Apologies to those who logged in yesterday for our regular link smorgasbord. Some good friends invited me onto their canal boat for a bit, and there I stayed!

As a conscientious objector to the ongoing war between the older and younger generations via UK house prices, I’ve wondered about running away at 4mph on a canal boat.

Sadly, as best I can work out narrowboats depreciate with a half-life of around 10 years. They’re not cheap to begin with, either – £40,000 to £80,000 or more used, and much more brand new – and they also eat up a couple of thousand annually to keep from rusting.

Then there are mooring fees, or rent by another name. Few boat owners can genuinely continually cruise the waterways (which itself costs around £800 a year in licences) so most need a permanent base. The better residential ones in London cost £4,000 to £8,000 a year, though elsewhere is cheaper.

As someone wise once said:

“A boat is a hole in the water that you pour money into.”

If I eventually do try living ‘on the cut’, you will learn about it here.

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One of the mantras of those gloomy about Western economies is that we face a lost decade like that suffered by Japan.

In fact, Japan endured more than one lost decade, going on the performance of the Nikkei stock market.

Having hit a high of 38,957 in December 1989, the Japanese index had fallen to 6,994 by October 2008.

That’s a decline of 82% over 19 painful years!

But Japan’s lost decade wasn’t just about stocks. Economic growth came to a near-standstill in the 1990s. Worst of all, with house prices slumping, Japanese firms retrenching and personal consumption evaporating, Japan entered a deflationary spiral – despite near-0% interest rates.

With US and UK interest rates now hovering barely above zero and a convincing economic recovery still not apparent – especially in the US, which has a persistent unemployment problem – the doomsters see parallels with Japan in the late 1980s:

• The US tech boomed propelled the Nasdaq market to a peak of 5,049. Ten years after the crash, it’s at just 2,291.

• The FTSE 100 peaked at 6,930 in 1989. At 5,366, we’re still in a bear market.

• We had a lending boom and a banking crash, just like in Japan.

• The US is even flirting with deflation (unlike the UK where inflation is stubbornly above target).

These things keep investing refuseniks up at night, counting their gold coins, shotgun cartridges, and cans of baked beans.

We’re not turning Japanese

While there are echoes of our predicament in the Japan of 20 years ago, I personally sleep well and don’t expect a lost decade either here or in the US.

That’s because I see more differences then similarities with Japan.

In contrast, like stalkers looking for signs of love in a restraining order, the Lost Decade obsessives ignore evidence that contradicts their thesis.

The reality is that our cultures, economies, and our response to the financial crisis have been very different in the US and UK, compared to Japan.

Savers versus spenders

Perhaps the biggest reason for my optimism is I see very little chance of deflation taking root in the West.

The Japanese were once notoriously high savers. Just look at the following graph from Investor Insight:

Japan is a savings-driven culture, even today. Back in the 1980s, credit card debt was unheard of, and 20-somethings stayed at home for years to save a deposit for their super-expensive shoebox houses.

If you’ve got a lot of savings tucked away, deflation isn’t so bad. In fact, your money is worth more every year as goods and services become ever cheaper.

Japanese citizens could therefore spend their savings to top up their living standards throughout the lost decade. Terrified of debt – especially after that massive housing crash – even super low interest rates didn’t make the alternative attractive.

Compare that to the US:

US consumers only really save in economic downturns, as can be seen in the early 1990s, the recession that followed the tech bust, and the big spike upwards in savings in 2009.

While US households in aggregate have financial and housing assets to at least match their liabilities (contrary to the hype) they don’t have – and are not used to having – massive amounts of cash tucked away. Deflation would bite the US hard.

What this suggests to me is that near-0% interest rates – and quantitative easing – will work in the US, and here in the UK where the situation is very similar, because consumers would eventually start borrowing again.

If the authorities print as much money as is needed, we’ll get inflation and escape the deflationary component of Japan’s lost decade. That is half the battle won.

Response to the banking crash

The next difference to appreciate is between Japan’s response to its collapsing asset bubble of the late 1980s, and our own more recent one.

• The Japanese housing bubble was insane, and on a different scale to our own.

• Perhaps our tech boom was similar, but thankfully that never spilled out to inflate the value of all companies. (Instead they sold at bargain prices)

• In Japan, broken banks limped on for years.

• In the West, banks like Northern Rock and Lehman Brothers went bust.

• In Japan, banks continued lending cheap money they’d never get back until late into the 1990s.

• In the West, our banks have dialed back on bad lending and are actually hoarding cash.

• Japanese banks kept near-worthless securities on their books for years at inflated values.

• While our rules have been softened more than some critics would like, the US and European stress tests show we’ve flushed out the vast bulk of toxic assets, albeit at a huge cost to shareholders and taxpayers.

I’m not saying our banks covered themselves in glory before or after the crash, or that the transfer of risk from private companies to the State is without other consequences.

I’m saying these things have happened here, and a heck of a lot faster. So again, we’re different to Japan.

Different economic models, too

Finally, look at how we’ve responded to the recession in the West, compared to the zombie-like situation of Japanese corporates in the 1990s.

