The Curse of the Yale Model
What has been a blessing for Yale has been a curse for most other investors. In a true “me too” fashion, thousands of institutional investment funds have switched to the “Yale Model” seeking the outsized returns that the Yale endowment has enjoyed for two decades. However, after spending billions on consultants and hedge funds, most institutions have less to show than if they had bought a portfolio of low-cost index funds.
The Yale Model is an investment strategy named after the university endowment that popularized the concept. The strategy produced superior returns over the past 15 years and made the Yale endowment the envy of all institutional investors. It was developed and made famous by David Swensen, Yale’s Chief Investment Officer, and Dean Takahashi, Senior Director of Investments. They suggest that large investors, such as endowments and public pension funds, can achieve superior returns by shifting a significant portion of investments away from traditional stocks and bonds and into carefully selected hedge funds, private equity, real estate, and other alternatives.
Swensen published details of this strategy in his 2000 book, entitled Pioneering Portfolio Management. It was an instant best-seller among professional investors who hoped to copy the plan and participate in the party.
Hundreds of college endowments have adopted some form of the Yale model over the past 10 years, and in doing so have spent billions of dollars on consulting fees, hedge funds, incentives and other profit sharing arrangements.
Table 1 shows how the allocation of the 823 endowments is diversified across five asset classes: short-term securities (including cash), fixed income (bonds), domestic equity, international equity, and alternative investments (hedge funds). Alternative investments dominate the portfolios. Most of these are hedge funds invested in equity-type investments, real estate and fixed income.
Table 1: Endowment Asset Allocation Ending June 30 Each Year
All the spending was a waste. The returns did not develop for most of these other schools. Reading about the Yale model does not make Yale-like returns, just as reading about Tiger Woods does not turn a mediocre golfer into a professional.
The model has failed most institutions because their investment committees are far less capable than the Yale board members. The people making the investment decisions don’t have the experience or skills that Yale has compiled. In fact, many people on these boards could be considered investment novices.
While the people making decisions for college endowments are smart, articulate, possess multiple college degrees, and may be successful in business or in the classroom, they don’t have investment skills. A majority of endowments would have performed better over the years − and saved billions of dollars in fees − if they didn’t try to pick winners and losers among hedge funds but had bought a simple index fund portfolio that achieved market returns instead.
Table 2 highlights the performance of 823 university endowments ending in June 2011. Also included is the performance of the Vanguard Balanced Index Fund (VBIAX), a fund that holds roughly 60 percent in equity indexes and 40 percent in bond indexes, and the Core-4 portfolio consisting of 70 percent in stocks and 30 percent in bonds, rebalanced annually. The 70/30 Core-4 portfolio in Table 2 is closer to the actual asset allocations that most endowments held over the time period.
Table 2: Endowments Compared to Vanguard Funds
Sources: NACUBO-Commonfund Study of Endowments® The Vanguard Group.
*The Core-4 portfolio consisting of four investor class funds; Vanguard Total Bond Market Index (30%), Vanguard Total Stock Market Index fund (42%), Vanguard Total International Stock Index (21%) and Vanguard REIT Index fund (7%).
Either of the Vanguard alternatives in Table 2 would have delivered higher returns over the past 1, 3 and 5 years, saved billions in wasted fees, and eliminated the need to hire thousands of consultants and analysts who added nothing to performance. Any investor could have bought either of these two Vanguard options and achieved higher returns than the average endowment over the years.
The students at most colleges would be better off if Swensen’s book was banned on campus rather than embraced by the endowment. It’s as if the investment committees at most colleges are nonchalantly walking through the steps in Swensen’s book, believing they are as skilled at picking investments as their Yale contemporaries, when the results obviously show they are not.
State pension fund trustees are just as bad as university endowments when implementing the Yale model. Pension returns also fall short of a simple index fund portfolio. The way around this sticky issue is for the trustees to change the benchmarks frequently. This makes the performance look better than it actually is.
Sydney Freedberg, former staff writer for the St. Petersburg Press and winner of four Pulitzer prizes for investigative journalism, conducted a lengthy investigation into the Florida Retirement System’s investment performance. Here is what Freeberg wrote about the way that state hides mediocre performance:
“The trustees also have accepted one of the pension industry's most dubious practices. The SBA and other funds choose their own benchmarks for determining success, and then frequently change them. Officials claim it's to ensure a fair comparison of individual asset classes, but it can be a surefire strategy for always appearing above average in performance. In the past 26 years, the SBA has changed its benchmarks 26 times.”
The trustees of state pension funds are paid hundreds of thousands of dollars in salary and bonuses to outperform the markets and they didn’t do it. The plan fell short of a simple portfolio of index funds that any individual investor could have bought. The trustees routinely change their benchmarks and set the hurdle low in order to obscure mediocre performance.
These cover-up schemes appear to suit the politicians in power. No elected Governor or Treasury wants to create a scandal around the mismanagement of state pension funds (even if they could figure it out), let alone fire dozens of surplus employees who helped pick and monitor these lousy investments. It’s easier to go along to get along.
The Yale model is a curse for institutional funds of all types which ultimately hurts the beneficiaries. It’s the students, taxpayers, and society at large that are hurt because there is less money. The highly paid professional trustees, unneeded workers, overly compensated consultants and hedge fund managers are the only ones who benefit.
Only a select few trustees are talented enough pick winning teams who can then pick winning alternative investments. The other Yale-wannabe trustees would act more like fiduciaries if they admitted mediocrity, cut back unneeded staff, got rid of the consultants and hedge funds, and invested in a low-cost index portfolio that achieved market returns. Swensen agrees with this premise in the second edition of Pioneering Portfolio Management:
“No middle ground exists. Low-cost passive strategies, as outlined in Unconventional Success, suit an overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions.”
Is the world of institutional investing likely to change because the Yale model doesn’t work for most? No, because no one is supposed to know it’s not working. Like the residents of Lake Wobegon, the trustees that oversee trillions in endowments and public pension money believe they are above average. They will do what it takes to seem smart: frequently change asset allocation, change managers, and change benchmarks. The more confusing it is, the less likely anyone will notice they don’t have skill.
It’s sad to say, the curse of the Yale model is here to stay.