Is the Yale Model Broken?

Declining returns and current market conditions have some questioning the infallibility of the endowment model—pioneered and perfected by David Swensen—and looking to reinvent.

Spoiler alert: The Yale model is not broken—at least not at Yale.

The alternatives-driven approach has worked spectacularly well for the $25.4 billion Ivy League university endowment and its longtime CIO David Swensen, becoming the stuff of legend and investment theory. 

In an origin story that is now canon, the endowment helmed by Swensen moved in the mid-80s from a more traditional mix of bonds and a few equities into carefully selected alternative investments—hedge funds, private equity, and venture capital—using external managers to capture the so-called illiquidity premium. This added $7 billion of value and earned a 12.9% return per annum over the past 30 years. From providing 10% of the university’s annual budget in 1985, the endowment now covers 33% of Yale’s costs. Its reach has extended beyond the New Haven campus as Swensen protégés went on to implement the model at universities like Bowdoin, MIT, Princeton and Wesleyan. Swensen himself would go on to literally write the book on institutional investing—publishing Pioneering Portfolio Management in 2000. That, some say, is when the Yale model really went mainstream—and, for better or for worse, became synonymous with the endowment model, inspiring many to attempt to replicate the returns of Swensen, Yale’s senior director Dean Takahashi, and their acolytes. 

“We define the endowment model as a diversified, value-based portfolio with a long-term investment horizon,” says Margaret Chen, head of CA Capital Management, the outsourced-CIO (OCIO) arm of consultant Cambridge Associates. “People would say that is consistent with the Yale model and maybe that is true. Yale has implemented this approach the most successfully and probably the most publicly so it is often called the Yale model.”

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But current market conditions and recent performance numbers for endowments have given traction to concerns first aired during the financial crisis—when Yale’s endowment, along with other major universities like Harvard and Stanford, declined more than 20% in 2009 before bouncing back—and the model was accused of excessive risk taking. Some universities, like Oxford, disavowed it entirely. But endowments, especially Yale, bounced back.

Today, discussions about the endowment model’s ability to deliver in this low-return environment are cropping up in papers, at conferences, and in conversations among investment professionals. Is one of the ultimate innovations in investing as sustainable for the next 40 years as it has been for the past 40? And if it is still worth copycatting—how can endowments and other asset owners make the Yale model work for them?

The Virtue of Patience

“It is absolutely true that as of June 30, 2016, if you invested only in the S&P 500 index or 10-year treasuries over the past five years, you would have done better than the endowment model,” says Chen of CA Capital, which has 74 clients and manages around $18 billion in discretionary assets. “But what I say to that is this: In investing you always want to look forward, not backwards. That is why the disclaimer that ‘past performance is not indicative of future results’ is so important. There will be periods when the endowment model will underperform a straight S&P 500 or 10-year treasury portfolio. It doesn’t happen very often, but it will. If you truly have a longer-term approach, you need to look over a long-term horizon to evaluate performance.”

Long-term views were tested earlier this year, when the results from the 2015 NACUBO-Commonfund study of 812 endowments representing $529 billion in assets reported returns had declined sharply to 2.4% from 15.5% in 2014. The 10-year return was at 6.3%, dipping well below the median 7.5% reportedly needed by endowments to maintain purchasing power. Wilshire Associates reported further slides from endowments in the first half of the 2016 fiscal year, with funds more than $500 million losing a median 0.73%, and posting their worst returns since 2009’s annus horribilis

Art by Victo Ngai

“[The endowment model] has evolved,” says Catherine Keating, CEO and President of Commonfund, an OCIO firm managing $24 billion in assets on behalf of more than 1,000 nonprofits. “It’s not broken. In fact, over the last 40 years, the model has worked. The institutions that have adopted it have really benefited from it, though not necessarily every single year. Looking at the returns over the last year or two, it has been more challenging, but you have to measure it over decades.”

Commonfund expects a 70/30 traditional portfolio to generate about 4% a year over the next few years, when endowments have a target goal of 7.5%. A continued focus on equity bias, diversification, and illiquidity premiums will help close the gap, says Keating. “The real question for investors today is not about the last 40 years, but it’s about the next five, ten, twenty, thirty, and forty. How do you continue to sustain yourself over time in the near term where our return expectations are more muted?”

How do you do that? “Honestly, we think you do it the same way the endowment model has always operated,” Keating says. “It’s just that we execute the model a little differently today.” 

