Introduction
Among elite investors, few can match David Swensen, former head of the Yale Endowment, for Swensen’s innovative approach to investing and asset allocation that revolutionized the way endowments are invested, an approach known as the the “Yale Model”. Over the course of three decades, Swensen has increased Yale’s endowment from USD 1.3 billion to more than USD 42 billion, with an average annual return of more than 12%. Today we will delve into the Yale Model to see what we can learn from them as we manage our own portfolios.
Yale Endowment and its establishment history
The Yale Endowment was established at Yale University (then Yale College) in 1718 with an initial £562 from Elihu Yale and grew to more than USD 40 billion over the next 300 years. The Yale Endowment Fund is the second largest university endowment in the world, after Harvard University.
The endowment was established to support the university’s operations over the long term, so Yale pursues an investment strategy designed to achieve its goals by carefully considering the risks and returns of each asset class, including equities, venture capital investments, and real estate investments, and by shrewdly selecting external asset managers within these asset classes.
The Yale Endowment Fund pioneered alternative investments in hedge funds, private equity, real estate, etc. In 1990, Yale became the first university endowment to define the Absolute Return strategy as a distinct asset class, with an initial target allocation of 15%. Absolute Return is synonymous with hedge funds, which are designed to provide positive returns in both bull and bear markets.
Yale Endowment’s Performance
Under David Swensen’s leadership, the endowment fund’s investment strategy has delivered spectacular returns. Over the 10-year period ending June 30, 2022, Yale’s endowment fund returned 12% per year, far exceeding the 10-year average return of other U.S. university endowments, which is estimated at 3.4% per year. Over a 20-year period, Yale’s endowment fund returned 11.3% per year, far exceeding the 20-year average return of college and university endowments, estimated at 3.5% per year.
Each year, the Yale Endowment allocates its income to the University’s operations. Although Yale has a huge USD 42 billion endowment, it is still not enough to cover all of the school’s operating costs. In fact, it only covers about 33% of the 2021 operating budget, and the school must cover the rest through alumni gifts and tuition.
Legendary Investor David Swensen
David Swensen (January 26, 1954 – May 5, 2021) served as chief investment officer of Yale University from 1985 until his death in May 2021. Under Swensen’s leadership, the Yale University Endowment Fund has grown from USD 1 billion in 1985 to a market value of USD 42 billion today. Other universities, including MIT, Princeton, Stanford and others, have endowment heads who have worked for Swensen. Once criticized for its aggressive investment approach, Swensen’s investment method is now widely known as the “Yale model”. Swensen believes that the best investment opportunities lie not in buying and holding common stocks, but in esoteric hedge fund strategies and risky investments.
The Yale Model
The Yale Model divides a portfolio into five to six components that are invested in different asset classes. The Yale Model focuses on equity investments and diversification, avoiding asset classes with low expected returns, such as bonds and commodities. The rationale for investing in different asset classes stems from Modern Portfolio Theory, a theory developed by Nobel Prize winner Harry Markowitz, which demonstrates that by diversifying across low-correlated assets, investors can effectively increase the risk-adjusted returns of their portfolios.
In contrast to the typical investor who invests only in stocks and bonds, Yale is widely diversified because of their size and the need for stability of investment returns. Imagine the need for more stable returns and passive income when you have to fund school operating expenses every year.
Over the past 25 years, Yale has significantly reduced its reliance on domestic equities by reallocating assets to non-traditional asset classes. in 1990, more than 70 percent of the fund was invested in U.S. equities and bonds. Today, U.S. equities account for less than 10% of Yale’s portfolio, with foreign equities, private equity, absolute return strategies and real estate accounting for the remaining 90%. The endowment fund has a very long investment horizon, generally spanning several years, and is well suited for investing in illiquid and inefficient markets such as Venture Capital, Leverage Buyout, and real estate.
Venture Capital
Through investments in start-ups, Venture Capital investments can deliver options-like compound returns. In 2018, Yale invested in Paradigm, a cryptocurrency hedge fund that invests in early-stage projects focused on cryptocurrencies, new blockchains and exchanges. Currently, Paradigm is one of the largest funds in the cryptocurrency space, with stakes in well-known cryptocurrency finance companies Amber, Coinbase, FTX, and others.
Market-insensitive Assets
Yale’s goal is to allocate at least 30% of its endowment to market-insensitive assets (cash, bonds and absolute return) that help Yale generate stable returns in both bull and bear markets.
In 1990, Yale became the first institutional investor to define “Absolute Return Strategy” as a separate asset class, with an initial target allocation of 15%. The portfolio is divided into two main categories: Event-Driven Investing and Value Investing. Event-Driving Investing is basically arbitrage by analyzing the impact of major events on stocks, such as knowing that two companies have a chance to announce a merger soon and making bets to profit out of it. Value investing is the analysis of individual stocks to find and invest in stocks that are undervalued, or short selling stocks that are overvalued. To date, the Absolute Return portfolio represents 20% of the endowment. Over the past 20 years, the average return has been around 8.1% per year.
What can investors learn from this
Establish goals and take a Long-term approach
One of Swensen’s goals was to grow the endowment to fund the annual expenses of Yale University, and it has been successful in spectacular fashion. Investors need to set goals when investing and analyze their strengths and advantages, whether to choose good stocks and hold them for the long term to achieve financial freedom or to speculate through buying and selling popular stocks for the short term.
Invest in foreign equity
Investors in general have home-bias and prefer to invest in local stocks, ignoring foreign stocks, thus missing out on potential gains.
Diversify
Diversification allows investors to manage risk and reduce the impact of market volatility on their portfolios. The idea behind diversification is that the same market event has a different impact on different asset classes. Therefore, theoretically, when one asset class underperforms, other assets that are performing well will limit the negative impact. This is the principle of diversification, in short, not putting all your eggs in one basket.
References
- The Yale Investment Office: https://investments.yale.edu/
- Paradigm: https://www.paradigm.xyz/portfolio
