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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM EST, Wednesday, April 11: Everyone has different theories as to why they hold bonds. A friend has 30% of his portfolio in bonds because he's "waiting for the next deal." He usually finds awesome deals, but they come along infrequently. Several readers think I should hold bonds as an insurance policy against the stock market crumbling. One reader cited Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania. In his famous book, "Stocks For The Long Run", Siegel reports the percentage of time since 1802 in which stocks failed to beat T-Bills. Not surprisingly, this percentage falls as holding period increases. But what is surprising, at least to many of us, is that this holding period has to grow to more than a decade to drop to below 10%.

% of time stocks didn't beat T-Bills,
according to Professor Jeremy Siegel

1 year
2 years
5 years
10 years
20 years
30 years

Frankly, I don't buy Professor Siegel's "statistics." And you'll see why below.

I'm still mulling my bonds. Once I had a theory that I'd stick enough in bonds to earn sufficient income to live on -- after all, I don't have a day job. But over the years as I learned about investing, I realized that having money in bonds brings a huge opportunity cost -- the opportunity of what you could earn elsewhere. As a result my allocation to bonds has progressively dropped over the years. Presently only 6.1% of my net worth is in bonds (all New York State/City muni bonds).

Apparently I'm not the only one to have figured this. (There are other geniuses out there.) Take Yale, the University. They do a little better than I do. Here are their latest incredible returns:

Yale's Annual Investment Returns
Year to June 30

Read that again. Yale earned 22.9% on a portfolio that started the year on July 1, 2005 at $15.2 billion. That's incredible. Downright phenomenal. Bloody amazing. Any other words of praise you can think of. How was their portfolio allocated?

Yale's Asset Allocation
Domestic Equity
Absolute Return
Foreign Equity
Private Equity
Real Assets
Fixed Income

You'll note the declining allocation to fixed income. Now for some excerpts from The Yale Endowment's annual report. Read this stuff carefully. You'll learn more from reading how Yale does it than from 1,000 investment books (and a thousand of my columns):

Over the past two decades, Yale reduced dramatically the Endowment’s dependence on domestic marketable securities by reallocating
assets to nontraditional asset classes. In 1986, 75 percent of the Endowment was committed to U.S. stocks, bonds, and cash. Today, target allocations call for 16 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real assets dominate the Endowment, representing 84 percent of the target portfolio.

The heavy allocation to nontraditional asset classes stems from their return potential and diversifying power. Today’s actual and target
portfolios have significantly higher expected returns and lower volatility than the 1986 portfolio. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

Asset class characteristics:

Yale’s six asset classes are defined by differences in their expected response to economic conditions, such as price inflation or changes in interest rates, and are weighted in the Endowment portfolio by considering risk adjusted returns and correlations. The University combines these assets in such a way as to provide the highest expected return for a given level of risk.

Absolute return:

In July 1990, Yale became the first institutional investor to pursue absolute return strategies as a distinct asset class, beginning with a target allocation of 15.0 percent. Designed to provide significant diversification to the Endowment, absolute return investments seek to generate high long-term real returns by exploiting market inefficiencies. Approximately half of the portfolio is dedicated to event-driven strategies, which rely on a very specific corporate event, such as a merger, spin-off, or bankruptcy restructuring to achieve a target price. The other half of the portfolio contains value-driven strategies, which involve hedged positions in assets or securities that diverge from underlying economic value. Today, the absolute return portfolio is targeted to be 25.0 percent of the Endowment, above the average educational institution’s allocation of 18.6 percent to such strategies. Absolute return strategies are expected to generate real returns of 6.0 percent with risk levels of 10.0 percent for event-driven strategies and 15.0 percent for value-driven strategies. Unlike traditional marketable securities, absolute return investments provide returns largely independent of overall market moves. Over the past ten years, the portfolio exceeded expectations, returning 12.9 percent per year with essentially no correlation to domestic stock and bond markets. An important attribute of Yale’s investment strategy concerns the alignment of interests between investors and investment managers. To that end, absolute return accounts are structured with performance related incentive fees, hurdle rates, and clawback provisions. In addition, managers invest a significant portion of their net worth alongside Yale, enabling the University to avoid many of the pitfalls of the principal agent relationship.

Domestic equity:

Finance theory predicts that equity holdings will generate returns superior to those of less risky assets such as bonds and cash. The predominant asset class in most U.S. institutional portfolios, domestic equity, represents a large, liquid, and heavily researched market. While the average educational institution invests 29.1 percent of assets in domestic equities, Yale's target allocation to this asset class is only 12.0 percent. The domestic equity portfolio has an expected real return of 6.0 percent with a standard deviation of 20.0 percent. The Wilshire 5000 Index serves as the portfolio benchmark.