Observers say this means finding new ways to access managers who deliver alpha over time, negotiating better-aligned fee structures—no small feat, especially for smaller endowments with fewer resources—relying on good quantitative analytics to identify true beta factors in the equity markets, and, importantly, practicing the patience necessary to endure market cycles.

As CA Capital’s Chen tells her clients, “Patience is a virtue, but when investing in endowment portfolios, it is essential.”

David Salem, CIO of Windhorse Capital Management, had a front row seat to the metamorphosis of Yale and its absolute return strategy. He was the founding CEO and CIO of TIFF, the Investment Fund for Foundations, of which Swensen was an adviser. In 2000, Salem reviewed Swensen’s book in Barron’s with these words: “…the ‘unconventional’ money-management approach that Swensen extols is anything but a path to profit for institutions lacking such talent. Indeed, numerous fiduciaries are likely to read this book and do precisely the opposite of what Swensen advocates: commit excessive sums to market niches whose strong past performances removed the discomfort associated with truly superior investment opportunities.” 

In a recent interview with CIO, Salem said he “predicted the endowment model would get overused, and disappoint. That’s happened, and it’s why the model’s failings are the topic du jour.”

A Model of One’s Own

“The endowment model gets misrepresented as a static blueprint for portfolio management,” says Scott Pittman of the Mount Sinai Medical Center. As the hospital’s CIO, Pittman oversees a $1.6 billion endowment that he has invested 70% in alternatives. “Using the term ‘model’ is a disservice,” he continues, “as it’s more of an innovative approach to how institutional investors should approach markets and think about opportunities and risks.”

Given today’s asset valuations, Pittman says, “it is even more important to consider the opportunity cost of each investment. An opportunistic mindset is needed as good opportunities are more limited. Where investment conviction is gained, you have to be willing to express and allocate capital more meaningfully.”

The endowment model’s defining characteristics, Pittman argues, are safe and sound: adding value through investment complexity and execution risk, targeting less competitive areas, opportunistically taking advantage of market dislocations, and leveraging institutional resources and a long-term capital base to gain an edge. “It’s an evolving concept and not everyone has evolved with it,” he adds.

“Using the term ‘model’ is a disservice, as it’s more of an innovative approach to how institutional investors should approach markets and think about opportunities and risks.”

“Using the term ‘model’ is a disservice, as it’s more of an innovative approach to how institutional investors should approach markets and think about opportunities and risks.”John Griffith, a vice president at OCIO firm Hirtle Callaghan, and the former treasurer and CFO of Bryn Mawr College, agrees. “Every school needs to have their own model,” he says. “The concept that people need to recognize is that Yale came up with a model that works perfectly for them… it just doesn’t work for everyone.”

Yale’s asset allocation is close to 60% illiquid investments, while the vast majority of colleges and universities are less than 20% illiquid, says Griffith. “You have to separate what Yale does from what anyone else can do. They have a balance sheet that is the strongest there is, their liquidity is great related to debt, and they have access to managers and deals.”

Mistakes are made when investors focus strictly on asset allocation, Griffith argues. Instead, the endowment model should open up a discussion of the institution’s specific risk profile. How strong is the balance sheet, enrollment pipeline, and the liquidity? What is the tuition discount rate? Is the gift flow robust? 

“You have to recognize the limits and advantages of your institution—the asset size, the resources, governance structure, specialized knowledge or skills within the institution,” says Pittman. “Investors should be very pragmatic about where they can add value and not strive to do everything, just because other smart people are doing it.”

Blindly copying something you don’t understand has its pitfalls. “I think people who have failed probably want to blame it on the market,” says Kevin Albert, global head of business development at Pantheon. “Importantly, being early to the game is huge in getting into the top funds in areas like venture capital. That’s a sustainable advantage because there are probably only 10 you want to invest in that are predictably successful.”

In order to succeed, asset allocation should be structured within a framework that allows a committee to understand an institution’s risks and exposures, and the resources in the investment office should be constructed in a way to execute the target goals of the institution. “Investors many times create a rigid team structure unsupportive of collaboration that can prevent a thoughtful, opportunistic mindset in portfolios,” says Pittman.

This is similar to a point that Gretchen Tai and Ken Frier, the former CIOs of Hewlett-Packard (HP), made in a paper earlier this year identifying flaws in the endowment model such as inflexible asset allocation and too much focus on manager selection. They proposed that a more liquid portfolio could best the Yale approach over the next decade. “The need for change is motivated by current market conditions, certain shortcomings in the endowment model, and the sheer difficulty of reproducing in the future what has worked so well for Yale in the past,” they wrote.

