Monday, March 25, 2013

Does the Yale Asset Allocation Model Still Work?

David Swensen has been head of Yale's investment activities for a number of years.  It is fair to say, I think, that his approach to asset allocation has dramatically changed the way the most large pension and endowment funds are managed.

Years ago, after a considerable amount of study of historic returns, Swensen came to the conclusion that investors were overpaying for liquidity that in all likelihood they would never need. 

Specifically, Swensen pointed out that the historic returns in areas such as private equity and hedge funds had been considerably higher than those in the publicly traded markets, yet endowments largely shunned these area because they typically were difficult to sell.

So Swensen moved Yale's endowment heavily into alternative asset classes (as high as 85% of the total value), and the initial returns were terrific.

Fellow portfolio manager (and regular RG reader) Rich Sipley passed along an  article on Yale's approach to asset allocation. The piece highlights the spectacular early returns that Yale achieved:

The Yale Model became the focus of much attention on account of its performance during the tech bubble.  From July 2000 through June 2003, while the S&P 500 fell 33 percent, Yale’s endowment actually gained 20 percent.  Yale’s portfolio continued to perform well until 2008 (returns of 19.4 percent in fiscal 2004, 22.3 percent in fiscal 2005, 22.9 percent in fiscal 2006, 28.0 percent in fiscal 2007 and 4.5 percent in fiscal 2008 – through June 30, 2008).

As the article notes, the tremendous success of Swensen's approach inspired a wide variety of endowments to mimic his approach. Indeed, working with Swensen at Yale became almost a rite of passage for any chief investment officer at prestigious institutions like MIT.

More recently, returns from the Swensen approach have not proved to be as strong as in prior periods.  Indeed, the article notes that a simple 60/40 stock/bond allocation has outperformed many endowment funds that followed the Yale model:

A simple 60/40 portfolio invested 60 percent in an S&P 500 index fund and 40 percent in a fund tracking the Barclays Aggregate bond index would have gained 12.6 percent annually over the last three years and 2.8 percent over the last five years, as compared with 10.2 percent and 1.1 percent, respectively, for the average endowment.  Yale did somewhat better than the average endowment with three-year returns averaging 11.83 percent and five-year returns averaging 3.08 percent. 

What's going on here?

The authors suggest that perhaps too many institutions are investing in the same asset classes, which is dragging down overall returns.  In addition, as they parse through the numbers:

The bottom line here is that Yale’s success has been driven largely by private equity – mostly venture capital – returns.  Outside of private equity, the research suggests that Yale appeared to underperform appropriate risk-adjusted benchmarks.

Interesting stuff.