Saturday, 22 September 2018

What's good for Yale isn't good for you

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James Saft on why the Yale Endowment model may not work for all.

James Saft

James Saft

Reuters Columnist

The Yale Endowment’s heavy emphasis on illiquid and alternative investments like hedge funds and private equity in its endowment is working like a charm.

You, however, are not Yale and neither, likely, is your pension fund, university endowment or personal portfolio.

Understanding why what is good for the goose underperforms for the gander is key to not just Yale’s fantastic performance, but improving your own.

Called the Yale Model, the endowment’s philosophy has been to be long on private equity, real estate, natural resources and hedge funds employing absolute return strategies. As a result Yale has thus been underweight traditional traded securities, be it fixed income or domestic and international equity.

The results have been fantastic, though flight to safety during the great financial crisis led to a serious underperformance due to a lack of fixed income and extremely high correlations in risk markets. In nine of the last 10 years, however, 10-year returns for the Yale Endowment have stood at the top of the league tables of similar funds compiled by Cambridge Associates, according to Yale, which last week released its annual review of the endowment’s performance.

And to compare it to a more traditional pension fund model, had Yale followed a 60/40 equity/bond split since 1988 the value of the fund would stand at just US$9.11bn today, as compared to its current value of US$20.78bn.

So should other long-term investors or even individuals try to turn themselves into mini-Yales? Almost certainly not.

Many other long-term investors have markedly increased their exposure to illiquid and alternative assets in recent years, notably many public sector pension funds which are facing unpleasant choices between reneging on commitments or cutting services and raising taxes. How nice instead to just beat the market.

That probably isn’t going to work, and to understand why, you first have to understand Yale’s relatively unusual investment horizon, which is essentially infinite, and secondly the positional advantage it has thus far maintained.

As a huge institution which intends to be around forever, Yale has the ability not only to suffer what would be disastrous swings in markets, but also to accept the limitations of having about 75% of its assets in alternative investments, most of which can’t be liquidated as market assets can.

Go passive, little man

But it is not as simple as just earning a stream of income from taking liquidity risk, as nice as it would be if that were true.

Yale, in its own opinion, outperforms because it is good at choosing managers, most of whom won’t answer your phone calls, and because it is good at negotiating advantageous terms.

“Yale has never viewed the mean return for alternative assets as particularly compelling,” it said in the review.

“While alpha is not dead, opportunities to access it may not be available to all investors.”

Yale cites figures which show a huge gap between the mean returns of top- and bottom-quartile managers in venture capital, leveraged buyouts, natural resources and real estate. In all four areas the best have outperformed the worst by more than 15 percentage points annually between 2003-12. Interestingly those dispersions are, if anything, lower than they were in the decade before, perhaps indicating that some of the advantages of going into illiquid assets are being arbitraged away by trend followers.

The clear implication is that your chances of beating what are the often pedestrian (and expensive) returns to be had in alternatives are not great. That’s absolutely true if you are an individual, and very likely true of even the largest institutions.

I personally also am quite scared by the movement of public sector pension funds into alternatives, as has been so notable in South Carolina, New Jersey and Rhode Island, among others.

Not only does this trend smack of wishful allocating, it seems ripe with potential for malfeasance. It is all too easy to see scenarios in which politicians, public sector employees or consultants engage in corrupt, or at the least, self-serving practices.

Even putting that aside, the big reason everybody can’t outperform is that this isn’t Lake Wobegon and we, and our investment managers, aren’t all above average.

“The most important distinction in the investment world does not separate individuals and institutions; the most important distinction divides those investors with the ability to make high-quality active management decisions from those without active management expertise,” Yale writes.

“No middle ground exists. Low-cost passive strategies suit the overwhelming number of individual and institutional investors.”

That, as we know, won’t stop many investors from trying, but it bears repeating.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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