The Yale Model
A pioneering investment strategy that disrupted conventional wisdom, achieved stellar results and inspired imitation across the investment world.
David Swensen served as CIO of the Yale University endowment from 1985 until his passing earlier this year, an unprecedented tenure of more than 35 years. Swensen is best known for pioneering the “Yale Model”, or more generically, the “Endowment Model” – so called because so many US university endowments sought to emulate Yale’s approach and its success. Swensen recognised early on that Yale’s endowment portfolio could be significantly repositioned to take advantage of the university’s very long investment time-horizon and by applying the principles of risk diversification embedded in Modern Portfolio Theory (MPT).
Reducing exposure to liquid assets
According to the Yale Investments Office website, between 1989 and 2000, Swensen reduced the Yale endowment’s exposure to liquid stocks, bonds and cash by approximately 50%, from around 85% of total assets to closer to 40%. Today, those liquid, tradeable securities account for around 25% of Yale’s $31.2bn endowment portfolio (as at 30 June, 2020). The bulk of Yale’s assets – c. 75% – are allocated to Private Equity, Venture Capital, Absolute Return (hedge funds), Real Estate and Natural Resources. Over the past 30 years, under the direction of David Swensen, Yale’s investments have produced an annualised return of 12.4%, inspiring envy and imitation across the investment world, from endowments and foundations, to pensions and family offices.
A US $30bn endowment that began with less than $800
Founded in 1701, Yale University is the one of the oldest universities in the US and one of the top-ranked universities in the world. The school’s endowment was established in 1718 following a £562 donation from Elihu Yale. Barely more than 300 years after Elihu Yale’s original donation, the Yale University endowment is valued at more than US $30bn.
University endowments are long-term investment vehicles the purpose of which is to support the teaching, research and public service missions of the schools. This includes part-funding the annual operating budget from which staff salaries and student grants and bursaries are paid. The endowment may also support the construction of new facilities and other special projects pursued by the school.
Key Takeaways I
The endowment has a long investment horizon and it is designed to be enduring so that it can support the university for generations to come. Does the idea that the endowment’s investment portfolio should both generate income to support current needs as well as preserve capital for the future sound familiar?
It should, because most family offices and even individual investors share the common investment goals of 1) generating returns (income), and 2) preserving capital (avoid losses).
Yale University’s endowment began fully embracing the virtues of private and alternative asset classes following the appointment of Swensen. The asset allocation of the Yale endowment began to shift towards less liquid assets in the late 1980s and 1990s, a trend which continues to this day.
The choice of asset allocation for any investor depends on three critical factors:
- Financial objective(s)
- Time horizon
- Liquidity requirements
The Yale University endowment must both preserve capital and meet its annual budgetary requirement to contribute to the operations of the university. A significant amount of money donated to Yale over the years has been for specific purposes, such as financing an academic position or a student scholarship programme and is intended to be in perpetuity. The award can only be granted if the capital is available to fund it, so preserving capital is vital to the endowment’s long-term success.
Today, the Yale University endowment is budgeted to contribute more than 1/3 of Yale’s total annual operating budget, or US$1.5bn in 2021, a spending rate that grows at 2.6% per year (expected inflation). Therefore, the Yale endowment must generate approximately 5% net income from its portfolio to meet its budget in 2021.
It is precisely because of the endowment’s need to provide significant annual income and provide inflation-beating returns (growth) that the Yale Investments Office has biased the endowment’s asset allocation in favour of equities – public and private – and assets with equity-like returns, and away from fixed income. Investments in real estate and natural resources are also expected to provide some protection from the corrosive effects of inflation.
“The heavy allocation to nontraditional asset classes stems from their return potential and diversifying power. The Endowment’s long time horizon is well suited to exploit illiquid, less efficient markets.”
- The Yale Endowment Investment Report 2020
Yale University has been around for more than 300 years, and it expects to be around for at least 300 more. Given its role in supporting the ongoing operations of the university, the endowment possesses the same unusually long-term perspective. With this long-term view, Yale is willing to allocate approximately 50% of the endowment portfolio to illiquid assets (private equity, venture capital, real estate and natural resources). Yale believes that these asset classes provide equity-like returns plus significant diversification benefits within its overall portfolio, because these asset classes behave differently, one from the other.
Although its need to generate cash annually is relatively high, a number of endowment asset classes provide regular income (coupons from fixed income investments; dividends from public equity; capital distributions from private equity; rent receipts from real estate).
By appreciating that most asset classes (even the less liquid ones) can and do generate reliable income streams, the endowment board has the confidence to allocate a significant percentage of the total portfolio to illiquid assets. Maintaining a modest cash balance helps ensure that all budgeted payments to the university can be made in full and on time.
Key Takeaways II
David Swensen’s crucial insight was that the endowment’s financial objectives and investment time horizon combined to permit a high allocation to assets with equity-like returns, and an opportunity to earn the excess returns associated with less liquid assets like private equity, venture capital, and real estate.
Our insight here at Dot Investing is that individual investors and family offices have similar, if not identical, objectives, investment horizons and liquidity requirements as the Yale University endowment. Where possible, some have adopted a similar allocation to Yale, however barriers remain that make it difficult for many others to follow suit.
Two key obstacles holding investors back from emulating David Swensen’s investment philosophy in their portfolios are knowledge and access to opportunities – addressing both is key to our mission here at Dot.
