Dominated Assets

In Unconventional Success the famous Yale Endowment manager David Swensen introduces an intuitive notion of a "dominated asset" which one can formalize (perhaps slightly over formalize) by the definition:

An asset A is dominated if there is another asset B such that under "any" realization of the financial future asset B will provide a "larger total return" than asset A.

Mathematical statisticians will see an analogy here to the notion of an "inadmissible estimator", and they will also see that even my "overly formal" definition is not fully precise. Still, it is close enough to be useful.

Examples Please?

The most straightforward example are indexed mutual funds that have expense ratios (or other charges) that are not at the market minimum. You might not think that there would be many such funds, but they are common as weeds. Even the once honorable TIAA-CREF provides you with funds that are dominated. They have lots of fellow bandits --- and bigger bandits, but that does not mean that CREF is not taking money out of your pocket that you did not have to pay.

172 SP500 Index Funds... 150 Brutally Dominated

"We cut 150 funds from our initial list of 172 S&P 500 index offerings because of loads and fees. That list included funds from Gartmore, Wells Fargo, Evergreen, JennisonDryden, BB&T and First American. Their investors should be outraged." --- Rob Wherry

Yup, 150 funds, many vetted by "advisors." All with fees (and loads!) that cost you from three to 20 times as much as you would be charged by Vanguard or Fidelity.

It is a travesty for an individual to come to the somewhat subtle intellectual decision that it is wise to be substantially "indexed" and then on the last step to get robbed of a substantial part of the proper return.

Are people knowingly buying "convenience," or have they simply been duped?

Related Mysteries

This rant is still a "stub" in Wiki-parlance. Here are notions that I will add to over time:

1. Two thirds of the funds in 403(b)s is invested in short term debt instruments (e.g. money markets, CDs, Treasury Bills). Can the world in aggregate really be so uncertain about the return from stocks? To me it seems inconceivable that the people holding all of this "cash" have made a considered decision to forego the additional return that has been historically realized by investing in stocks.

2. David Swensen takes the view that corporate bonds are "dominated" from the point of view of US retail investors by US Treasuries. His point is that the retail investor who holds corporate bonds is not properly compensated for the credit and call features of the bonds. I see the point, but I would not go so far. There is a whole market out there creating a risk/return equilibrium. If one minimizes fees, say by holding Vanguard "Total Bond Market" index fund, I see no compelling reason to believe that this asset as dominated by treasuries, even if one acknowledges that treasuries do have some essentially unique "insurance" features.

3. David Cowan has said on his blog that he "only" wants to be invested in illiquid assets. The equilibrium argument is that liquidity has value for many investors so you must forego incremental expected return to pay for the benefit of liquidity. This is an argument for venture capital, private equity, and direct investment in real estate and natural resources. Unfortunately, the typical working Joe cannot sensibly participate in these markets, except perhaps through rental real estate. If you are handy, don't mind the occasional confrontation, and are not too paranoid about liabilites, rental real estate may work for you. Alternatively, if you can really extract the "use dividend" then a second home can also work, though I suspect that (going forward at least) the second home is a risky proposition --- especially if you do the accounting honestly.

4. Since I have bashed CREFs SP500 Index fund, it is only fair that I mention that the TIAA Retirement Product Real Estate Fund is a miraculously undominated asset. It is as close as an individual can get to fairly priced direct investment in commercial real estate. It has a smoothed return stream that actually "incredible" in the sense that it is so unlike any other financial asset that it is hard to believe. It is a very special product with "zero beta," beyond bond returns, and near monotonicity. Careful though: CREF also has a REIT index fund with a similar name --- but which is brutally dominated!

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