and the Financial Crisis
April 20, 2010
The devastation caused by the crash of 2008 was not limited to individual retirement portfolios. The endowments of most prominent universities suffered terribly, causing many of these institutions to drastically slash budgets and cut back planned capital spending.
Yale may have the most respected investment acumen, thanks to its manager, David Swensen, who is credited with developing the “endowment model,” a paradigm he has refined over his quarter-century tenure at the university. Yale’s performance during the 2008 crash was far from stellar, however, leading many to question the validity of the assumptions that underlie the endowment model.
By constructing a portfolio that serves as a proxy for Yale’s and simulating it using Monte Carlo analysis, I show that Yale’s performance was worse than what would be mathematically expected, but not significantly enough to question the endowment model’s tenets.
Moreover, Yale’s performance and philosophy suggest two very important lessons for advisors and investors – to diversify beyond equities and fixed income, and that some illiquid asset classes can be an important source of alpha.
Swensen’s endowment model posits that portfolios must be diversified far beyond public equities and bonds in order to generate the most attractive risk-adjusted returns. The alternative asset classes it advocates include commodities, real assets, private equity, venture capital, and absolute return strategies.
Yale’s endowment lost 24.6% in its fiscal year ending June 2009, posting its first negative return in twenty years. (Even including FY 2009, its 20-year average return is 13.4%.) That nearly 25 percent loss was considerably worse than the average endowment, which lost 18.6% over the same period.
To begin, we will examine the key concepts underlying the endowment model. We will then examine some benchmarks for the various asset classes and for Yale’s portfolio as a whole.
An overview of the Endowment Model
The annual reports issued by Yale’s endowment provide an overview of the philosophy that drives the endowment model. We will examine a number of the key principles.
If diversification fails to protect a portfolio in the face of a financial panic, why bother to diversify? The answer lies in the diversified portfolio’s lower risks and higher returns.
Diversification is a core tenet of the endowment model, even though diversifying may not provide much protection from a financial crisis.Many investors mistakenly believe that diversification is a key risk management tool, and the quote above notes that the truth is more nuanced. The idea that a well-diversified portfolio is a low-risk portfolio is common, but portfolio theory certainly doesn’t suggest that this is the case. A diversified portfolio has higher average expected return for a lower average risk level, but that is a far cry from the idea that a diversified portfolio is somehow sheltered from the effects of a market collapse.
Higher equity allocations
As to equity orientation, history teaches us that over reasonably long holding periods, higher-risk equities outperform lower-risk bonds. In fact, for the capitalist system to function properly, expected returns for equities must exceed expected returns for bonds. Both practice and theory point long-term investors toward portfolios with significant holdings of equity positions. (p. 3)
Another key theme of the endowment model is that long-term investors will be well served by substantial exposure to equities and to asset classes with equity-like risk.This quote does not pertain only to publicly listed firms, however, and Yale maintains a substantial allocation to private equity. Essentially, Yale believes in the equity risk premium and, since its time horizon is substantially longer than that of individual investors, it can tolerate volatility over the short term for the sake of achieving higher long-term returns.
Embrace active management
Despite recognizing that the U.S. equity market is highly efficient, Yale elects 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.(p.12)
Yale employs active management as a key component across the asset classes in which it invests. Active management in the portfolio emphasizes stock picking and fundamental strategies that look for under-valued assets.
Note, however, that Yale specifically structures its relationships with active managers to avoid the perverse incentives that are often inherent in the structure of active management (e.g., asset-based fees for public mutual funds which reward managers irrespective of their performance), as this quote illustrates:
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 significant sums alongside Yale, enabling the University to avoid many of the pitfalls of the principal-agent relationship. (p.11)Yale has this crucial ability with regard to selecting active managers that individuals do not.
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