Reckoning with Risk (4)

When David Swensen began managing the Yale Endowment in 1985 as a young Ph.D. in economics (from Yale, of course), endowment investing was a sleepy backwater within the financial world. Nearly all endowments invested close to the then-standard 60 percent domestic equities/40 percent domestic bonds portfolio. Swensen changed that world and succeeded spectacularly.

Today, investments strategies, funds and other products created to mimic “alternative” investments popularized by the so-called “Yale model” are readily available to both institutional and retail investors and, at least conceptually, provide excellent opportunities. But they remain problematic in execution.

Swensen’s innovation was recognizing that an endowment’s perpetual life allowed it to handle substantially more risk (volatility, drawdown, market and other risks) and substantially less liquidity than endowments typically employed, as delineated in his 2000 book Pioneering Portfolio Management. Swensen posits that portfolios should be diversified far beyond public securities and should hold dramatically fewer bonds. In 1991, 53 percent of Yale’s endowment was committed to U.S. stocks, bonds, and cash; today, barely 10 percent is devoted to domestic marketable securities with only 4 percent in fixed income.

Yale currently identifies seven major asset classes for investment plus cash (with target allocations in parenthesis): private equity (34 percent), real estate (20 percent), absolute return (17 percent), foreign equity (9 percent), natural resources (9 percent), domestic equity (7 percent), and fixed income (4 percent). Yale’s annual net investment returns have averaged 14.2 percent over the past 20 years. Not surprisingly, the Yale model’s success attracted imitators among endowments, followed by pensions and institutional investment managers, albeit often with less than stellar results. After seeing that from July 2000 through June 2003, as the S&P 500 fell 33 percent Yale’s endowment gained 20 percent, investment advisers broadly extended Yale’s influence to individual investors. Initially, alternative strategies were primarily accessible through hedge funds, usually in the form of limited partnerships, meaning that investors had to have a lot of money to qualify. Alternative mutual funds—SEC-registered vehicles designed to replicate alternative strategies and developed to meet this demand—make such approaches much more broadly available.  Non-traded vehicles and investment advisers using alternative strategies are now common too.

The nearly 25 percent loss to the Yale portfolio because of the global financial crisis in its fiscal year 2009 (compared to an S&P 500 loss of roughly 26 percent over the same period—nearly all correlations tended toward 1) led some to question the validity of the Yale model. A report by the Tellus Institute and the Center for Social Philanthropy boldly called for “a transformation of the Endowment [Yale] Model of Investing.” Humphreys, Joshua. 2010. Educational Endowments and the Financial Crisis: Social Costs and Systemic Risks in the Shadow Banking System, A Study of Six New England Schools.Center for Social Philanthropy and the Tellus Institute.  The Yale model received additional scrutiny in a paper questioning whether the model’s success should, in fact, be credited to risk exposure as well as manager skill. See Mladina, Peter, and Jeffery Coyle. 2010. “Yale’s Endowment Returns: Manager Skill or Risk Exposure?” Journal of Wealth Management (Summer).

Obviously, one difficult patch (even a really difficult patch) is hardly sufficient evidence to discredit Swensen’s work in toto. The idea that a broadly diversified portfolio is a low-risk portfolio is common but wrong. See, e.g., Considine, Geoff. 2009. “Not Without Risk.” Financial Planning (September).  A well-diversified portfolio has higher average expected return for a lower average risk level, but that is not to say that it is somehow sheltered from significant drawdowns. However, there are crucial lessons to be learned from the Yale portfolio’s performance during the crisis. The biggest is that advisers must consider more than just asset allocation across markets. Also crucial is that liquidity risk cannot be ignored, especially when the portfolio is being used to fund substantial current spending.

It is a good rule of thumb that investors (and especially individual investors) generally need more liquidity than they think. During the crisis, when liquidity was difficult to obtain, alternative assets were frequently liquidated at less than 50 percent of the previous year-end net asset value.See, e.g., McGrady, Colin, and Brad Heffern. 2009. “Secondary Pricing Analysis, Interim Update, Summer 2009.” Cogent Partners.  Simply put, institutions with insufficient liquidity in 2008 got crushed. As a consequence, Swensen took pains to point out that he “never took the position liquidity wasn’t important, just that it’s generally overvalued.”Golden, Daniel. 2009. “Cash Me If You Can.” PUC-Rio online article (April).

Despite the difficulties the crisis brought (the Yale portfolio did out-perform the S&P 500 during that time), institutional investors remained committed to alternatives and individual investors shifting into alternatives continued apace. Indeed, judiciously used and portioned, alternative investment strategies should provide outstanding opportunities to enhance portfolio strength, especially during the secular bear markets. But doing so effectively is much easier said than done. When Mohamed El-Erian, the former head of the Harvard Endowment, was asked if individual investors could mimic what the top endowments do, he replied, “It would be like advising my son or daughter to drop out of school to play basketball with the goal of becoming the next Michael Jordan” (quoted in Faber, Mebane T., and Eric W. Richardson. 2009. The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Hoboken, New Jersey: John Wiley & Sons Inc.).

Swensen’s own book for individual investors, Unconventional Success, specifically advises them not to try to imitate Yale’s success. A subsequent edition of Pioneering Portfolio Management does make a significant concession, however: “I have come to believe that the most important distinction in the investment world does not separate individuals and institutions: the most important distinction divides those investors with the ability to make high quality active management decisions from those investors without active management expertise.”

Despite the concession, Swensen still rejects the idea that the Yale model can be applied to individual investors. “No middle ground exists. Low-cost passive strategies, as outlined in Unconventional Success, suit an overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions.”  Other experts, obviously, think that these hurdles can be overcome.  Irrespective of which camp you’re in, the lessons we can learn from the Yale portfolio in crisis should be clear: (a) asset allocation (even outstanding asset allocation) doesn’t necessarily provide a safe harbor, especially in crisis; and (b) we typically need more liquidity than we think.  Once again, risk is risky.

Advertisement