David Swensen grew his fame, and Yale’s fortune, by redefining how university endowments are managed. The investment guru pioneered a revolutionary approach upon which investors bestowed a simple name: The Yale Model.
But the financial crisis has called into question the wisdom of that model. Unlike the early 2000s, when Yale’s diversified holdings helped sidestep the burst of the dot-com bubble, today every kind of asset has plunged, dragging Yale’s portfolio down an estimated 25 percent, to roughly $17 billion. Even the best and most diversified investors — including Swensen’s many imitators at universities and nonprofits across the country — have nowhere to hide.
“It doesn’t matter whether you’re talking about traditional risky assets or alternative risky assets,” Swensen said in an interview with the News last week. “In the midst of a crisis, assets depreciate.”
And in the midst of that crisis, it is too soon to say how his model will fare, Swensen said. But he is keeping his eye on the long term. He said sticking to his model will not only allow the endowment to withstand the current crisis but will also position Yale to profit during the eventual recovery.
Investors are taking his word for it.
“What David has figured out extremely well is what are the integral parts of a very sound investment process,” said Anthony Knerr ’60, the founder and director of a consulting firm for non-profit institutions. “Wouldn’t it be terrific if every American college had a David Swensen? But alas, that’s not the case.”
Keeping the strategy
Swensen said the financial crisis has not altered his strategy at all.
“Implementing the strategy in a time of market turmoil is more challenging than it is when markets are more settled,” he said. “But the basic principles, having an equity orientation and having diversification, haven’t changed a lot.”
What does change are the prices of Yale’s assets: as the market fluctuates, Yale must buy or sell in order to maintain its targets for each asset class. Swensen’s approach uses statistical analysis, calculating risk and expected return, to divvy up the portfolio into a fixed distribution of different kinds of assets.
As one kind of asset declines in value, Swensen advocates buying more to meet the preassigned target. When an asset class appreciates, the Yale model says to sell in order to keep allocation down. In other words, the model forces investors to buy low and sell high.
“The notion is that when markets move they pull you away from your long-term policy targets,” he said. “If an asset class posts poor relative performance you need to rebalance by purchasing, and if an asset class posts strong relative performance than you need to sell.”
Today, all asset classes are performing poorly. The worst, Swensen said, have been emerging market equities.
There has been a slight shift away from securities, Swensen said, in favor of illiquid assets, such as real estate, oil, gas and timber. These so-called “real” assets were the class that Swensen’s strategy popularized — the class that helped him steer Yale’s endowment to four consecutive years of double-digit growth between 2004 and 2007.
“Over long periods of time the illiquid assets are less efficiently priced and they generally promise higher prospective rates of return,” Swensen said. “Some people lose sight of that in the midst of a market trauma.”
For the long run
Swensen’s tactics led a recent shift toward alternative assets – A study in the Journal of Economic Perspectives found that the allocation of Ivy League endowments in illiquid assets increased from 9.3 percent to 37.1 percent between 1993 and 2005.
But despite Swensen’s continuing confidence in his model, he has often discouraged imitators.
“Few institutions and even fewer individuals exhibit the ability and commit the resources to produce risk-adjusted excess returns,” he wrote in the introduction to the revised edition “Pioneering Portfolio Management,” which was re-released this month.
Today’s crisis has seen investor flight from risky assets to the only security with safe return: U.S. Treasury Bonds. Swensen claims this shift is a temporary phenomenon driven by investors with nearsighted focus — illiquid assets, though riskier, promise hefty returns in the long run. And the long run is Swensen’s chief concern.
“David really understands that Yale is more than 300 years old, and when buildings are built at Yale they are expected to last 100 years,” said Charles Ellis ’59, an investments consultant and a former member of the Yale Corporation’s Investment Committee. “He is a very long-term thinker in the most disciplined way.”
Because other investors are fleeing risk, Swensen said, today’s crisis more closely resembles the credit crunches of 1987 or 1998 than the 2000 bubble. But today’s contraction is much more severe.
With credit markets frozen, Swensen said, assets are mispriced, which spells opportunity for investors with the capital to take advantage of firesale prices. Years from now, those bargains will pay off, he said.
But for now, all those declines mean there is no way to avoid this year’s 25 percent drop this year, which effectively erases the 28 percent gain of 2007 and brings the endowment back to what is was in 2006.
“If you have a return like you did June 30, 2007, when we were up 28 percent, or June 30, 2000, where we were up 41 percent — if it goes up 28 percent or 41 percent it can go down by double-digits too,” Swensen said. “It’s just that there was a very long period, more than 20 years, where that didn’t happen.”
As of last June, the endowment’s 10-year annualized return was over 16 percent. Swensen began managing Yale’s endowment in 1985, when it was worth about $1.3 billion.