What can investors learn from the Yale-Endowment fund?

With a remarkable yearly return of 17.5% over 20 years, the Yale endowment fund and its Chief Investment Office David Swenson have attained a quasi-mythical status in the world of institutional management. Mr Swenson never chased a trend or followed the crowd. His endowment fund has been a pioneer in many asset class decades before they became widespread. They didn’t start investing in commodities in the past two years, and their first private equity commitment dates from the 1970s’.

By analysing the Endowment annual report, and after having read Mr Swenson’s publications on asset management, we ask ourselves the question: what can investors learn from his outstanding track record?

Mr Swenson describes his image of mainstream investors in a very direct way: “Investors generally fail to follow the most basic investment precepts. Instead of concentrating on the central issue of creating sensible long-term asset-allocation targets, investors too frequently focus on the unproductive diversions of security selection and market timing (…). Instead of constructing equity-oriented, well diversified (…) portfolios, investors too frequently choose to mimic the conventional, poorly structured consensus. (…) Disappointing results represent the nearly inevitable consequence of ignoring fundamental investment principles.”

Of course, the resources at disposal and the time horizon of Yale can’t be fully replicated by most investors. For example, direct investments in timber, access to top-tier venture capital partnerships or allocating mandates to specialist boutiques is beyond the reach of most wealthy private individuals (save for the few who have a quasi-institutional status) and many institutions.

His asset allocation is probably also inadequate for most investors (only 5% in bonds, 20% in equity and 20% in private equity), although it has evolved considerably over the years.
 
However, many characteristics of Mr Swenson’s philosophy are very rational, elegant and surprisingly easy to implement. Below, we will only review four interesting aspects from his publications:

Independence
An organisation that is free of any conflict of interest stands a better chance of performing and managing assets than one that is under constant pressure to sell products. For this reason, Mr Swenson prefers to work with institutions that have their interests fully aligned with his own objectives. Therefore, smaller investment managers who are not solely focused on ROA and assets gathering have a higher probability to outperform.

Alignment of interests can be negotiated in the form of a performance fee and in making sure that your portfolio manager doesn’t accept commissions from third-party providers. Such a set-up eliminates unnecessary transactions and/or products in your portfolio.

Diversification
In a passage of his book, Mr Swenson describes an average portfolio allocation that a famous investment house recommended shortly before the correction of 2000. Hi conclusion: with all the best analysts and advice, they completely failed in building a diversified portfolio, as most positions behave in a similar way when markets fell.
Diversification is not necessarily about being invested in different geographic markets or sectors, but more about making sure that these markets don’t behave in a similar way when an event of unpredictable magnitude happens.

In today’s environment, investors who believe to be diversified by having a portfolio investing in emerging markets, commodity and “themes” funds (such as luxury, water or infrastructure) may end up being having one large exposure in emerging markets with a different label on it.

Instruments
Most of the resources at work for manager selection at Yale are in asset classes with large returns dispersions, such as private equity or hedge funds. For traditional asset classes (equity and bonds) they favour either low-cost passive funds or mandates to specialist boutiques.

Most private investors are invested in mutual funds with high fees and poor performance. Index trackers offer a low-cost liquid alternative that will never under-perform. But again, independence is a requisite condition if you want your money manager to favour index trackers.

Re-Balancing
Re-balancing is the process of regularly returning the portfolio back to the original asset allocation target. As most investors fail in their attempt to time the market, consequent rebalancing adds a consistent market-timing element. Regular re-balancing improve the odds of making contra-intuitive decisions, such as selling equity after they have risen and buying them after they have fallen..

In conclusion, we see that many of Mr Swenson’s investment guidelines fail to provoke any emotional excitement, as they are surprisingly basic, easy to understand and extremely rational. However, they require the willingness and discipline of investors to put these principles at work in a consistent and systematic way.

Link to Yale University-Endowment's 2006 report