Checking in on the “Yale Model”

For many years now, institutional investors have consistently tried to follow the lead of the Yale Endowment and its talismanic leader, David Swensen, by investing heavily in illiquid alternative investments such as private equity via hedge fund vehicles. Indeed, the so-called “Yale Model” has been perhaps the primary investment innovation in the institutional space over the past 25 years. But the times they are a-changin’.

On November 6, preliminary data was released concerning endowment performance for the fiscal year ending June 30, 2013. After many years of underperformance, smaller (under $100 million) and midsize ($100 million to $1 billion) endowments have now outperformed the “big boys” (in excess of $1 billion) over the most recent three and five-year periods. Previously, more than 90 percent of endowments with less than $1 billion in assets underperformed in every time period since such records have been kept. 

This change has been the result of high public equity returns, according to Columbia Professor James Stewart and Yale’s Roger Ibbotson, because smaller endowments tend to allocate a larger percentage of their assets to publicly traded securities and less to illiquid alternatives. Since hedge fund vehicles and alternative strategies generally have done poorly since the 2008-09 financial crisis, it shouldn’t be surprising that endowments that have less money there have done better.

Moreover, a 2012 Vanguard study has provided a good basis for endowments (and especially smaller endowments) to consider more traditional equity allocations along with the possibility that they can’t effectively “be like Yale.” The study established that a low-cost, actively managed “balanced” fund produced returns that surpassed those of the average small endowment by a whopping 47 percent and the average midsize endowment by over 14 percent over the last 25 years, even though it didn’t outperform the average large endowment. Many such endowments now get it, finally following Swensen’s own advice:  those without Yale’s access and expertise shouldn’t try to emulate its investment strategies.

Performance isn’t all that is noteworthy about the data. Largely as a consequence of poor performance in the alternatives space, endowments have dramatically reduced their AI allocations to an average of 47 percent, down from 54 percent in 2012. Moreover, traditional equity allocations have also increased dramatically. The average allocation to domestic equities has risen from 15 to 20 percent and the average allocation to international equities has grown from 16 to 19 percent. Thus allocations to public equities, on average, now exceed AI allocations.

The key here, or so it seems to me, is why investors are using alternatives as well as how they are balanced with public equities. An imbalance toward alternatives and away from equities is a dangerous bet. Alternatives shouldn’t be expected to outperform a strong cyclical bull market in stocks. I noted as much to the FT a few weeks ago. Diversification inherently means that some investment strategies will do well while a few are doing poorly and others are doing just okay.

However, many of these alternative investments have been sought out for their return characteristics rather than as diversifiers.  Moreover, many are positioned as absolute return vehicles, allegedly nimble enough to provide positive returns in any environment.  The data suggests that, in this context, alternative investing has not been very successful. In 2012, for example (since AI most often come in a hedge fund wrapper), the HFRX Global Hedge Fund Index gained just 3.5 percent and has returned just 1.7 percent per annum over the past 10 years. That’s hardly consistent with expectations, especially when hedge fund managers are being paid “two and twenty.” In fact, the S&P 500 has outperformed the HFRX for ten straight years, with the exception of 2008 when both fell sharply. More significantly, a standard 60/40 portfolio has delivered returns of more than 90 percent over that same period compared with a meager 17 percent after fees for hedge funds.

Obviously, as a strategy becomes more popular, it suffers from both falling expected returns and rising correlations.That appears to be the case for the Yale Model. The outperformance by the big endowments in the 1990s was driven largely by investments in older, more established venture capital firms which were frequently difficult to get into and size-constrained but with great results. For example, Yale made “home run” early investments in Compaq, Oracle, Genentech, Dell Computer, Amgen, Amazon, Yahoo, Cisco Systems, Red Hat, Juniper Networks, Google, Facebook, LinkedIn, Twitter, and Zynga. By 1999-2006, the performance advantages of these types of funds had largely dissipated. A major academic survey found that “an influx of capital into private equity is associated with lower subsequent returns.” In other words, the trade had gotten increasingly crowded.  For further support of this idea, Cambridge Associates estimates that 3 percent of venture capital firms generate 95 percent of the industry’s returns and adds that there is little change in the composition of those 3 percent of firms over time (more here). Newer and smaller players (“not Yale”) don’t have that level of access.

According Yale itself, “nearly 80 percent of Yale’s outperformance relative to the average Cambridge Associates endowment was attributable to the value added by Yale’s active managers, while only 20 percent was the result of Yale’s asset allocation.” But, obviously, not everyone can get access to what and who Yale does. Because the difference between good and not-so-good is particularly acute in this space, lesser endowments get disappointing leftovers. Moreover, since even Yale has now significantly reduced its private equity exposure, if you don’t have Yale’s access and expertise, you might well decide to limit AI exposure to that needed for reasonable diversification. And you might not even play at all.

According to Yale’s own analysis, an “average endowment” runs a 28 percent chance of losing half of its assets (in real terms) over the next 50 years and a 35 percent chance risk of a “spending disruption” over the next five years, on account of asset allocation decisions. In Swensen’s own words, “the most important distinction isn’t between the institutional investor and the individual. It’s between those that are set up to make high-quality active management decisions and those that aren’t. The investment management world is a strange place in that the right solution is not in the middle. The right solution is at one extreme or the other. One end of the spectrum is being intensively active. The other is being completely passive. If you end up in the middle, which is where almost everybody is, you pay way too much in fees and end up getting subpar returns.

“At the active end of the spectrum, you’ve got institutions like Yale and Harvard and Princeton and Stanford and others, who’ve really built high-quality investment teams that have a shot at making consistently good active management decisions. But there’s a vanishingly small number of such investors. Those on the passive end of the spectrum have figured out that they don’t know enough to be active. The passive group is not nearly as big as it should be. Almost everybody should be there.”

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