A Chapter from Swensen's Book


Given his reputation and the title of the book, we would be remiss not to feature excerpts from David Swensen’s Pioneering Portfolio Management. Below are portfolio construction & management highlights from Chapter 6: Portfolio Management. The manager anecdotes in this chapter are fairly interesting too, providing readers a window into how an institution (Yale/Swensen) evaluates its external managers. Portfolio Management, Risk, Expected Return

“In a world where risk correlates with return, investors hold risky assets in pursuit of returns exceeding the risk-free rate. By determining which risky assets are held and in what proportions, the asset allocation decision resides at the center of portfolio management discussions.”

“…the complexities of real-world investing drives a wedge between the easily articulated ideal and the messy reality of implementing an investment program.”

Putting aside whether you agree that risk is correlated with return, it is safe to postulate that markets are (usually) efficient enough to require investors bear some degree of risk, in the pursuit of any rate of return above the risk-free-rate. The portfolio management process involves determining which returns are worthwhile pursuing given the associated risks, and relative to the risk-free rate. However, sh*t happens (“a wedge between the easily articulated ideal and the messy reality”). So how does one navigate through the “complexities” and “messy reality” of implementation? Read on…

“Some investors pursue active management programs by cobbling together a variety of specialist managers, without understanding the sector, size, or style bets created by the more or less random portfolio construction process…Recognizing biases created in the portfolio management process allows managers to accept only those risks with expected rewards.”

“Disciplined implementation of asset allocation policies avoids altering the risk and return profile of an investment portfolio, allowing investors to accept only those active management risks expected to add value.”

“Concern about risk represents an integral part of the portfolio management process, requiring careful monitoring at the overall portfolio, asset class, and manager levels. Understanding investment and implementation risks increases the chances that an investment program will achieve its goals.”

“Unintended portfolio bets often come to light only after being directly implicated as a cause for substandard asset class performance.”

Awareness of what you own (the risks, expected return, how the holdings interact with one another, etc.) is an absolutely necessity. This concept has surfaced many times before on PM Jar, likely indicating that it is an important commonality across different investment styles and strategies.

Leverage, Expected Return, Risk, Volatility

“By magnifying investment outcomes, both good and bad, leverage fundamentally alters the risk and return characteristics of investment portfolios…leverage may expose funds to unanticipated outcomes. Inherent in certain derivatives positions, leverage lurks hidden in many portfolio, coming to the light only when investment disaster strikes.”

“Leverage appears in portfolios explicitly and implicitly. Explicit leverage involves use of borrowed funds for pursuit of investment opportunities, magnifying portfolio results, good and bad. When investment returns exceed borrowing costs, portfolios benefit from leverage. If investment returns match borrowing costs, no impact results. In cases where investment returns fail to meet borrowing costs, portfolios suffer.”

“…portfolio returns should exceed leverage costs represented by cash, the lowest expected return asset class.”

“Sensible investors employ leverage with great care, guarding against introducing materials excess risk into portfolio characteristics.”

Traditional academic leverage discussions focuses on the theoretical spread between cost of borrowed capital and what is earned through reinvestment of borrowed capital. While this spread is important to keep in mind, the actual utilization and implementation of leverage in a portfolio context is far messier that this elegant algebraic formula. There are many other articles on PM Jar discussing leverage in a portfolio context.

Leverage, Risk, Volatility, Derivatives

“Simply holding riskier-than-market equity securities leverages the portfolio…the portfolio either becomes leveraged from holding riskier assets or deleveraged from holding less risky assets. For example, the common practice of holding cash in portfolios of common stocks causes the domestic equity portfolio to be less risky than the market, effectively deleveraging returns.”

“Derivatives provide a common source of implicit leverage. Suppose an S&P 500 futures contract requires a margin deposit of 10 percent of the value of the position. If an investor holds a futures position in the domestic equity portfolio, complementing every one dollar of futures with nine dollars of cash creates a position equivalent to holding the underlying equities securities directly. If, however, the investor holds five dollars of futures and five dollars of cash, leverage causes the position to be five times as sensitive to market fluctuations.

Derivatives do not create risk per se, as they can be used to reduce risk, replicate positions, or increase risk. To continue with the S&P 500 futures example, selling futures against a portfolio of equity securities reduces risks associated with equity market exposure. Alternatively, using appropriate combinations of cash and futures creates a risk-neutral replication of the underlying securities. Finally, holding futures without adequate balancing cash positions increases market exposure and risk.”

One must tread carefully when utilizing derivatives not because they are derivatives, but because of the implicit leverage that comes with derivatives.


“Less liquid asset types introduce the likelihood that inability to vary exposure causes actual allocations to deviate from target levels…Since by their very nature private holdings take substantial amounts of time to buy or sell efficiently, actual portfolios usually exhibit some functional misallocation. Dealing with the over- or under-allocation resulting from illiquid positions creates a tough challenge for the thoughtful investor.”

“…rebalancing requires sale of assets experiencing relative price strength and purchase of assets experiencing relative price weakness, the immediacy of continuous rebalancing causes managers to provide liquidity to the market.”

Expected Return, Risk

“Returns from security lending activity exhibit patterns characteristic of negatively skewed distributions, along with their undesirable investment attributes. Like other types of lending activity, upside represents a fixed rate of return and repayment of principal, while downside represents a substantial or total loss. Unless offset by handsome expected rates of return, sensible investors avoid return distributions with a negative skew…negatively skewed return pattern exhibits limited upside (make a little) with substantial downside (lose a lot), representing an unattractive distribution of outcomes for investors.”