The Ivy Portfolio: Book Review

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Includes: BND, DBC, GSG, RWX, TIP, VB, VEU, VNQ, VTI, VWO
by: Opportunity Trader

Summary

A look into the market-beating investment strategies of the Yale and Harvard endowments.

Demonstration of a practical investment method traders can apply themselves on ETFs.

Comprehensive explanation on the historical performance of the demonstrated investment strategies.

Two additional active trading systems traders can mimic.

In The Ivy Portfolio, authors Mebane T. Faber and Eric W. Richardson begin the book by explaining the theory and the strategy behind the investment strategy of Harvard University and the Yale University endowments. Routinely, the endowments of Harvard and Yale have produced double-digit annual returns. Not only did they produce outstanding returns, but they realized this by also reducing volatility and drawdown.

Source

Ivy Endowment Investment strategy

How did the endowments reach these high returns year after year? They apply an active asset allocation system in which they spread their investment over several asset classes and they rebalance the allocations on a systemically base. The main asset classes here are:

  • US stocks
  • Foreign Stocks
  • Bonds
  • Cash
  • Real Assets
  • Private Equity

While both endowments use a different approach in determining their exact asset allocation into these asset classes, their total assets will always be spread among different classes and not be concentrated into one category. The historical returns per year can be found in the table below

Source: The Ivy Portfolio book

The strength of this approach is that it forces the investor/trader to think strategically about the way he will allocate his assets over these classes. While most investors are highly focused on the stocks/sectors they buy (and the price level of the stock market), his approach will force you to spend more attention to your effective asset allocation. This will encourage traders to focus more on the overall picture of their portfolio and less on the bottom level (which stocks at which prices, which fund should I buy now, ...).

That's not to say you will easily achieve the same returns the Harvard and Yale endowments have achieved. The authors sometimes gave the impression successful investing can be cut down to effective asset allocation, but in reality, the key issue will be determination of which proportion of your equity you invest in which asset class. For the endowments, this is done by (full-time) professional fund managers (whose financial returns are tax-exempt) with more tools to effectively do this.

Building your own Ivy portfolio

The authors of the book then suggest to create your own Ivy portfolio by using the following (simplified) asset allocation:

The Ivy Portfolio:

  • Domestic Stocks 20%
  • Foreign Stocks 20%
  • Bonds 20%
  • Real Estate 20%
  • Commodities 20%

This can be implemented by using a portfolio with 5 ETFs:

The portfolio can also contain 10 ETFs by adding the following 5 ETFs:

The exact percentages invested in each asset class can be tailored to the individual investor his preferences, but the total investment should be balanced around these main asset classes. The portfolio can then be rebalanced on a monthly or a quarterly base in function of the inflows and outflows that take place in the investor's portfolio.

For the period 1985-2008, this would give the following results:

Source: The Ivy Portfolio book

Active Management

In the last part of the book, the authors demonstrate two trading systems in which the investment method presented earlier can be applied in an active way.

1) QUANTITATIVE SYSTEM

In the first system, only one asset class will be used. In the book, they use the S&P500 index where one should use the following rules to make the buy and sell decisions:

  • Buy rule: Buy if monthly price > 10-month simple moving average
  • Sell rule: Sell and move to cash when monthly price < 10-month simple moving average

This would have given the following results over the period 1900-2008

Source: The Ivy Portfolio book

2) ROTATION SYSTEM

In this second system, we will use the five asset classes mentioned earlier. Here you simplly calculate the

  • 3-month total return for each asset class
  • 6-month total return for each asset class
  • 12-month total return for each asset class

And then you calculate the average performance for each ETF. You can then choose to invest your funds in either the top one ETS, the top two ETFs or the top three ETFs. This exercise can be repeated at the end of each month by rebalancing the portfolio. This would have given you the following performance during the time period 1973 - 2008:

Source: The Ivy Portfolio book

While the backtest results for both systems certainly look impressive, we need to keep in mind they only run until 2008. One of the largest financial crises of all time took place during and after that period. The credit crisis also changed the financial world and the investment landscape, which means one needs to look at these backtest results with a certain precaution.

Nonetheless, these strategies can certainly provide inspiration for the construction of a tactic asset allocation model. Especially the relationship between the annualized return and the risk (volatility) needs to be monitored to evaluate the trading system over the tested period.

Conclusion

The Ivy Portfolio is a well-written book on the investment strategy of the two largest endowment funds. The returns are realized by implementing a tactical asset allocation model, which can also be implemented by individual investors via ETFs. For those who prefer a more active investing system, two active management strategies are presented.

The main message of the book is that individual investors should focus on asset allocation and not on individual stock picking strategies. I think the book provides convincing reasons for this investment method.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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