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Oct 10 2011

Spotlight - Why David Swensen Is Wrong

From his perch in the Ivory Tower, the Yale University Chief Investment Officer's perspective on mutual funds misses the mark.

By Kerry O'Boyle, Aston Asset Management

David Swensen has a bone to pick with investors who use mutual funds. In a scathing editorial in the New York Times (The Mutual Fund Merry-Go-Round – August 13, 2011), the highly regarded manager of the Yale University endowment and creator of the "Yale Model" of investing took the "mutual fund industry" to task for what he sees as its many failings. To summarize, he believes that for decades, mutual fund managers, brokers and financial advisers, and even independent rating firm Morningstar have all conspired to dupe naïve individual investors into making poor investment choices by luring them into inferior funds in an effort to line their own pockets. As diabolical as this all sounds, Swensen's credibility on the subject diminishes with each passing paragraph as he smears with a broad brush of generalities and innuendoes not only all mutual funds, but financial advisers and individual investors. Capping it all off is a plea for more government regulation of investing that would "encourage" investors to embrace low-cost index funds.

The Industry 

Swensen appears to have a poor grasp as to what constitutes the "mutual fund industry." He uses terms such as mutual fund company, brokers, advisers, and fund managers interchangeably with "the industry" as if each were synonyms for the others. In fact, few mutual fund companies have their own brokerage arms—legions of brokers and advisers to peddle their proprietary wares. Most need to convince financial advisers of the worth of their funds just as they would any individual investor. Most fund managers, those actually responsible for managing a fund's assets on a daily basis, are seldom directly involved in how their funds are sold or marketed. Brokers and financial advisers have no say in how individual mutual funds are managed, just as mutual fund companies have no control over the advice that the advisers provide their clients. In short, the monolithic "industry" that Swensen has lumped together, and upon which he rails, doesn't exist. More accurately, the investment community is a collection of businesses offering services that frequently complement each other, but also compete directly and indirectly for the attention of the end investor.   

Yet, even when writing specifically about mutual fund companies, Swensen provides little support for his assertions. He states that, " … for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors" without explaining why those two outcomes must be mutually exclusive. He merely declares that, "In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets—and invest poorly." While there may be instances of firms for which such criticism applies, it's quite a leap to proclaim all such traits as nearly universal across all fund providers. Indeed, it appears that Swensen's main criticism is with a capitalist structure where businesses compete and profit. All private companies have to balance producing profits for their owners with producing superior goods and services for their customers.

Perverse Investor Behavior 

Swensen is also seemingly unwilling to find fault with anyone but the "mutual fund industry" for the poor investment results that he believes that individual investors have suffered. Although he begins his editorial by noting that, "As stock prices have gyrated wildly, many investors have behaved in a perverse fashion, selling low after having bought high" the blame for all of this, in his view, lies entirely with the fund industry. Aided and abetted by the Morningstar star-rating system, the industry "aggressively market[s]" highly-rated funds and "encourage[s] performance-chasing." Gullible investors "respond to industry come-ons" and pay fees to the "parasitic mutual fund industry," resulting in decades of "below-market returns." Swensen writes as if convincing investors to make poor investment decisions is somehow a desirable goal for advisors and mutual fund companies. To the contrary, fund providers and advisers have a long-term vested interest in doing well by investors, as investment success builds and maintains relationships and increases assets and profits for both investors and those serving them. It's up to investors to decide if their needs are being met.

Ultimately, what becomes clear is Swensen's condescending belief that individual investors using mutual funds don't, and can't, achieve adequate investment returns (such as he generates, one assumes, at his Yale endowment)—and are foolish to try. Citing studies by Morningstar on so-called Investor Returns, he derides the performance of individual investors. (Interestingly, Swensen is more of a fan of Morningstar methodologies when they suit his view.) Unfortunately, Investor Returns are based on aggregate monthly fund flow information, not the actual performance of any individual investor. The data cannot pinpoint when assets that left a fund came in or when assets that came in, left. At best, Investor Returns can be used as a rough guide as to whether investors, in aggregate, tend to time the purchases and sales of a particular fund effectively, not as a measure the overall success of individual investors.

Nanny-State Investing

Armed with his Yale endowment bias and little perspective on the needs of smaller investors, Swensen offers a solution—low-cost index mutual funds and heightened US Securities and Exchange Commission (SEC) regulatory and enforcement power to "encourage", some might say force, their use by investors. He states that the burden of proof must be on the vendor in selling "a high-cost product" (re: actively managed funds). No such burden of proof appears necessary, however, for the academically sanctioned indexing approach, despite it being based on increasingly challenged statistical methods and theoretical assumptions. Index funds have proved to be no panacea for investors concerned about the absolute returns and volatility of their portfolios during the market shocks of the past few years.

Swensen, who has criticized the construction methodologies of certain indexes in the past, offers no specific recommendations. Indeed, he offers little specific advice to individual investors at all other than to "educate themselves" and "invest in a well-diversified portfolio of low-cost index funds" while failing to give any insight as to how an investor should go about this. It's surprising that Swensen decides that government and the SEC should be the savior of individual investors given an earlier charge that "regulators do not provide effective oversight." The current restrictive regulatory environment placed on mutual funds can't guarantee investors favorable results, but it hasn't yielded any Ponzi schemes or Bernie Madoffs yet either.

Swensen ends his editorial by writing that, "This is serious business. The financial security of millions of Americans hangs in the balance." Yes, it is serious. Too serious to let government do to investing what it has done to home owners (via Fannie Mae and Freddie Mac), small businesses (oppressive regulation), and the fiscal stability of this country. Too serious to turn a vast and multi-layered industry attempting to serve millions of investors into a straw man to be torn down by gross generalizations from a man perched in an ivory tower disconnected from the goals and fears of individual investors. Too serious to promote a simplistic, one-size-fits-all nanny state solution for investors needing more.

Simple, But Not Easy

David Swensen is a pioneer in institutional investing who deserves much credit for sharing his expertise and management philosophy with the investment community, but he can't micromanage success for millions of individual investors. In one area, however, Swensen is right—financial education is the key. Investors need to become better informed about how markets work, fund selection, diversification, and the monitoring of their portfolios. As Warren Buffett famously noted, investing is "simple, but not easy." It takes practice, and a constant desire to learn and stay informed.

But many individual investors do not have the time or interest to fully commit to becoming savvy investors. They rely on the expertise of mutual fund families and financial advisers to bridge the gap by understanding their needs and goals and knowing how to build a portfolio to match them. Swensen's approach of skewering all of those that don't fit his narrow paradigm of investing doesn't help individuals to identify quality fund families or find informed and trustworthy advisers. Sound investment practices and advice are out there, but it is investors' ultimate responsibility to seek it out and heed it.


Kerry O'Boyle is an Investment Strategist with Aston Asset Management. Prior to joining Aston he wrote on a variety of investment topics as a mutual fund analyst for Morningstar, Inc. He is a graduate of the U.S. Naval Academy, and holds an M.A. in Liberal Arts from St. John's College, Annapolis, MD.

For more information about Aston Asset Management, LP and its subadvisors, please call 800-597-9704, or visit

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