Despite recognizing that the U.S. equity market is highly efficient, to pursue active management strategies, aspiring to outperform the market index by a few percentage points annually. Because superior stock selection provides the most consistent and reliable opportunity for generating excess returns, the University favors managers with exceptional bottom-up fundamental research capabilities. Managers searching for out-of-favor securities often find stocks that are cheap in relation to current fundamental measures such as book value, earnings, or cash flow. Yale's managers tend to emphasize small-capitalization stocks, as they are less efficiently priced and offer greater opportunities to add value through active management. Recognizing the difficulty of outperforming the market on a consistent basis, Yale searches for managers with high integrity, sound investment philosophies, strong track organizations, and sustainable competitive advantages.

Fixed income:

Fixed income assets generate stable flows of income, providing greater of nominal cash flow than any other Endowment asset class. The bond portfolio exhibits a low covariance with other asset classes and serves as a hedge against financial accidents or periods of unanticipated deflation. While educational institutions maintain a substantial allocation to fixed income instruments and cash, averaging 17.6 percent, Yale's target allocation to fixed income constitutes only 4.0 percent of the Endowment. Bonds have an expected real return of 2.0 percent with risk of 10.0 percent. The Lehman Brothers U.S. Treasury Index serves as the portfolio benchmark.

Yale is not particularly attracted to fixed income assets, as they have the lowest historical and expected returns of the six asset classes that make up the Endowment. In addition, the government bond market is arguably the most efficiently priced asset class, offering few opportunities to add significant value through active management. Based on skepticism of active fixed income strategies and belief in the efficacy of a highly structured approach to bond portfolio management, the Investments Office chooses to manage Endowment bonds internally. In spite of an aversion to market timing strategies, credit risk, and call options, Yale manages to add value consistently in its management of the bond portfolio. Willingness to accept illiquidity leads to superior investment results without impairing the portfolio protection characteristics of high-quality fixed income.

Foreign equity:

Investments in overseas markets give the Endowment exposure to the global economy, providing substantial diversification along with opportunities to earn above-market returns through active management. Emerging markets, with their rapidly growing economies, are particularly intriguing, causing Yale to target more than one-half of its foreign portfolio to developing countries. Yale's foreign equity target allocation of 15.0 percent stands slightly below the average endowment's allocation of 20.0 percent. Expected real returns for emerging equities are 8.0 percent with a risk level of 25.0 percent, while developed equities are expected to return 6.0 percent with risk of 20.0 percent. The portfolio is measured against a composite benchmark of developed markets, measured by the Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East Index, and emerging markets, measured by the MSCI Emerging Markets Index.

Yale's investment approach to foreign equities emphasizes active management designed to uncover attractive opportunities and exploit market inefficiencies. As in the domestic equity portfolio, Yale favors managers with strong bottom-up fundamental research capabilities. Capital allocation to individual managers takes into consideration the country allocation of the foreign equity portfolio, the degree of confidence Yale possesses in a manager, and the appropriate asset size for a particular strategy. In addition, Yale attempts to exploit compelling undervaluations in countries, sectors, and styles by allocating additional capital and, perhaps, by hiring new managers to take advantage of the opportunities.

Private equity:

Private equity offers extremely attractive long-term risk-adjusted return stemming from the University's strong stable of value-added managers that exploit market inefficiencies. Yale's private equity investments include participations in venture capital and leveraged buyout partnerships. The University's target allocation to private equity of 17.0 percent far exceeds the 6.4 percent actual allocation of the average educational institution. In aggregate, the private equity portfolio is expected to generate real returns of 11.4 percent with risk of 29.0 percent.

Yale's private equity program, one of the first of its kind, is regarded as among the best in the institutional investment community. The University is frequently cited as a role model by other investors pursuing this asset class. Since inception, private equity investments have generated a 30.6 percent annualized return to the University. The success of Yale's program led to a 1995 Harvard Business School case study- "Yale University Investments Office"-by Professors Josh Lerner and Jay Light. The popular case study was updated in 1997, 2000, and 2003.

Yale's private equity assets concentrate on partnerships with firms that emphasize a value-added approach to investing. Such firms work closely with portfolio companies to create fundamentally more valuable entities, relying only secondarily on financial engineering to generate returns. Investments are made with an eye toward long-term relationships -- generally, a commitment is expected to be the first of several -- and toward the close alignment of the interests of general and limited partners. Yale avoids funds sponsored by financial institutions because of the conflicts of interest and staff instability inherent in such situations.

Real assets:

Real estate, oil and gas, and timberland share common characteristics: sensitivity to inflationary forces, high and visible current cash flow, and opportunity to exploit inefficiencies. Real assets investments provide attractive return prospects, excellent portfolio diversification, and a hedge against unanticipated inflation. Yale's 27.0 percent long-term policy allocation significantly exceeds the average endowment's commitment of 8.4 percent. Expected real returns are 6.0 percent with risk of 15.0 percent.

The real assets portfolio plays a meaningful role in the Endowment as a powerful diversifying tool and a generator of strong returns. Real assets provide relative stability to the Endowment during periods of public market turmoil, at the price of an inability to keep pace during bull markets. Pricing inefficiencies in the asset class and opportunities to add value allow superior managers to generate excess returns over a market cycle. Since inception in 1978 the portfolio has returned 17.4 percent per annum.

