Is David Swensen the new Warren Buffett?

Mr. Buffett, one of the richest men on the planet, has educated and entertained investors for years with his annual letter to Berkshire Hathaway shareholders. More recently, it is the annual report by Mr. Swensen that has quietly become required reading for professional investors.

Mr. Swensen is the chief investment officer of Yale University. He is the fellow who turned institutional investing on its head by demonstrating the virtues of alternative investment classes and by racking up an exceptional performance history. Over the past 20 years, the Yale endowment has scored investment returns of 16% a year. Over the past 10 years, performance has been even higher, at 17.4%.

Mr. Buffett’s long-term record is even more sensational. He has built pershare book value in Berkshire Hathaway at an average annual gain of 21.5% over the past 40 years, outperforming the S &P 500 by an average of 11.2 percentage points each year.

In recent years, however, Mr. Buffett’s performance has been less impressive. Last year the increase in Berkshire Hathaway’s book value was 6.4%, compared to a 22.3% rise in the Yale endowment (for the year ending June 30, 2005). For 2004, Yale outscored Berkshire 19.4% to 10.5% (with no adjustment for the difference in fiscal years.) In fairness, in 2002 and 2003, Berkshire Hathaway was the winner; for the preceding two years Yale had a large advantage.

Is Mr. Buffett behind the times? More importantly, is Mr. Swensen the new standard bearer for intelligent investing in the 21st century? Where do these two extraordinary money-makers part company?

The big bet made by Mr. Swensen in the past 20 years has been to diversify away from traditional holdings in domestic common stocks and bonds. In 1985, more than 80% of Yale’s endowment was invested in domestic marketable securities. As of last June, the figure had dropped to less than 20%. Though it might not have seemed a low-risk strategy at the time, over the years the monies Yale has funneled into real assets such as timber, oil and gas, and real estate, as well as into private equity and hedge funds, have meant that the institution has been protected from the convolutions of the stock market in America.

Mr. Swensen describes in this year’s report the theoretical framework behind the investment plan, which rests on a mean-variance analysis initially devised by Nobel laureates James Tobin and Harry Markowitz. This is a method of analyzing risk and return among asset classes and of testing how a portfolio might be affected by various shocks or influences. He also discusses Monte Carlo simulations. Mr. Buffett would probably turn purple if one of his advisers tried to insert such language, much less such a concept, into his folksy common sense letter.

Thankfully, Mr. Swensen also cites “qualitative considerations” and “market judgment” as important to results – in other words, acknowledging the role of smart people. He champions active managers in all of the six asset classes in which Yale invests except debt, which Yale manages internally. Preference is given to young, hungry firms whose interests are aligned with those of the endowment; that is, the firms are expected to be investing side by side with Yale.

Mr. Swensen has a strong equity bias and is a believer in long-term investing, especially since it allows the manager to put funds into less liquid properties. He also emphasizes looking for opportunities in less efficient markets, and in the value of being a contrarian. Most likely, Mr. Buffett would agree with many of these preferences. His company is widely diversified, with 68 operating units at present. He, too, criticizes managements and investors for being shortsighted and in many ways he has invested against the prevailing winds. Also, both men express exasperation with managers who are more concerned with earning large fees than with making money for their clients.

What they clearly do not share is Mr. Swensen’s enthusiasm for hedge funds and private equity investing. In 1990 Yale took the lead in allocating funds to this group of managers. Over the years, because of excellent returns, the amount of Yale’s endowment allocated to these sectors has increased. Absolute return vehicles (hedge funds) now account for 25.7% of the endowment, against a target of 25% and compared to the norm for educational institutions of 17.6%. Private equity accounts for 14.8%, with a target of 17%. On top of that, so-called “real assets,” which includes real estate and timber, make up 25% of the portfolio; the target was just raised from 20% because of strong performance. (A skeptic might wonder if this raising of a target because of strong results presages some slippage in discipline.)

It is on the subject of hedge and private equity funds that Mr. Buffett becomes cranky. He ridicules the notion that managers of such funds reap sizeable portions of any winnings their expertise may generate but do not participate in losses. His difficult experience exiting the derivatives business of General Reinsurance, which cost more than $400 million, has perhaps left a bad taste in his mouth. He seems convinced that virtually no one understands these complex instruments so central to the workings of hedge fund managers. As Mr. Buffett says, “A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger.” Calling the experience of Berkshire Hathaway analogous to “a canary in this business coal mine,” Mr. Buffett warns others to keep their distance.

Mr. Buffett’s lack of enthusiasm for hedge funds may well prove prescient, but in the meantime those who have invested with the best managers are looking pretty good. Yale makes clear that their choice of managers in this area is critical. They seek out those who “invest a significant portion of their net worth side by side with Yale,” to be sure they don’t fall prey to the disincentives that Mr. Buffett deplores. The strategy has been successful for Yale, returning 12.7% per year over the past 15 years and recording zero monthly correlation with the Wilshire 5000, another objective.

Private equity investing has been even more successful for Yale, returning an astounding 39.5% annually for the past 10 years, and 31% since inception in 1973. The program emphasizes the kind of partnering with managements that define the best practices of this industry, and it has paid handsomely.

Mr. Buffett, now 75, may retire soon, leaving behind many investors who will miss his chatty communications, which are full of jokes and country music titles such as “My wife ran away with my best friend and I miss him a lot.” Somehow, even Mr. Swensen’s best lines, such as “Rewarding investments tend to reside in dark corners, not in the glare of floodlights,” while convincing, just aren’t as much fun.

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