Solution to Case on Yale Model – Investment Management Class

1. How is Yale’s investment philosophy reflected in its strategic asset allocation? Yale’s investment philosophy is one of the critical factors that played into the success of the fund’s performance in the past years. The philosophy is based on 5 principles: focus on equity, diversification, opportunities in inefficient markets, outside managers and alignment of manager’s incentives with Yale’s interests. In the paragraphs below I will discuss how each of these principles is reflected in the endowment’s asset allocation, as shown from Exhibit 1. Yale’s belief in equities is reflected through the endowment’s heavy allocation in equity from 1985-2010. The weight allocation, however, is heavier in the earlier years (1985-1999) than in later years (1999-2010). In the early years, the allocation equity (both domestic and foreign) has been higher than other class assets. From 2000- onwards, allocation to other asset class such as private equity, real assets, and absolute return starting to rise and dominate the asset portfolio.

By 2010, the weight of real assets (27.5%), private equity (30.3%), and absolute return (21%) individually are higher than the weight of both equities combined (16.9%). This is not exactly in line with their philosophy focusing on equities. Yale’s second philosophy is diversification to reduce risk by limiting exposure to any single class. This is reflected in their asset allocation over the years. In Exhibit 1, Yale has been consistently investing in 6 asset classes: domestic equity, foreign equity, bonds, cash, real assets, private equity, and absolute return. While the weight of these asset class changes over time, Yale maintain their philosophy and still invest in all of these class. They change the weight in a particular class if they feel that market misvalued a particular class and therefore opportunity for further gain. Yale’s third philosophy is seeking opportunities through less efficient markets. As mentioned in the case (p.4), the gap between 25th and 75th percentile is bigger in less liquid assets such as hedge funds (4.9%), venture capital (12.4%), buyout funds (16%), and real estate (24.8%).

This explains why in the recent years Yale invests heavier on private equity, absolute return and real assets. In that respect, the move to less liquid assets is aligned with their philosophy as they see more opportunities in these less efficient markets. Yale’s fourth and fifth philosophy is to hire outside managers and align their incentives with Yale’s interests. Their action has been consistent with this philosophy. For example, they do not invest heavily in emerging markets despite many opportunities from market inefficiencies. They won’t invest in a country until they find a respectable manager that fit their criteria. In summary, overall Yale has been allocating their assets consistent with their philosophy.

2. Provide quantitative evidence to support the claim that “manager selection has accounted for more than half of Yale’s superior performance relative to the average endowment”.

Graph 1: Cumulative Return for Twenty Years Ending June 30, 2012
Source: The Yale Endowment Annual Report (2012)
The graph above indicated that Asset Allocation Value-Add is only 1.1%, compared to Manager Value-Add at 4.1%. Together, this brings Yale Endowment’s performance 5.1% higher than the average endowment (Cambridge Median). The data quantitatively support Yale’s claim that manager’s superior performance accounts to more than half of Yale’s superior performance compared to the average endowment. Graph 2: Yale Moves Towards Risk-Return Efficiency

Source: Source: The Yale Endowment Annual Report (2012)
Yale Investment Office actively changes its asset allocation in order exploit market inefficiencies and to bring the portfolio performance to the efficient frontier (shown in graph 2). As asset allocation has reached the efficient frontier, the role of having superior fund manager is becoming more critical. Manager’s selection is a factor that differentiates Yale from other endowments. 3. What are the factors underlying Yale’s investment philosophy and process which account for its successful investment performance? [In other words, in business jargon, what are the “value drivers” of the so-called “Yale model”?] The combination of five factors in Yale’s investment philosophy plays an important role to Yale’s successful investment performance. However, among the five factors, the most critical and non-replicable factors are Yale’s ability to identify and invest in inefficient markets and to hire superior managers with aligned incentives; all of which came from expertise and years of experience in the industry.

David Swansen’s expertise, in particular, plays a big role. The success of the model is attributed to Yale’s ability to combine both quantitative analysis (mean-variance analysis) with market judgments to structure its portfolio. In addition, Yale also uses statistical analysis to actively test their models with factors affecting the market, therefore understanding the sensitivity of their portfolio in response to various market changes. Yale also follows and forecasts the cash flow of private equity and real assets in its portfolio to decide the need for hedging. And finally, Yale’s long-standing relationship with private equity and venture capitalists gives Yale access to high-return investments that are not accessible to new comers otherwise. 4. Do you believe that Yale’s investment approach can be applied by other endowments and long-term investors? Briefly state your reasons.

Not entirely. Many endowments have tried to copy Yale model, however have not been as successful due to the following reaons: 1)David Swansen’s savvy investment skills to pick stocks, find inefficient markets and select superior managers cannot be replicated by other endowments 2)Yale’s strong relationship with private equity gives Yale access to high-return investments that would be hard to access otherwise. 5. Should the disappointing performance of Yale during the 2008 financial crisis lead us to revise our opinion about the merits or demerits of the Yale model at all? Not necessarily. As Yale is looking for a long-term investment, their performance should be measured over long term horizon. As shown in Exhibit 6, the annualized Yale’s return between 1980-2010 is 14.6%, the highest among all 6 benchmarks in exhibit 6 (ranging from 3.7-13.5%). Yale was able to consistently perform well despite financial turbulence in the past (except for the 2008 recession).