Edge is a private investment firm located in Atlanta, GA.  For more information on Edge, please visit www.edgecappartners.com or call 404-890-7707.

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Executive Summary

The Yale Endowment is arguably the most successful investment institution with a 17.2% annualized return from 1986 – 2006.  Should wealthy taxable investors replicate their endowment investment approach?

Edge believes that replication of the Yale investment methodology would be difficult for most investors with less than a $60 million liquid portfolio and may not be favorable even if they could.  Why?

1.  Taxes (and IRR Myths)

• Yale does not pay taxes.  We estimate that taxes would have eaten up 150 basis points of Yale’s 17.2% annualized return from 1996 – 2006 due to turnover, capital gains, dividends, and interest from their underlying managers and investments.
• If we conduct the same analysis with Yale’s active benchmark performance, the effect of taxes is more profound with a 250 basis point drag on performance (over 19% of the pre-tax return).
• We also remind you that there are lies, damn lies, and statistics^1>.  While Yale’s private equity portfolio has earned a 34.4% annualized IRR over the past 10 years, we estimate the “actual” (modified IRR) pre-tax return to an individual with cash waiting to be called is 21%.  

2.  Access

• We estimate that an investor must have a liquid portfolio in excess of $60mm at a minimum without incurring additional fees for access.  However, this minimum is likely far too low for true replication considering the unpredictable spending needs of the individual investor and high minimums by some investment managers.
• If a typical private equity fund generated a net return of 2.0x committed capital and a 20% IRR, an investor in an access vehicle such as a feeder fund would earn a net pre-tax return of 1.88x committed capital and a 17.2% IRR.
• If a typical hedge fund generated a net return of 12.9% (Yale’s 10 year annualized return for “Absolute Return” managers), an investor in a fund of fund would earn a net pre-tax return of 11.0%.  Moreover, the investor would earn 7.2% after-taxes.

3.  Time Horizon

• Yale takes advantage of their high degree of certainty on spending requirements to give up liquidity in search of return.  Yale has 44% of its portfolio allocated to illiquid assets.  We argue that such a high allocation to illiquid investments is not suitable for individual investors because of their low degree of certainty on spending. 

Combining these three factors together, we estimate that taxable investors with less than $60 million in liquid assets would have earned a net 13.8% annualized return from 1996 – 2006 compared to Yale’s 17.2% return.  This does not even include annual fixed costs for the infrastructure of Yale’s illustrious investment office.

Introduction

The Yale Endowment’s annual report should be required reading for any sophisticated investor.  We view David Swensen and the Yale Investment Committee as a champion of “modern” portfolio management who extends the academic foundation laid out by Harry Markowitz and James Tobin to include evolving alternative asset classes.  Yale’s 17.2% annualized returns from 1986 – 2006 resulted from their forward-thinking investment philosophy, the architecture of their portfolio structure, and, of course, healthy capital market returns.

As advisors to families of substantial wealth, we often ponder the question: How can Edge apply the lessons from the Yale Endowment franchise to the taxable, affluent investor?  It is our opinion that replication of the Yale investment methodology would be difficult for most investors with less than a $60mm liquid portfolio and may not be favorable if they could.  Why?  Taxes, access, and time horizon.  However, the process of defining asset classes by the market forces which drive risk and return and not by its legal structure is an invaluable lesson which can advance private investors out of the homogeneity of traditional asset allocation models.

Let us first explain why Yale has produced a superb long-term record (not surprisingly, Edge shares similar philosophies):

• Yale’s defense against large losses stems from the architecture of their portfolio structure
• Academic theory and informed market judgment evaluates expected returns, risk, and correlation of investment assets
• Broad diversification
• Significant equity orientation toward inefficient, non-traditional asset classes
• Long-term investment horizon
• Discipline in adhering to the investment policy by maintaining target asset allocation through an annual review to rebalance
• For example, shortly following the 1987 stock market crash when equity markets declined 20%, Yale purchased thousands of S&P 500 Index futures to rebalance the portfolio to investment policy targets
  
  

• Yale strongly favors long-term commitments to carefully chosen managers who are often at an early stage in their development
• The primary criteria for those managers selected demonstrate:
• Superior investment skills
• Sound investment philosophies
• A commitment to investment returns and not gathering assets
• “Young and hungry” principles
• A coherent organization and sustainable business strategy
• Appropriate fees and incentives that keep managers motivated
• High integrity
• In other words, Yale seeks skillful, emerging managers who are managing relatively small pools of capital

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