In the Lost Decade, much of what had been lauded in the Japanese economic model turned around to drag it under.

Not the good stuff – Kaizen, automation, and the just-in-time production lines that made Japanese factories the envy of the US rust belt.

Rather the networks of family and corporate cross-holdings, the jobs for life of salarymen, and the extreme desire to save face that also was part of the Japanese economic miracle.

It took a long time for the scale of the crisis to become apparent in Japan, because as I’ve said the banks obfuscated for years, as did politicians.

• Interest rates were far slower to fall than more recently in the West.

• Even when it was clear to everyone that Japan was in a hole, companies failed to shed workers or factories.

• Banks didn’t make savage writedowns over a couple of quarters like ours – they limped along, technically broken, for more than a decade.

• Cross-holdings between Japanese companies saw dying ones kept alive by healthy ones.

To be sure we’ve had some of this in the West. Lloyds and RBS survive due to taxpayer support, as does the likes of GM in the US.

But look at the bigger picture. The massive bounceback in corporate profitability and the coincident rise in unemployment in the West is evidence of capitalism working at its ruthless best.

Incidentally, demographics in the US are totally different to Japan, too. Thanks to immigration, the US still has a growing young workforce – yet another critical distinction that the Lost Decade doomsters overlook.

No easy ride, but no Lost Decade

I appreciate this may sound Panglossian to some readers, but it’s really not.

The Japanese experience is near-unique in our experience of capitalist economies. Even today it confounds the economic rules. It’s the exception, not our inevitable fate.

We might well suffer other bad stuff that I don’t expect, such as a double-dip recession or a period of extremely high inflation from our warding off of deflation. Our future standard of living has definitely fallen from where we expected it to be three years ago.

If you want gloomy scenarios, those are much more likely. But to say we’ll go Japanese is really a leap, considering how un-Japanese we were to begin with.

I wrote last year about how to construct the Ivy League portfolio proposed by David Swensen, the endowment fund manager at Yale and author of the nerdy investment classic Unconventional Success.

My Ivy League portfolio was based on a US article that followed Swensen’s advice; I simply re-worked it for UK ETFs.

While it has the diversification that Swensen champions, I knew even then that this ETF portfolio wasn’t really a proxy for the true Yale fund, which has delivered market trouncing average returns of over 16% in the 21 years to 2007.

Rather, it was a case of do what he says, not what he does. The Ivy League portfolio follows the advice Swensen presents in Unconventional Success as the optimal strategy for private investors – to use ETFs, avoid non-Government bonds, and shun expensive funds.

The Ivy League Portfolio Vs. Swensen

It was therefore always going to be interesting to see whether a private investor could get Yale-like returns from these six cheap to buy-and-hold ETFs.

And the answer appears to be: we can’t.

According to an article published on The Motley Fool last week, the real Yale portfolio run by Swensen trashed the US ETF proxy in every year (ending June) from 2005 to 2008.

As for the year ending June 2009, that year the ETF portfolio and the real Yale portfolio matched each other. But it was hardly a champagne moment – both recorded a loss of 25%! (The results to June 2010 aren’t yet in).

Factors that saw the real Yale porfolio win

The Motley Fool says it’s easy to see where the real Yale portfolio got its edge:

According to the Yale fund’s annual report (pdf file) for the year ended 30 June 2009, the fund had less than 20% in domestic and foreign equities, and less than 5% in fixed income.

Around a quarter of the fund was allocated to ‘Absolute Return’, another quarter to ‘Private Equity’, whilst the largest allocation, nearly a third of the portfolio, was to ‘Real Assets’.

Interesting.

Firstly, it seems Swensen was as bearish about the Government bond bubble as I was back in late 2008, given the small amount he was holding in June 2009. Still, a US private investor sticking to Swensen’s fixed boundaries for the ETF model portfolio would have only seen their 15% allocation of Treasuries drop in value by 1% to June anyway, thanks to the big rally of late 2008 they’d have enjoyed before the pullback.

No, the real damage was done by the ETF portfolio’s weighting towards equity and commercial property, which fell between 30%-50% in the year to June 2009 alone.

In contrast, Swensen had more than 75% of his money in very un-ETF like funds, presumably in an attempt to avoid correlation with equities.

Yale’s out-performance would therefore appear to be a clear win for both active fund management and market timing, which is contrary both to Swensen’s book and my own modest thoughts on investing!

Is it fair to judge the ETF Ivy League portfolio this way?

You can certainly argue it’s not a useful comparison to pitch Swensen’s model ETF portfolio against what he actually does for Yale:

• The institutional funds Swensen buys for Yale are cheaper than those sold to private investors, and he has a team of people to investigate them before investing.

• Plenty of the out-performance of private equity and real estate had dissipated by 2009.

• March 2009 onwards would have seen a huge surge in the ETF portfolio’s equity positions – perhaps even enough to make up for previous years. The dates covered in the Fool article are then unfortunate for the ETF approach. It will be interesting to see the results to June 2010.

• Everything became correlated in 2008 and 2009, which meant it was harder for a simple ETF portfolio to diversify away the big falls in the market.

