David Swensen on Core Asset Classes vs. Non-Core Asset Classes

Over the weekend, I finished reading "Unconventional Success: A Fundamental Approach to Personal Investment" by David Swensen, the chief investment officer of the Yale University endowment. In his book, Swensen discusses asset allocation, a very important topic for long-term investors. I found his argument on the core asset classes vs. the non-core ones particularly useful. Specifically, Swensen believes the following ought to be the investor's core asset classes.

Domestic Equity
Domestic equities provide high return and good protection against inflation in the long run. The corporate management often serves shareholders' interests reasonably well.

U.S. Treasury Bonds
Treasury bonds are "risk-free" and provide reliable diversification and excellent hedge against financial crises. The government is a market-neutral player.

U.S. Treasury Inflation-Protected Securities
TIPS are also "risk-free" and provide the most reliable protection against unexpected inflation. The market size of TIPS is about one tenth of that of treasury bonds.

Foreign Developed Equity
Foreign investments have similar expected returns as U.S. equities. In the long run, foreign equities also provide good diversifying power, although in the short term the global market often reacts to financial crises synchronously.

Emerging Market Equity
Emerging markets are substantially more risky and compensate with higher expected returns (risk premium). A drawback is that corporates in emerging markets are often less well regulated and can harm foreign investors' interests.

Real Estate
Real estate investments combine bond-like returns from rental income and equity-like returns on the residual value. Real estate provides great protection against inflation due to the strong correlation between inflation and the replacement cost of real estate (intrinsic value).

Swensen recommends using the above core asset classes to construct the following example portfolio:

Domestic equity	30%
Foreign developed equity	15%
Emerging market equity	5%
Real estate	20%
U.S. Treasury bonds	15%
U.S. Treasury Inflation-Protected Securities	15%

On the non-core asset class part, Swensen also provides reasons why the following should not be the investor's core holdings.

Domestic Corporate Bonds
They suffer from credit risk, illiquidity and callability, as well as misaligned interests with the corporate management and shareholders.

High-Yield Bonds
These are the so-called junk bonds. They magnify corporate bond's drawbacks even further and the extra return does not provide adequate compensation.

Tax-Exempt Bonds
These municipal bonds, especially long-term ones, suffer from credit risk and call options. Their value could be heavily altered by marginal tax rate changes, either positively or negatively. However, short-term tax-exempt bond or money market funds are worth consideration.

Asset-Backed Securities
Asset-backed securities are highly complex products created by those most sophisticated Wall Street financial engineers. The complicated structures do not serve investors' interests. Investors do not receive adequate rewards for accepting credit and call risks. The government-sponsored enterprises (GSE) cause false assumptions on their credit attributes.

Foreign Bonds
Although foreign bonds might have different interest rates from U.S. bonds, the end result (of unhedged foreign bonds) is equivalent to holding U.S. bonds plus some currency exchange exposure. Foreign currency exposure, while providing some diversification, has no real returns.

Hedge Funds
Although some hedge funds produce good returns, it is too difficult to identify them beforehand. The hefty fee arrangements erode returns enormously.

Leveraged Buyouts
Leveraged buyouts incur a higher degree of risk (highly leveraged) and hefty fees (management fees and profit share) without delivering satisfactory risk-adjusted returns. The fund managers' motivation of seeking high returns diminishes when the fund becomes large.

Venture Capital
Over long periods of time, the return of venture capital investments as a whole is similar to that of the public market investment, failing to compensate the extra risk involved. The top-tier well-established firms often have superior access to deals, entrepreneurs and capital markets and provide higher returns. However, such successful firms are usually closed to new money, leaving only unattractive choices to investors.