The paper was the culmination of Tai’s tenure as CIO during HP’s asset allocation journey, when she examined established models that included the mean-variance optimization method and the endowment model. “We analyzed the Yale model—not just what they did, but whether that approach could work for our organization,” she says. “We were concerned that it’s not going to work for us. Not to say that it’s not going to work for everyone else, but it wasn’t going to work for us, and therefore we needed to find a different solution.”

The market conditions and popularity of the model concerned Tai, as well as a payout ratio that, if it was more than 10%, could quickly spiral out of control. “Once you get to, say, 15%, you just lose velocity and you cannot take off. From the pension plan perspective, we always think of it from a funded status, but it is important to keep that in mind even if you don’t have a total pension liability kind of mindset.”

Every fund—pension or endowment—has spending requirements that need to be met, and Tai says it’s important to figure out the absolute minimum level of assets that needs to be maintained at all times, and structure the portfolio so that it never dips below that level. “If that’s the case and you’re getting close, you need to either cut spending more aggressively or you have to take a lot less risk in order not to breach that level,” she explains. “Our analysis found we could not take as much illiquid allocation as commonly alluded to in the Yale model. I think the difference between Yale and everybody else is sources of cash. Yale and some of the Ivy schools can actually write a letter to their alumni base and do a pretty successful fundraising campaign. That kind of cash inflow is not the luxury that most of us have at a smaller endowment, foundation, or pension plan. It won’t be a fun conversation to go to the CFO and ask for capital contribution after a downturn.”

Lastly, Tai says, from an organizational competitiveness perspective, the illiquid type of asset classes are very labor intensive and would require building a larger investment team, which could be an issue with plan sponsors that are sensitive to cost. “We had a limited amount of resources,” she says, “so we had to be efficient with our limited headcounts.”

What ended up working for HP was a dynamic model that emphasized better beta management, allowing for flexible, and sometimes significant, asset allocation changes when either the market condition or risk appetite necessitated it. 

“Investors should be very pragmatic about where they can add value and not strive to do everything, just because other smart people are doing it.”Other models for long-term investment have cropped up, too: the Norwegian model, with its focus on investing in traditional public markets; the Canadian model, which uses in-house resources to invest directly in real assets; and, at the University of California, a collaborative model for investing in innovation and energy by leveraging and developing social capital.

Still others are taking the endowment model and looking at ways to evolve it further. “[Yale’s] innovation was to look at taking advantage of abundant alpha and an illiquidity premium that might have existed over that time frame,” says Mark Baumgartner, CIO of the Institute for Advanced Study (IAS). “I think you can question whether or not that strategy is going to perform as well as it has going forward given that finding alpha has become very competitive, and given the convergence of pricing between public and private markets.”

 “One concern is that many risk premia are currently compressed,” he adds, “so looking forward, the traditional equity-beta heavy endowment model may not yield what it has before.”

 IAS, an $800 million endowment, has what some would consider an unconventional portfolio in a time when many institutional investors continue to follow the California Public Employees’ Retirement System’s lead in dropping hedge funds and their 2-and-20 fees. IAS is 100% in alternatives, a large portion of which are hedge funds. “I think we’ve taken a page out of what some would call David Swensen’s playbook, which is to think unconventionally,” he says. “There are a lot of skeptics out there because of how hedge funds have performed, but we think that it’s not about what has happened, but what will happen. David Swensen’s approach was very unconventional in the ’80s and ’90s, and my guess is that Yale continues to evolve their model.”

 This doesn’t mean IAS will forever eschew traditional managers or strategies, but for now Baumgartner says this strategy fits IAS’s current, unique objectives. “That’s part of the endowment model: skating toward where the puck will be.”

The Crucible

It should be of little surprise that when nearly a dozen investment professionals are asked about the state of endowment investing, there will be nearly a dozen different answers and approaches. And it should be of no surprise that those answers are thoughtful and forward-looking.

“It’s tough,” says Mount Sinai’s Pittman. “It’s sobering when you interact with very successful legends in the industry with long careers and they look at the markets and say, ‘This is the toughest environment we’ve seen to invest.’ It gives perspective and reason to take caution.”

The cultural aspect of the investment process becomes as important as structure no matter the model being embraced. “Every team member is part of the process for each investment we make.  Everyone is expected to contribute and challenge ideas,” says Pittman. “We do our best to challenge our personal biases along the way. The coordination, communication, and the debate across the portfolio becomes even more important in the current environment.”

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