When Yale University’s chief investment officer David Swensen passed away from cancer in May, the investment world lost a giant.
Swensen was appointed Yale’s endowment manager in 1985 at the age of 31.
Thanks to the university’s stellar long-term track record, Swensen went on to become one of the most influential endowment chiefs in the U.S.
Soon after Swensen implemented his approach, endowment managers across the country began imitating it. It came to be known as the Yale Model.
The university recently named 36-year-old Matthew Mendelsohn to succeed Swensen as the new chief investment officer.
Mendelsohn has some big shoes to fill.
Previously, he ran Yale’s venture capital portfolio. It has been the leading light of the endowment, boasting annual returns of 21.6% over the past 10 years.
As a Swensen protégé who has worked at Yale Investments Office since 2007, Mendelsohn is unlikely to change the endowment’s investment philosophy.
Yet, based on the investment returns over the past decade or so, perhaps he should.
The Yale Model
Harvard may have a bigger endowment. But make no mistake, Yale’s is the most admired.
If imitation is the sincerest form of flattery, the Yale Endowment has been flattered like no other.
The endowment funds at Stanford, Princeton, MIT and Penn are each headed by former pupils of Swensen. Each is hoping some of Yale’s magic will rub off on their own funds.
But what is the secret to Yale’s success?
Swensen was the first to apply the modern portfolio theory (MPT) taught in finance textbooks to a multibillion-dollar university endowment.
MPT teaches that if you diversify across asset classes beyond U.S. stocks and bonds, you can generate higher returns at lower risk.
Over the course of 30 years, Swensen invested more and more of the Yale Endowment into alternative investments. These include natural resources, venture capital, private equity, real estate and foreign stocks.
Swensen’s Big Bet Gone Awry
The Yale Model worked remarkably well… until it didn’t.
The endowment made its reputation from its remarkable performance through 2007. In the decade ended that year, the fund returned an astonishing 17.8% per year.
But in the 10 years through June 2020, the returns tumbled to just 10.9% annually.
In comparison, the S&P 500 returned 14% per year over the same period… That’s a whopping 3.1% difference. Compound that difference over time, and Yale lost out on billions of dollars.
Put another way, a simple S&P 500 index fund trounced the Yale Model.
One big bet stands out in Yale’s portfolio: its tiny allocation to U.S. stocks. As it turns out, Yale has been underweight domestic stocks for decades.
The endowment’s allocation to U.S. stocks tumbled from approximately 50% in 1987 to 21.5% in 1997. By 2005, it had dropped to 14.1%. Today, it is 2.25%.
That means a massive 97.5% of Yale’s endowment is invested in assets other than U.S. stocks!
This lowly allocation reflects Swensen’s view that illiquid assets like private equity and venture capital offer better risk-adjusted returns than traditional U.S. stocks.
As the most recent Yale Endowment report put it…
Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets…
Stanford’s and Princeton’s allocations are also below 10%.
Here’s the problem: By focusing on illiquid investments, Yale has chosen to ignore the largest asset class in the world… and has missed out on some of the best and most innovative companies.
Yale has next to no exposure to the wealth created by Apple (Nasdaq: AAPL), Alphabet (Nasdaq: GOOGL), Amazon (Nasdaq: AMZN) and Facebook (Nasdaq: FB).
Yet together these companies have generated trillions of dollars in returns over the past decade.
Is Redemption in the Cards?
Yale’s bet on illiquid investments may still come good.
This month, top universities will report their investment returns for the year ended June 2021.
Barron’s speculates that returns may be stellar. Some large endowments are predicted to report returns of more than 30%, reflecting significant gains in private equity and venture capital.
Last month, the Wilshire Trust Universe Comparison Service reported that the institutional funds it tracks returned a median of 25.3% – the best returns in 35 years.
The profits from Yale’s massive allocation to venture capital and private equity might help it catch up to the returns generated by U.S. stocks.
But even then, Yale faces a high hurdle. After all, the S&P 500 returned 40.8% over the same period.
On the one hand, I admire the Yale Endowment for sticking to its philosophy through thick and thin.
On the other, the hallmark of great investors is the flexibility to correct course if something is not working.
Yale’s reluctance to invest in U.S. stocks has not worked… and has cost the endowment billions of dollars in profits forgone.
Time will tell if the next 10 years offer redemption.