The “endowment” model of investing, often simply referred to as the “Yale” model, after Yale’s legendary Chief Investment Officer, David Swenson, who literally wrote the book on multi-asset class investing and is widely credited for Yale’s incredible long term investment performance. Many articles, case studies, and academic papers have been written about Yale’s extraordinary returns and its innovative approach to risk, return, and liquidity factors to name a few. In addition to being a thought leader in endowment investing, Yale is extremly communicative about their investment process and the theory behind it.
We wrote this piece solely as reference material for other articles on FoundationAdvocate. We know that Yale is ntended to is not a discussion on its merits or shortcomings, merely a quick glance at the logic behind it.
In addressing what went wrong, it is important to understand the core investment strategy that most large colleges employ to manage their assets, called either the “Endowment Model” or the “Yale Model” after Yale’s David Swenson who popularized the methodology with spectacular success.Without position level details, one cannot perform a thorough attribution analysis to see exactly what worked and what didn’t. However, using information from Yale’s endowment report as a proxy for the institutional approach (Yale points out that its investment policy is based on work by Nobel prize winners, and its legendary Chief Investment Officer, David Swenson, literally wrote the boon on endowment investing), we think we can see what went wrong.
The graph below shows Yale’s long term expectations for investment returns along with the associated risk/volatility by asset class. One can see the intuitive relationship between risk and return moving from low yielding, but safe fixed income to the high octane venture capital at top right. The hashed line approximates a constant Sharpe ratio, or the incremental amount of return accompanying an incremental amount of risk.
If you look at Yale’s asset allocation, it is easy to see that alternative assets (the 3 gold bubbles), Venture Capital, Leveraged Buyouts, and Absolute Return, are the largest and collectively represent 59% of total assets The green bubbles, Cash/Fixed Income, Domestic, International and Emerging Market Equities are the publicly traded components of the portfolio and total just 25% of the total. The balance, 16% of assets, in blue are real estate and natural resources.
A core concept behind the endowment model is that as long term investors, they can weather the volatility of the highest returning assets over time as long as they have some more stable investments to protect them in downturns.
The Efficient Frontier
A second core concept that can be seen in Yale’s target portfolio is the Efficient Frontier for portfolio construction. If you imagine the two endpoints of the lines as the two extremes of portfolios, bottom left represents a portfolio with 100% allocation to Fixed Income/Cash, so of course the portfolio’s risk/return would be the same as the underlying assets. The same is true at top right for a portfolio solely in venture capital.
The theory of the Efficient Frontier is that as you add other assets to your portfolio you can bend the risk/return trade off away from a linear relationship (the dotted line) to better outcomes (the Efficient Frontier) because asset classes are not completely correlated with one another. The Efficient Frontier is the representation of the highest yielding portfolio for a given amount of risk.
Yale’s target return is shown and one can easily see that it is well over the linear risk.return line.
One can see the relationship between risk and return across asset classes follows a linear pattern with a few notable exceptions – hedge funds, leveraged buyouts, and venture capital – which all float above the hashed line, effectively promising a bit of “free lunch” in terms of excess return without the associated volatility.
Therefor the playbook for many institutional investors has been to try to take advantage of the more attractive risk/return characteristics advertised by alternative assets (hedge funds, private equity, venture capital) by allocating more heavily to these strategies and less to traditional asset classes like stocks and bonds. For example Yale’s target allocation to U.S. stocks is just 3%.
Allocating to alternative assets adds another factor to consider in the risk/return equation – liquidity – which is the ease with which one can buy or sell assets. Public markets are extremely liquid, one can buy or sell millions of dollars of securities with a mouse click, but for example, selling a real estate holding may take longer, and some alternative assets like venture capital typically take years to bear fruit. One factor contributing to alternative assets promised better returns deemed the “liquidity premium” is merely getting compensated for having your money locked up for longer periods, for example a 9 month CD earns more than a 3 month CD.
Returning to the endowment playbook, institutional investors know that they need to take liquidity into consideration. On the one hand, they want the bigger bang for the buck promised by alternative assets like private equity, but they also realize they need steady access to cash, which means investing in liquid public markets.
Again using the Yale chart as a guide, there are four public asset classes to consider for sources of liquidity, fixed income (we will return to this below), U.S. stocks, developed market stocks, and emerging market stocks. Many institutional investors decided to emphasize international and emerging market stocks figuring that since private equity and venture capital are largely U.S. based industries, they already had exposure to the U.S. Furthermore, since (according to Yale assumptions) developed international markets have the same risk/return expectations as U.S. stocks, they can diversify (lower overall volatility) by going international.
Fixed Income or Hedge Funds
In the Yale chart, notice which is the second least risky/volatile asset class. It’s hedge funds, and then look at how much higher the return expectations are for hedge funds versus bonds. Many investors reasoned that in a low interest rate environment, hedge funds would provide much of the stability of bonds but with better returns.