Most of us have heard the popular adage “There’s no such thing as a free lunch.” This was made popular by one of the staunchest proponents of free-market economics, Milton Friedman, when he wrote the book bearing this phrase as the title, in 1975. What most people don’t realize is that this phrase was not “invented” by Milton Friedman but by Robert A. Heinlein, who used it in his 1966 science-fiction novel The Moon Is a Harsh Mistress.
Harry Markowitz, in his seminal paper “Portfolio Selection”, published in 1952 by the Journal of Finance, laid out a theory for portfolio construction which minimizes the expected risk and maximizes the expected returns. He called it “Modern Portfolio Theory” or MPT for short. More about MPT in a later post. His ideas were so much ahead of their time that it took a few decades for them to gain traction on Wall Street. Finally, the Nobel Committee recognized the significance of his work and he was awarded the Nobel prize for economics in the year 1990. He once famously said that the only free lunch available to investors is diversification. Many notable economists such as Bill Sharp, Merton Miller, Eugene Fama, Burton Malkiel & Jack Bogle have used this as a basis for their own work.
Most cutting edge research & intellectual output, in the past 200 years, has come out of a few top universities in the US. The work done by the above mentioned economists is no different. They have all been nurtured and paid for, at least partially, by the universities. Have you ever wondered how these universities find the money to fund so much research? Do I hear “the tuition fee paid by the students”? The answer is no, the tuition fee doesn’t even scratch the surface. The government funds a lot of research where the output has implications on defense or public good. Many private firms too fund university research. In fact, a lot of Wall Street banks provide research grants in areas which might have a real impact on the business the firm is doing. But, for most work which doesn’t fall under either the government or the private bucket, there is one more source of funding, especially in the top universities. This hidden treasure is called the university endowment. This is the money people, typically alumni, have donated to the university. The endowments of some of the universities are bigger than the GDPs of most countries. Here are the top 10 US universities in terms of the size of their endowment chests.
| University name | Endowment size (2015) |
| Harvard University | $38 Billion |
| Yale University | $26 Billion |
| Princeton University | $22 Billion |
| Stanford University | $22 Billion |
| Massachusetts Institute of Technology | $13 Billion |
| University of Pennsylvania | $10 Billion |
| University of Michigan—Ann Arbor | $10 Billion |
| Texas A&M University—College Station | $10 Billion |
| Columbia University | $10 Billion |
| University of Notre Dame | $9 Billion |
These numbers are mind boggling. In fact, the Harvard endowment is bigger than the GDPs of half of the countries in the world. Does this mean that all the money these Universities have has been donated? The answer is no, the universities hire endowment fund managers to invest this money and generate meaningful returns for the university. That is how the pot has grown to such gargantuan sizes. These endowment fund managers seldom make the headlines or have their faces plastered all over CNBC or Bloomberg even though most of these managers have a better record than the Wall Street Hedge Fund managers… who seem to be dime a dozen nowadays…. constantly hankering for media attention and investor money.
One of the most legendary endowment fund managers is David F. Swensen, the Chief Investment Officer of Yale University. He has managed the Yale endowment for the past 30 years, generating a return of ~15% on an annual basis for this period. This record is unparalleled in the world of endowment fund managers. This record is all the more enviable given that Yale University imposes some restrictions on how much risk the fund manager is allowed to take. Most universities have similar restrictions. This limits the universe of investment options the fund manager has at his disposal.
David Swensen chronicled his approach in a couple of books: Unconventional Success: A Fundamental Approach to Personal Investment and Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, the first of which is good read for individuals like us.
If I were to boil down his investment mantra into a bunch of easy to remember/ implement points, they would be
- Don’t try anything fancy, especially if you don’t understand it or have half baked knowledge… this is a recipe for failure
- Stick to a simple diversified portfolio….with exposure to various asset classes…. he also says that asset allocation/ diversification is the closest you would ever get to a free lunch in the investment world
- Keep your costs down…. be it the management fees charged by funds or the brokerage charges levied on trading or the taxes owed due to realization of capital gains
- Re-balance periodically to keep your asset allocation in line with your long-term goals… no more than twice a year though, to keep the costs low
Sounds very simple and intuitive doesn’t it? Most people fail to make good returns in the market because they fail consistently to do one or more of the above “simple” things. I have used Swensen’s model portfolio and adopted it to the Indian situation with examples of possible asset candidates. Click here to see his original model portfolio.
- Stock – 55%
- Domestic equity – 30% (Nifty, Sensex, Nifty Junior, Midcap 100 ETFs)
- Foreign developed equity – 15% (NASDAQ 100 ETF, Developed Market mutual funds)
- Emerging market equity – 10% (HangSeng ETF, China or Emerging Market mutual funds)
- Bonds – 30%
- Corporate bonds – 15% (Too many options …. choose a wide basket of AAA, AA bonds)
- Sovereign or Quasi Government Bonds – 15% (RBI Bonds, Bonds issued by companies where GoI is the majority owner … SBI, NTPC, NHPC, PFC, REC, IRFC etc.)
- Real Estate – 15% (REITs… will be available in India soon…. and Property investments)
This is not a silver bullet allocation… one needs to modify the allocation suggested by Swensen to suite his own individual circumstances.
As a part of his Financial Markets course, Bob Shiller, another Nobel laureate and professor at Yale University, always has one guest lecture session by David Swensen. Anyone interested in serious investing should definitely watch this lecture …. and indeed the whole course, which is available on YouTube. The link to the full course playlist is here. If you don’t have the time to listen to all the lectures, but only want to “sit in” on David Swensen’s guest lecture session, the video is below
One becomes a successful investor not by executing trades suggested on CNBC… but by coming up with an analytical framework and sticking with it under thick and thin. The surest way to lose money is to change ones investment philosophy when things start going south…. In fact, I feel that in times of distress one needs to be more committed to ones philosophy. The markets will test your patience, and reward the one who perseveres through the tough times. Having said that, the analytical basis for the investment framework needs to be sound and backed up by historical performance…. An example of a philosophy I would call flawed would be to say I will blindly buy everything that Porinju Veliyath buys….. because he has done well and is suddenly the talk of the town. By all means do take his advice, but don’t substitute it for your own thinking and framework.
You must realize that there are always 2 parties in any trade… if you are buying, the person on the other side of the trade has the exact opposite thesis to yours and is selling…. and if you are selling, the person on the other side of the trade has the exact opposite thesis to yours and is buying…. one must clearly be able to articulate why he is right when the person on the other side is doing exactly the opposite thing…. What makes you think that you are more “intelligent” than the other person…. and hence it is you who is poised to win? Especially given that you don’t know who the other party is … for all you know it might be a fund manager who has an army of analysts whose daily job it is to find investment ideas.
Do you think there are other free lunches apart from diversification and asset allocation? Isn’t “free lunch” food for thought? Do share your observations/ thoughts.
Addendum:
1. Harvard endowment performance – click here to read
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