The Yale University endowment’s significant allocation to non-traditional asset classes like private equity, venture capital and real estate stems from their return potential and diversification benefits. Their addition to Yale’s portfolio has the potential to both increase returns and reduce the volatility of those returns, an outcome that every investor should aspire to achieve.
Below we detail the five (5) non-traditional asset classes that have made a key contribution to the success of the Yale University endowment.
1. Venture Capital
Venture capital (VC) has grown from one of Yale’s smallest allocations in 2010 to being its largest today. One of the earliest and certainly largest allocators to venture capital, Yale has enjoyed significant success allocating to talented VC managers over the past two decades, achieving an annualised return of 11.6%.
Yale’s VC programme is focused on seed and early-stage investments in innovative start-ups and associated follow-on investments. Yale is attracted to the potential for option-like returns from its early-stage investments, with downside limited to its modest early investments but where a runaway success such as Amazon or Facebook can generate many multiples of the original investment.
Key to Yale’s success in venture capital is partnering with outstanding managers in their early years. Having started its VC programme very early on Yale has been able to retain and exploit its long-standing relationships with many of the industry’s leading VC firms.
2. Private Equity - Leveraged Buy-outs
Leveraged buyouts have had a meaningful allocation (>10%) from the Yale endowment since around 1995 and grew to approximately 20% around 2010. Today the target allocation to Leveraged Buyouts stands at 17.5%. With a risk profile similar to domestic (US) equities, Yale’s leveraged buyouts allocation has grown as its allocation to US equities has shrunk.
Yale’s approach to leveraged buyouts is to partner with managers that actively seek to add value to their portfolio companies. This value-add, in addition to leverage employed in the strategy, are the key drivers of outperformance versus US equities. Diversification benefits are derived from being exposed to certain company-specific, idiosyncratic risks as well as to quarterly fair-value accounting of private equity performance. Over the past 20 years Yale’s leveraged buyout allocation has generated an 11.2% annualised return.
3. Real Estate
Real Estate has been a mainstay in Yale’s portfolio for over 30 years, ranging between 10% and 20% of their total portfolio throughout that time. Real estate’s defining characteristics of consistent income generation and capital growth provide an effective hedge against unexpected inflation, which is an important objective for Yale’s endowment. The cyclicality and illiquidity of real estate have naturally limited Yale’s allocation, but pricing inefficiencies and the opportunity to add value to portfolio holdings allows Yale’s skilled managers to generate long-term excess returns. The Yale real estate allocation has generated an annualised return of 8.3% over the past 20 years.
4. Natural Resources
Currently the smallest non-traditional allocation in Yale’s portfolio, Natural Resources today accounts for less than 5% of Yale’s total portfolio. Natural resource investments such as oil and gas, timberland and agriculture are known to protect portfolios against unanticipated inflation, as well as to generate high levels of regular income for the portfolio – mirroring Yale’s investment objectives. Given the highly cyclical nature of natural resources, Yale’s approach seeks to generate excess returns through tactical positioning during the market cycle. For its efforts, Yale has generated an impressive 13.6% per annum performance from its Natural Resources allocation.
5. Absolute Return
The only non-traditional asset class in Yale’s allocation that is liquid, Absolute Return has been a meaningful allocation (>10%) since the early 1990s and has averaged around 20% since 1995. Yale is credited with defining “absolute return” strategies as an asset class in 1990 and kicked off its commitment with a 15% target allocation. Yale pursues only two of the many hedge fund strategies in existence; these are event-driven strategies and relative-value/arbitrage strategies, both of which exploit market inefficiencies. These strategies are characterised by low correlation to traditional asset classes (and therefore meaningful diversification benefit in a broader portfolio) and high long-term real return. Indeed, over the past 20 years Yale has achieved an annualised return of 8.1% from its absolute return portfolio, with low correlation to equities and bonds.
Key Takeaways III
Yale’s allocation to non-traditional asset classes has made a significant contribution to its ability to sustain the demands placed on it to support the University’s annual operating budget, as well as enabling the endowment to maintain its purchasing power in the face of unpredictable inflation. The Yale Investment Office’s own scenario analysis suggests that the risk to its ability to provide the target level of annual income to the University has declined by 50% since 1985, and the risk of inflation impairing the purchasing power of the Endowment’s assets has declined by an incredible 90%. This reduction in estimated risk has been attributed to Yale’s allocation to non-traditional assets growing from 11% in 1985 to 77% in 2019.
Whilst Yale’s shift in asset allocation may seem extreme, it is important to note that it has been implemented incrementally over the past 35 years as the Investment Office has grown in both experience and resourcing. Another key to Yale’s success has been its manager selection, in particular its willingness to back smaller, up-and-coming managers and to grow with them and learn from them. The outperformance of new and small managers is well documented in academic literature and Yale has exploited this phenomenon to great effect over several decades.
Diversifying Your Own Portfolio
Family offices and individual investors can now undertake a similar journey, starting with a small allocation and growing their exposure to non-traditional assets such as venture capital, private equity and real estate as their experience and confidence grows. Fortune favours the brave, as the saying goes, so a willingness to walk a less trodden path by investing in newer managers and smaller funds of alternative assets is your surest way of emulating Yale’s success and building a higher performing and more resilient investment portfolio over the long term.