Wednesday, March 31, 2010
This was an interesting story that just came across Twitter about the Yale Endowment.
First, some background.
David Swensen - the head of Yale's endowment investment group - has been one of the most influential voices in university endowment investing strategies for years. The chief investment officers for MIT and Harvard, for example, both worked for a time with Swensen, and his beliefs influenced them greatly. Swensen has also written a couple of books targeted to individual investors.
Swensen's ideas about the appropriate investing strategy for endowments are numerous. One of the most important, however, involves the role that private investing (as opposed to investing in publicly-traded stocks and bonds) should play in large endowment investment strategy (BTW: I have read both of his books).
Historically, Swensen found, investors who focused on less-liquid sectors achieved significantly higher returns with lower risk than endowments that used the more traditional capital market investments. It seems logical to Swensen, therefore, that large endowments like Yale - which typically tap only a small portion of their endowment annually for operating expenses - should focus most of their investments into more lucrative areas like private investments.
Under Swensen's guidance, then, Yale moved aggressively into private investments such as timberland, private equity, and hedge funds. If my memory serves me correctly, at one time nearly 80% of Yale's endowment was in private investments.
Up until 2008, the reported returns of the Yale endowment were terrific. Swensen seemed to have found the "holy grail", and he was profiled numerous times as the man who had figured out a way that universities could earn out-sized returns without significant risk.
Then the credit markets froze, stock markets collapsed, and a number of hedge funds and private investors were nearly wiped out. Instead of reporting good returns, Yale and other endowments were forced to face up to huge losses. The illiquidity that did not seem to matter when markets ere good suddenly became a liability, especially as college presidents needed funds for on-going capital improvements.
This vicious cycle has continued into 2010, even though the bond and stock markets have greatly improved over the past year. Most of the strategies for private equity, for example, involved investing in small companies, nuturing them for several years, then taking the companies public, reaping great rewards for their investors.
However, the IPO market remains sluggish, and investor appetite for risk remains muted.
Which leads to today's story. According to the note, Yale is increasing its allocated exposure to private equity from 21% to 26%, which on the surface seems to be making a bullish statement. However, as the article notes, Yale really doesn't have much choice, since they were already committed to these "capital calls" due to investments made in prior years.
All of this is not to say that Swensen will not eventually be proven right, especially if the capital markets continue to regain their health. However, it does indicate that even the smartest investors can do too much of a good thing.