What Makes the Yale Model of Investing So Successful?
Art by Klaas Verplancke
For more than a decade, Yale University’s model of asset allocation has been the gold standard in endowment investing. It was pioneered by David Swensen, Yale’s chief investment officer who passed away last year, and Dean Takahashi, former Senior Director of the Yale Investments Office. The model has spawned countless articles and discussions about the role alternatives and liquidity should play in a healthy portfolio.
But just how much of the university’s investment success comes from its asset allocation? And are there other, lesser-known strategies out there that endowments should be looking to replicate?
It’s All About the Long Term
“The model’s success is largely due to the fact that it’s been very successful maintaining a long-term mindset,” said Larry Kochard, a former endowment chief investment officer at both Georgetown University and the University of Virginia. He now works as the CIO at Makena Capital Management, which focuses heavily on alternative investments.
According to Yale’s most recent published endowment report, from 2020, the focus on alternative assets remains critical to the endowment’s investment strategy.
“Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management,” the report says. “The endowment’s long time horizon is well suited to exploit illiquid, less efficient markets.”
In addition, alternative investment contracts, such as buyouts and venture capital, often require investors to be locked in for between three to 10 years, according to Kochard. This forces investors to tune out short-term market events, such as dramatic upswings and downswings brought on by, say, a pandemic.
“In particular, Yale, Princeton, MIT [the Massachusetts Institute of Technology], and many other endowments are really good at tuning out market corrections,” Kochard said. “People get overly fixated about things like the Federal Reserve or Russia invading Ukraine, but what has set a lot of these endowments funds apart is their ability to think long term and be willing to take on liquidity risk.”
What the Critics Say
There are some cynics, however, who believe the primary reason for Yale’s success comes down to its prestige, and that it would be near impossible for institutions with fewer resources to replicate the same kind of success.
“While there might be more lower-status universities with smaller endowments that are also investing in private equity, they don’t have the same ties to the top private equity investors,” said Charlie Eaton, an assistant professor of sociology at the University of California Merced. “If you have an Ivy League alumni network and social ties, you’re going to have access to a lot more valuable private information to build your hedge fund or private equity fund.”
Eaton is currently working on a book set to be published in February that uses data on university board members and information from the National Association of College and University Business Officers (NACUBO) endowment study to show the relationship between board member connections and investing success.
So far, Eaton’s research, with the help of co-author Albina Gibadullina, has already showed that billionaires with ties to private equity and hedge funds were three times more likely to join a school board of a Forbes-ranked top 30 university than other universities. Fifteen out of the 23 current members of Yale’s investment staff attended Yale as undergraduates.
Kochard acknowledged that having access to the best managers is critical to an endowment’s success.
“It’s all premised on having access to the best funds,” he said. “Being able to evaluate a fund and determine, between 10 funds, which are the two that are exceptional is key.”
Nevertheless, while there is ample evidence of the advantages top universities have over less prestigious university endowment funds, there have still been newcomers in the endowment space over the past year that have thrived.
Washington University in Saint Louis—The Co-Investing Strategy
Washington University in Saint Louis returned an astonishing 65% on its endowment investments this year.
“Washington University has been pushing the envelope a little more in terms of what it does with co-investing and direct investing,” Kochard said.
Co-investing is when a manager has maxed out its investments in a portfolio of a company, so instead the institutional investor will be given the opportunity to invest directly as a minority shareholder in that same company. Co-investments allow investors to participate in highly lucrative investments without paying the traditionally high fees that come with private equity.
Kochard believes that the Washington University investment staff’s experimentation with co-investing will continue to be fruitful in years to come.
“I think they’ve carved out a niche. They have a good team. They have a great CIO,” he said. “Their returns could vary from year to year, but I like what they’re doing.”
Kochard also thinks Washington University’s generalist model of investing has had strategic benefits.
“As opposed to having people that just do buyout and people that just do venture capital and just do hedge funds or just public equity, they have people on their team that are involved across the portfolio,” he said. “It allows for the competition of capital across different groups to be more effective.”
The Future of Yale
While Yale didn’t lead the Ivies this year, the endowment still reported an impressive 40.2% return for the fiscal year from June 30, 2020, to June 30, 2021.
“The challenges when you get to be that size are much bigger,” said Kochard. “It becomes increasingly difficult to be able to scale certain investments to size certain investments. But given the size that they have, I think their returns are quite extraordinary.”
This will be the first full year that the endowment team will be without its 35-year CIO, Swensen, the famous pioneer of the Yale strategy. Instead, the fund will be under the leadership of new Chief Investment Officer Matthew Mendelsohn. Mendelsohn, another graduate of Yale College, has been working at the endowment for 14 years.
Senior Director of the Yale Investments Office, Dean Takahashi, also recently stepped down in 2019 to work on climate change issues. Swensen and Takahashi worked together at Yale for over 30 years, and their collaboration together lead to not only the creation of the Yale model of investing, but also to the recruitment and mentoring of many other future institutional investors.
Kochard said Yale’s pattern of promoting from within and rewarding its management talent for loyalty will continue to pay off.
“It’s easier to think long term when you have greater continuity of team,” he said. “And so the fact that they promoted from within for their next CIO is really a testament to the fact that they’re rewarding people for staying at Yale.”
The Future of Alternatives in Endowment Investing
Alternative investments will continue to play a large role in successful university endowment investing structures. Prestigious universities consistently allocate larger proportions of their portfolios to alternative investments than the average university. In 2020, Yale allocated 17.5% of its portfolio to leveraged buyouts, a number more than double the average educational institution’s allocation of 8.4%.
Venture capital also made up 23.5% of Yale’s portfolio in 2020, more than triple the average allocation of 7.7%, according to the university’s own investment report.
Smaller endowments were significantly less likely to follow the heavy focus on alternatives prescribed by the Yale model, according to the NACUBO 2020 endowment report.
“For example, while the allocation to investment-grade fixed income for institutions with more than $1 billion in assets was 5.3%, it was 22% for those with $25 million to $50 million in assets and 27% for those with less than $25 million,” said the report.
Yet, an endowment will need more than just proper asset allocation to thrive. In order to succeed in the alternatives space, an endowment needs excellent manager selection, a motivated and loyal investment team, and a robust alumni network to help it along the way.
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