The illiquid nature of real assets combined with the expensive and time-consuming process of completing transactions create a high hurdle for casual investors. Real assets provide talented investment groups with the opportunity to generate strong returns through savvy acquisitions and managerial expertise. A critical component of Yale's investment strategy is to create strong, long-term partnerships between the Investments Office and its investment managers. In the last decade Yale played a critical role in the development and growth of more than a dozen organizations involved in the management of real assets.

I'll write more tomorrow about Yale. For now, you can read their 28-page annual report, "The Yale Endowment 2006." Click here.

Don't say I didn't tell you. Australia is BOOMING: From today's Bloomberg:

Australian Dollar Near a 17-Year High as Metals Prices Increase By David McIntyre

April 11 (Bloomberg) -- The Australian dollar traded near a 17-year high as prices rose for metals the country exports, improving the outlook for economic growth.

The currency is the world's biggest gainer in the past month as traders raised bets the Reserve Bank of Australia will increase interest rates from a six-year high of 6.25 percent. A measure of six metals climbed to a record on the London Metal Exchange. Raw materials exports account for about 14 percent of the economy, with China the second-biggest market after Japan.

``China's demand for base metals, which the Australian dollar is significantly leveraged to, remains firm, keeping sentiment high towards the currency,'' said Sue Trinh, a foreign- exchange strategist at RBC Capital Markets in Sydney. ``The data is printing firmly, underpinning rate-hike expectations.''

The Australian dollar bought 82.43 U.S. cents at 4:15 p.m. in Sydney and reached 82.67 cents, the highest since October 1990. It traded at 82.39 cents late in Asia yesterday.

The currency pared an advance as some investors said a 5.7 percent gain over the past month was too much.

``The Australian dollar over 82.40 cents is overbought so I have no interest in buying it over that level,'' said Peter Pontikis, treasury strategist at Suncorp-Metway Ltd. in Brisbane, Australia.

The Australian dollar's 14-day relative strength index against its U.S. counterpart rose as high as 75.9 today, from 52.4 a month earlier, approaching a threshold that signals the rally may be too rapid. A level above 70 flags a reversal.

Hard for Exporters

Australian Treasurer Peter Costello, speaking in London yesterday, said the currency's record level made it hard for exporters. At the same time, the currency would help prevent inflation from accelerating because imports would be cheaper.

The chance of a quarter-percentage point rate increase rose to 54 percent from zero over the past month, according to a Credit Suisse index. Sharada Selvanathan, a currency strategist at BNP Paribas SA in Singapore, said data over the next few weeks, including tomorrow's employment report, would be a crucial influence on those expectations.

``In the very short term, the Australian dollar is going to retain support, and I wouldn't be surprised to see it above 83 cents,'' she said.

RBC's Trinh also said the currency may reach 83 cents this week after data such as job-vacancy advertisements, which climbed to an all-time high in March, according to an Australia & New Zealand Banking Group Ltd. report yesterday. Home-loan approvals rose 0.3 percent in February, as expected by economists, a government report showed today.

Rate Differentials

Australia's dollar advanced to a decade-high against the yen as a bigger-than-expected drop in Japanese machinery orders suggested the country's 5.75 percent rate advantage is more likely to widen than narrow.

``The Australian dollar is quite strong not only against the yen, but also against the dollar, due to growing prospects of widening interest-rate differentials between Australia and other countries,'' said Daisaku Ueno, a senior economist and currency analyst in Tokyo at Nomura Securities, Japan's largest brokerage. ``Australia's central bank will raise rates in May or June.''

The Australian dollar was at 98.29 yen compared with 98.19 yen in late Asian trading yesterday. It reached 98.50 yen, the highest since May 1997.

The yield on the Australian government two-year bond rose 1 basis point to 6.31 percent. A basis point is 0.01 percentage point. The price of the 8.75 percent security maturing in August 2008 fell 0.031, or A$0.31 per A$1,000 face amount, to 103.064. Bond yields move inversely to price.

The spread with Japan's two-year notes was 5.50 percentage points, close to the 5.53 percentage points on April 3, the widest in two months.

To contact the reporter on this story: David McIntyre in Sydney at

Another golf joke
Last winter Fred met a woman while on vacation in the Keys and fell madly in love with her. On the last night of his vacation, the two of them went to dinner at the Ocean View and had a serious talk about how they would continue the relationship.

"It's only fair to warn you, I'm a total golf nut," Fred said to his lady friend. "I eat, sleep and breathe golf, so if that's a problem, you'd better say so now."

"Well, if we're being honest with each other, here goes," she replied. "I'm a hooker."

"I see," Fred replied, and was quiet for a moment. Then he said, "You know, it's probably because you're not keeping your wrists straight when you tee off."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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