and the Financial Crisis
April 20, 2010
What can we conclude?
While FY 2009 was a painful one for Yale, its 20-year annualized return of 13.4% is remarkable. One bad year is insufficient evidence to discount the conceptual framework developed by Swensen and his team. The Yale model combines portfolio theory with a focus on selecting active managers who will add value. While I cannot judge the active component of Yale’s strategy, I can offer some broad observations.
First and foremost, Yale has consistently stated that the vast majority of its assets are invested in asset classes with risk and return properties consistent with equities, resulting in an overall allocation that is not low-volatility. With only 4% of the target asset allocation in bonds, it cannot be surprising that this portfolio lost almost as much as the S&P500 in FY 2009.
For individual investors and advisors, one take-away is that diversification works to increase risk-adjusted returns over long periods, but it does not provide much protection during severe market dislocations. This conclusion applies to all portfolios, not just Yale’s.
My analysis of the risk exposure in Yale’s portfolio suggests that its true risk is higher than Yale’s estimates, but I do not have the details of the Yale holdings. The risk in my synthetic portfolio could be reduced by carefully selecting low-correlation components and hedging with derivatives, bringing its risk closer to that of Yale’s.
In my analysis, I have not explicitly accounted for the relative impact of illiquidity on portfolio performance. With an additional source of alpha (via adding illiquid assets), we could easily end up with the same expected returns, but lower total portfolio risk, and we could match Yale’s projections even more closely.
Research by Roger Ibbotson suggests that an investment strategy that targets illiquid public securities has historically generated a high level of alpha (greater than 5% per year). Investors and advisors who wish to follow Yale’s approach of trying to increase portfolio returns by taking on liquidity risk may do so using relatively illiquid (but public) securities. Illiquid public securities also tend to have high levels of non-market (i.e., non-systematic) risk. In fact, this research suggests that non-systematic risk is the key driver of surplus return and that the illiquidity is secondary. To build a sub-portfolio with elevated levels of non-systematic risk, one could combine low-beta, low-R-squared stocks. These stocks naturally tend to have higher proportions of non-systematic risk, lower liquidity, and have historically reaped premium returns. We will explore model portfolios that exploit these effects in a future article.
Implications for advisors and investors
The endowment model (as practiced by Yale) makes sense when viewed through the lens of our Monte Carlo simulations. Its FY 2009 returns were within reasonable estimates of probability. The emphasis on alternative asset classes in Yale’s portfolio means that even comparing the returns from the S&P500 to the endowment portfolio is somewhat suspect. Perhaps Yale placed too much faith in the lack of correlation between its portfolio and the movements of the broader capital markets, but the overall logic behind Yale’s model is perfectly sound, even in light of FY 2009.
Swensen remains a staunch advocate of the principles of portfolio management that we have laid out in this discussion. The long-term record of Yale’s endowment, combined with the approach’s consistency with financial theory, validates his position.
The lessons for advisors and individual investors who wish to gain some of the advantages of the endowment model are:
- Bet on the equity risk premium
- Diversify far beyond stock and bond indexes
- Exploit low-liquidity asset classes where appropriate
- Neither (2) nor (3) will necessarily provide protection in a market crisis
These conclusions do not mean that one should invest in private equity, venture capital or hedge funds, however. Swensen makes it clear that Yale’s advantages in these areas stem largely from the ability to uniquely align incentives with managers, a capability that individuals do not have, as well as his expertise and the extensive resources available to him to select and monitor Yale’s managers. Fortunately, there are other ways for us to exploit the benefits available from real assets and from relatively illiquid investments.
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