With a new report out from the Yale Endowment, now is a good time to do a heat check on how the so-called “Yale Model” of investing is doing. I have written about the Yale Model numerous times (see here, here, here and here, for example). It emphasizes broad and deep diversification and seeks to exploit the risk premiums offered by equity-oriented and illiquid investments to investors with an investment horizon that’s sufficiently long – in Yale’s case, essentially forever. It has worked exceptionally well for Yale. For others…not so much.
The newest report from David Swensen and the Yale Endowment was released last week and demonstrates that the university has been well-served by its Endowment and the investment approach it (and he) pioneered. For fiscal 2013 (ending June 30, 2013), Yale earned a 12.5 percent return, well ahead of the 11.3 percent average for foundations and endowments, if lower than domestic public equities (that should be expected in a year when one investment class dramatically outperforms).
With annual net ten-year investment returns of 11 percent and 20-year returns of 13.5 percent, the Endowment has grown substantially, despite significant institutional expenditures therefrom. Perhaps most significantly, if Yale’s assets had been invested in a classic 60:40 portfolio since 1988, the Endowment’s value today would total $9.11 billion, far less than its current value of $20.78 billion.
For the current year, target allocations to real estate (19 percent) decreased by 3 percentage points and private equity (31 percent) by 4 percentage points, reflecting Yale’s view of the relative opportunities in those sectors. Approximately one-half of the portfolio is illiquid. Roughly 95 percent is allocated to equity and equity-like investments.
I have questioned whether the Yale Model is “past it” – whether its approach is now so often copied that the “trade” is crowded and alpha is dissipated. This year’s report strongly contends that such alpha remains available, but reiterates that it isn’t available to everyone. As the report points out, “Yale has never viewed the mean return for alternative assets as particularly compelling.” The key to success for Yale is access to the best managers, at the best price, with a careful alignment of interests. Since Yale is aligned with the best managers – who are not taking on new investors – the Endowment believes that it is healthy and needn’t alter its strategy.
For investors who came later to the party, the prospects aren’t nearly as good. “While alpha is not dead, opportunities to access it may not be available to all investors.” For example, with respect to private real estate, the report notes that “[t]he illiquid nature of private real estate and the time-consuming process of completing transactions create a high hurdle for casual investors.” Thus “[t]he costly game of active management guarantees failure for the casual participant.”
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. That’s far greater risk than most investors (and nearly all individual investors) can bear. The newest report also includes an explicit warning to investors who aren’t Yale.
“Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns.
“… No middle ground exists. Low-cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high-quality active management decisions. The framework of the Yale model applies to only a small number of investors with the resources and temperament to pursue the grail of risk-adjusted excess returns.”
In other words, the first people to the buffet table get most of the tasty stuff. Everybody else would be better off eating elsewhere. Significantly, and by way of example, Cambridge Associates estimates that three percent of venture capital firms — which have provided a huge proportion of Yale’s excess performance — generate 95 percent of the industry’s returns and adds that there is little change in the composition of those three percent of firms over time (more here). Yale has ongoing access to that three percent. Few others do (and if you aren’t sure, you don’t).
Note Swensen’s own words of warning.
“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.”