On the other hand, we’re more interested in results than in excuses. We can’t invest alongside Swensen, so can we do anything to better replicate his method?

Doing a Swensen to spice up the all-ETF approach

It’s no easy thing for a private investor to access decent absolute return or hedge funds. As Swensen himself says in Unconventional Success, big institutions get superior deals and are better equipped to evaluate what they’re offered.

Yet it can’t be beyond us to add some assets to Swensen’s bare bones ETF portfolio to try to diversify further, like he does with Yale.

We’re told Swensen’s money was mainly in absolute return, private equity, and real assets as of June 2009. What can we do to copy him?

Absolute return funds – I’m sceptical about whether most absolute return funds will deliver what they promise over the long-term. Private investors also face higher charges and greater risk, due to not being able to do the due diligence that Swensen’s large team will bring to bear. I think absolute return funds are a classic case of dangerous exotics. But even the Daily Mail is now suggesting otherwise, so check out their article if you want some names to research further. Personally I’d suggest you increase bond holdings or cash if you’re nervy, rather than buying a fund manager a sports car. Alternatively, consider a cautious investment trust like the Personal Assets trust, which is relatively transparent and not too expensive to hold.

Private equity – Here’s better news. Investment trusts like 3i and HGCapital enable retail investors to get exposure to the private equity cycle, and they currently look cheap. Some even pay a dividend. They will be correlated with equities, though. Riskier but of interest to some UK investors – and potentially less correlated – are Venture Capital Trusts (VCTs), which invest in small companies and can pay a hefty dividend. Many have a dismal record, so I’d stick to the likes of Northern and Baronsmead’s VCTs. The annual expenses will be over 3%, but the dividends are tax-free.

Real assets – Here it’s actually easier for us than Swensen. He has to invest in gold and the like – and so can we – but we can also buy antique furniture, paintings, stamps or even a bigger home to try to lock in some of the benefits of real assets (chiefly a lack of correlation with equities and some inflation proofing). Your collection of first edition Marvel comics might not be big enough to excite a Yale fund manager, but it could work wonders for your own balance sheet.

The Ivy League portfolio: Take 2

Here’s an example of how the Ivy League ETF-based portfolio might be tweaked in light of the above thoughts. I should stress – as should be obvious – that this is not a portfolio recommended by David Swensen!

Also note that while I’ve reduced equity holdings, I’ve also increased the emerging market weighting to 10% since last time, and reduced REIT exposure, both in light of comments made by Swensen in interviews since he wrote Unconventional Success.

The NEW Swensen inspired portfolio

• Domestic Equity (10%): FTSE 100 / FTSE 250  (ISF / MIDD)
• Emerging Market Equity (10%): MSCI Emerging Market Equity (IEEM)
• Foreign Developed Equity (10%): FTSE Developed World (IWXU)
• Property (REITs) (10%): FTSE EPRA/NAREIT UK Property (IUKP)
• U.K. Government Bonds (15%): FTSE UK All Stocks Gilt (IGLT)
• U.K. Inflation-Linked Bonds (15%): £ Index-Linked Gilts (INXG)

Plus additions of:

• Absolute return (10%): Personal Assets trust / 3-4 expensive funds
• Private equity (10%): Investment trusts (3i / HGcapital / VCTs)
• Real assets (10%): Physical Gold ETF (PHGP) / Your stamp collection

My revamping doesn’t even match – imperfectly – the weightings accorded by Swensen in his Yale fund to private equity and absolute return. But it does reduce pure equity exposure – although the investment trusts I’ve suggested will undoubtedly be somewhat correlated with the markets. The bigger holding of government bonds should offset some of this.

Also note that when buying investment trusts or funds, it’s a good idea to invest through several different companies to increase diversification and reduce the risk of management failure or fraud.

Beware: You could be tinkering at the wrong time

While I quite like the look of the Ivy League Portfolio 2.0, I suspect it’s a terrible time to reduce equity exposure so radically.

Swensen made the same point in an interview with Yale’s Alumni Magazine at the nadir of the bear market last year:

If an individual investor followed the program I outlined in Unconventional Success, they probably did reasonably well, through the crisis, thus far. They’d have 15 percent of their assets in U.S. Treasury bonds. They’d have another 15 percent in U.S. Treasury inflation-protected securities. Those two asset classes have performed well.

Of course, the other 70 percent of assets are in equities, which have not done well. […]

I recommend that investors rebalance. Rebalancing is even more important amidst these huge declines in the stock market because it presents a great opportunity. People can sell the Treasury securities that have appreciated dramatically to bring their allocation to the 15 percent target, and they can redeploy those funds into domestic equities and foreign equities and emerging market equities and real estate investment trusts, all of which are now much cheaper, and therefore have higher prospective returns.

Such rebalancing would indeed have led to huge gains in 2009 to 2010, as well as reducing the risks of holding overvalued government bonds. Read my series on rebalancing your portfolio to learn more.

Note: As ever, this article is just for your interest. It is not personal investment advice. Read about other easy ETF portfolios before making any decisions.