on co-investments to reduce fees and to generate higher returns in this bull market. Do you think it’s an accident waiting to happen, or do you think this will continue on?

SWENSEN: You know, I’m not a big fan of co-investments. Josh Lerner did a study—Josh is at Harvard Business School—looked at six very large programs that had been in existence for a long period of time. And the conclusion that he came to was that the co-investments, in spite of the fact that they had lower fees, underperformed the funds in which the investments were located. You could speculate that one of the reasons might be that co-investments are generally larger deals than a firm is used to doing. And it’s been my longstanding impression that when firms step out of their comfort zone and do something big—think KKR and RJR and 26-to-1 leverage; it just didn’t work out all that well—that you step out and then you—and you suffer.

I think there’s a huge amount of dysfunction in the co-investment relationship between LPs and GPs. There are lots of LPs who do it for reasons that might be investment-related and might have other motivations. And so sometimes the general partner will promise co-investment opportunities to investors in exchange for a commitment to the fund, which I find odious. And if a GP is putting together a co-investment pool with eight or 10 or 12 LPs, it’s an enormous distraction because each of the LPs is going to do their own independent due diligence, they’re going to be going to the general partner asking their stupid questions—(laughter)—and distracting the general partner from doing what the general partner is supposed to be doing, which is making great investments, making the companies better, and generating returns for the entire population of LPs.

So I would prefer a world in which there weren’t co-investment because I think in some cases it’s a dirty business. And even when it’s not a dirty business, it’s a distracting business.

RUBIN: David, I have a feeling we could spend the rest of this afternoon and tomorrow asking you questions, but you really are a national treasure. And let me make a comment. Firstly, David, thank you for being with us. You were terrific.

Let me also make a comment about the Council, if I may. All of us, by being members of the Council, have the opportunity to get access to people like David and so many others from around the world who will come here to be part of the Council that we wouldn’t have access in any other way. So really this is a great institution, and you coming here to be with us and helping us in other ways is terrific. We appreciate it. (Applause.)

Thank you, David. You were terrific. (Applause.)

(END)

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