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What You Can Apply From Yale’s Strategy

In my last entry, I went over the target asset allocation of Yale’s endowment and the limitations involved in trying to emulate such a strategy. Despite the limitations, there are some things that the average investor can employ:

• The first is including some real asset exposure in the portfolio. It’s not that hard to do for the average investor as there are mutual funds that have the objective of owning real estate investment trusts (REIT’s) or other real estate based stocks. You can also directly buy real estate, but I don’t think many people have the capacity or time to be able to manage things like a true business to be efficient at it. In addition, there are several mutual funds that specialize in broad based commodity exposure. The nice thing about these asset classes is that they don’t correlate with stocks or bonds over time; lowering volatility and potentially enhancing returns at the same time. Just keep in mind that like any asset class, certain real assets can go through extended periods of under-performance.

• The second thing to point out is that there are several registered mutual funds available to the general public that employ hedge strategies; this may serve as a nice diversifier that has that extra layer of safeguards, transparency and liquidity that a private hedge fund can’t give you. Of course this means less risk and with that, less reward as well. Recently Morningstar came out with a long-short fund category to recognize these types of mutual funds.

• Many private equity firms are going public. Some provide financing, some take equity stakes and some are firms that buy out publicly traded companies. Recently an ETF came out that represents an index of these publicly traded firms. Similar to mutual funds that have hedge strategies, these options might provide an added layer of transparency, safeguards and liquidity as well, although again you lose some risk/reward with this in a public format. I would just be wary of these companies as it seems like this is the “next big thing” and although I don’t believe in out-performance via timing, it generally suggests that this area may be over-hyped and over-valued at this time. Even the ETF is employing an index that can’t truly be backdated to determine historical risk/reward characteristics since this is so new.

• And finally, Yale’s portfolio highlights how little one is compensated for investing in cash and fixed income. Certainly you would want to keep your short-term cash flow needs in conservative asset classes. But when it comes to the long-term, you really should be employing this in growth strategies because you are cruelly punished for avoiding risk altogether. In a fixed income portfolio, once taxes and inflation are involved, you’re lucky if you are able to make any real rate of return at all; in many cases you may actually be losing purchasing power. And that can be a killer to a person who is facing a retirement that can last more than 30 years. For those who are risk averse, I highly suggest educating yourself and understanding the risk/reward nature of equities, understanding the risk of inflation and trying to incorporate some equity exposure in your investment strategy. Although it may seem counterintuitive, limiting yourself to cash equivalents and bonds may actually be placing your financial security in greater peril.

And on a final note, the best way to employ any investment strategy is from an overall asset allocation perspective with the focus on total return rather than being myopic on its individual components. You may have some investments that are currently doing well and others that aren’t doing as well, but in the end you won’t get punished for putting all your eggs in one basket; and isn’t that what diversification is all about? And in today’s investing environment, there are a lot more options to explore.

How Yale Invests

Yale’s endowment is well known for its excellent results with an uncommon approach. David Swenson has managed the fund since 1985; earning an annual compound growth rate of 16.3% over that time span.

Where does Yale invest? The following is the endowments current asset allocation target:

0% Cash
4% Fixed Income
25% Absolute Return
12% Domestic Equity
15% Foreign Equity
17% Private Equity
27% Real Assets

What initially strikes me is how little the endowment focuses on equities as only 44% of the portfolio is dedicated to stocks. Normally having this little in equities would tend to suggest a conservative portfolio with a short-term horizon. But this isn’t the atypical portfolio either. What the portfolio lacks in risk from its overall exposure in equities is what it does within the equity structure. Nearly 40% of the equity segment of the portfolio is dedicated towards private equity, otherwise known as venture capital. More than half of its foreign equity stake is in emerging markets, making up 17.5% of the endowments equity position. And its overall foreign exposure is at least 34%, which is an allocation that is reasonable in my perspective, but I think many people invest too little in foreign equities.

The second thing to note is how much is allocated towards alternative assets. Real assets constitute such things as direct ownership in real estate and commodities, representing 27% of the allocation. Absolute return strategies are private hedge funds, representing a quarter of the portfolio. Combined, these alternative assets make up 52% of the overall allocation.

Finally, look at how little exposure is given to fixed income and cash. At 4% in bonds and nothing at all in cash, Swenson is making a strong case that these asset classes provide little reward for the inherit level of risk although I would think the risk is certainly from an opportunity cost perspective.

Should you invest like Yale? It probably would be inadvisable or impossible to truly do what Yale does from the position of an individual investor. To start, you aren’t Yale. Yale has a time horizon that is much longer than your life expectancy, most people don’t have the risk profile to stomach this strategy and your overall goals/circumstances are different to Yale’s. In addition, venture capital and private hedge funds aren’t areas where the Average Joe can directly invest in and lack disclosure and safeguards where most people don’t have the aptitude to assess the risk accurately. Also private equity, real assets and hedge funds aren’t liquid enough to be suitable for a lot of individuals.

But I do think there are a few things that the individual investor can take from this from an asset allocation perspective. I will discuss this in my next entry.