The Investment Scientist

Posts Tagged ‘yale endowment

“They are the cancer of the institutional investment world.” – David Swensen

Would you consider forming a partnership with someone you don’t know, in which you would contribute the money and that someone would conduct a business that you don’t understand, and do the accounting as well?

Most business owners would respond with a resounding “No!” The reason is obvious: such an arrangement is the surest way to lose money.

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University endowments are important institutions. They play a critical role in maintaining the academic excellence of the universities that rely heavily on their income. Recently, these endowments have drawn much attention because of their superior investment returns compared to other institution investors, such as investment banks and insurance companies.

There is much diversity among university endowments. Ivy League endowments such as those of Yale and Harvard are well ahead of the pack in terms of investment returns.

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The financial crisis has sparked a debate about the Yale model, that it doesn’t work as advertised in the current market condition. Here is David Swensen‘s response in an interview with Seth Hettena, Special to ProPublica.

The first thing I’d say is it’s too short a time period over which to judge. If you want to have a fair assessment of any investment strategy, get through the crisis and then look back and see how things performed.

If you look back 10 years from June 30, 2008, Yale’s performance was 16.3 percent per annum. Bonds were 5 percent plus or minus, and stocks were 3 percent plus or minus. So what are you going to do? You’re going to give up that kind of performance to hold a lot of bonds to protect against the financial crisis? Where’s the alternative that performs so much better? 100 percent government bonds? Is that the alternative? Well, then what would have happened if you had held that the decade before? I don’t get it.

They’re not thinking about what happened the 10 years before and they’re not giving us time to get through this crisis and see how it plays out for the Yale model against a more traditional portfolio. That’s one of the really interesting things in these articles that have been critical of the Yale model and sometimes of me personally: Where’s the alternative? What’s the option? Yeah, the model fails. Well, relative to what?

Here is the source.

Once upon a time, the Yale University Endowment invested like the rest of us, in just two asset classes: US equity and fixed income. After taking over the reins in 1987, David Swensen, the chief investment officer of Yale Endowment, moved aggressively into non-traditional and often illiquid asset classes like foreign equity, absolute return, real assets and private equity.

Chart: The Yale Model asset allocation
[enable picture display to see this chart]
Picture credit: thedividendguyblog.com

His unconventional approach produced a 20-year unbroken record of positive returns, resulting in stellar growth of the endowment from $1b to $17b. No wonder rival school Harvard University studies him closely. Other institutional money managers trip over themselves trying to mimic him.

Yale’s six asset classes are defined by their different expected response to economic conditions, such as inflation, growth and interest rate. Here is my own simplified explanation and cautionary note about these asset classes in relation to us as individual investors.

Absolute Return is a class of investment that seeks to generate long-term returns not correlated with the market.It does this by exploiting market inefficiencies. There are two basic strategies: event-driven and value driven. Event driven strategies rely on specific corporate events such as mergers, spin-offs or bankruptcy restructuring. Value driven strategies rely on buying under-valued assets while at the same time short-selling over-value assets. Don’t try this at home! You might just be the inefficiency being exploited.

Private Equity is a class of investment that participates in leverage-buyout (“LBO”) and venture capital. Venture capital is money that funded Google. However, it also funded thousands of failed ventures. LBO partnerships engage in the exercise of buying badly run businesses, reforming them, and then reselling them for a profit. Good private equity funds are generally close to individual investors. However, many below-average funds (often with exorbitant fees) are being aggressively marketed by Merrill Lynch and the like to unsuspecting high-net-worth individuals.

Real Assets include real estate and commodities. They are tangible (as opposed to paper assets) and they’re a good hedge to inflationary forces. This asset class is accessible to individual investors through Exchange Traded Funds (ETFs) and physical property such as the houses they live in.

Fixed Income is an asset class that produces a stable flow of income. It provides greater certainty than other asset classes. Fixed-income investments will perform badly in an inflationary environment, with the exception of treasury inflation protected bonds or TIPS. This asset class is readily accessible to individual investors.

Foreign Equity includes both matured market equity and emerging market equity. With US economy becoming an ever smaller slice of the global pie. This asset class provides a great way to participate in foreign growth. However, their diversification benefit is over-rated. With the exception of China, foreign stock markets highly correlate with the US market. Foreign equity is very accessible to individual investors.

Domestic Equity needs no additional explanation.

By all mean let David Swensen enlighten you, but don’t fall all over yourself trying to mimic him. What is good for Yale is not necessarily good for you. This is an advice coming from none other than Swensen himself.

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David Swensen discusses the current state of the market and derivative trading >>>

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Jack Bogle, father of index funds, likes David Swensen and Warren Buffet >>>

Boston Globe: “Harvard’s endowment plunges $8 billion

WSJ: “Harvard hit by loss as crisis spreads to college

Harvard Crimson: “Yale losses a quarter of its endowment

Edward Eptein in The Huffington Post argues in “How much has Harvard really lost?” that Harvard endowment loss could be a lot higher than disclosed.

Check out how Harvard and Yale endowments performed prior to this fiscal year here. Note their fiscal year ends in June 30th.

In a recent ABC news piece, Dr. David Swensen, manager of $34 billion Yale Endowment had this to say about Jim Cramer:

On ‘Mad Money,’ Cramer promotes a mindless short-term approach to markets by encouraging frenetic trading of individual stocks. Such a high-cost, tax-inefficient strategy almost guarantees failure.

In the same article, my view on Jim Cramer was also mentioned:

Zhuang is no fan of Cramer. Like Swensen and Ehrenberg, he argues against frequent trades and says Cramer may be influencing investors to overreact to financial news.

(For Swensen’s stellar track record, click here.)


Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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