Time to Ditch the Yale Endowment Model

(Originally published here.)

Institutional investors are different from you and me — they have a lot more money. Pension plans in rich countries manage almost $30 trillion in assets, for example. This opens doors at the offices of hedge funds, private-equity firms and other expensive money managers and creates opportunities to directly invest in projects inaccessible to regular people, such as dams, natural-gas fields and real-estate developments. But while a select few institutions can generate higher returns — for less risk — than we lowly mortals can achieve with low-cost index funds, the average fund should avoid trying to get too creative.

The modern style of institutional investing can be traced to Yale University’s David Swensen, who literally wrote the book on the subject. (Full disclosure, I’m a Yale graduate.) Three core ideas inform his thinking.

1. Savers are paid to take risk. If you want to generate big returns you have to be willing to endure large losses at any point.

2. Universities and other institutional investors have long time horizons because they expect to exist forever. This makes them different from regular people who save for retirement.

3. Contrary to standard academic theory, which suggests that savers should invest in broad indexes and avoid fees, market imperfections create opportunities for talented money managers. They can improve a portfolio’s performance through a combination of high returns and diversification benefits.

These ideas have been embraced in part because Swensen has generated an average annual return of 13.7 percent for the Yale endowment over the past 20 years. Someone who bought the S&P 500 stock index and reinvested all dividends over the same period would have earned just 8.8 percent.

One implication of Swensen’s ideas is that institutional investors should concentrate their portfolios in assets that aren’t traded on public markets. As of June 2012, about two-thirds of Yale’s endowment was invested in gas fields, timber forests, real estate and private equity. These illiquid assets are difficult to sell on short notice without offering steep discounts. Investors are supposed to get compensated for taking this risk with higher returns. That’s attractive to institutions because, in theory, they don’t need to worry about accessing their money at short notice.

In practice, institutional time horizons are often shorter than one might expect. Endowment disbursements are the single biggest source of revenue at rich schools like Yale, Harvard and Stanford, which were among the first to adopt this strategy. Pension plans exist to pay income to beneficiaries on a regular schedule. These obligations should be offset by liquid assets that provide stable cash flows. Instead, many institutional investors pretend that they can endure large swings in the value of their illiquid holdings.

This self-deception works well as long as asset values keep rising. It’s easy enough to persuade bankers to accept a timber forest in Eastern Europe as collateral for a loan when they are confident that they can always sell it to someone else at a higher price. This allows institutions to transform illiquid assets into cash without having to go to the trouble of trying to sell them to someone.

When their portfolios are losing value, however, institutions are stuck with their existing fixed liabilities and no easy means of paying for them. They can’t expect to borrow much money against their depreciating illiquid assets, except at a punitive interest rate. And they can’t hope to sell their holdings quickly without enduring steep losses. After all, these gas fields and forests are rarely traded and are therefore hard to value. Prospective buyers need to time to conduct due diligence and would probably be extra cautious to avoid overpaying for junk in a down market.

The potential for a mismatch between assets and liabilities is one big problem with the Yale model. Another is the focus on hunting for the best hedge funds, private-equity managers and stock pickers. This is where most of the money is made (and lost) in the endowment business. According to the Yale endowment’s most recent report, “nearly 80 percent of Yale’s outperformance relative to the average Cambridge Associates endowment was attributable to the value added by Yale’s active managers, while only 20 percent was the result of Yale’s asset allocation.” That’s great for Yale, but it’s impossible for every institution to have the best managers.

By definition, many institutions end up hiring managers who are below average. Consequently, many of them would be better off investing in index funds rather than finding themselves on the wrong side of the wide gulf that separates the performance of the best and worst managers.

Source: Yale University Investments Office

Source: Yale University Investments Office

Making matters worse is that the widespread adoption of the “Yale Model” has crowded capital into venture capital and private equity. A useful survey of the industry by Steven Kaplan of the University of Chicago and Per Stromberg of the Stockholm School of Economics found that “an influx of capital into private equity is associated with lower subsequent returns.” As more money becomes available to buy the same set of companies, those companies become more expensive and therefore less likely to generate big profits for investors.

A few institutions have done very well buying exotic assets, paying high fees for the world’s best money-managers and using the proceeds to fund a significant chunk of their operating expenses. (Even the Yale endowment, however, has underperformed the S&P 500 over the past five years.) Most, however, will never be able to accomplish this. Instead, they will buy overpriced boondoggles and pay high fees to have their money managed by mediocre traders. These institutions would be better off putting their assets into index funds that charge low fees and track liquid markets.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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