The Yale Investments Office defended its practice of paying relatively high fees to external endowment managers in its annual report released last week, taking a forceful public stance on one of the most hotly discussed topics among institutional investors in recent years.
As in previous years, the report provided additional information regarding the endowment’s performance in the past fiscal year, and included a breakdown of the endowment’s allocation of its assets. Its publication follows the University’s fall 2016 announcement that the endowment had earned a 3.4 percent return last year. However, the routine inclusion of a detailed summary was accompanied by a strong refutation of the increasingly popular claim among finance experts that instead of paying the high fees charged by many external investment managers who seek to outperform markets, Yale and other institutional investors should instead pursue an index strategy, where fees are much lower and the goal is to replicate the average investment returns of markets — not beat them.
“While investing in a passive index strategy would have resulted in lower fee payments by Yale over the past 30 years, it would have resulted in dramatically lower net returns, diminishing the endowment’s ability to support the University,” the report argued. “An index approach to managing the University’s endowment would shortchange Yale’s students, faculty and staff, now and for generations to come.”
Yale invests nearly all of its $25.4 billion endowment with active managers, who take into account a variety of factors before making specific investments while aiming to provide better returns than a predetermined benchmark. By contrast, investment managers pursuing an index strategy seek to replicate the returns of a predetermined benchmark, and charge a fraction of the fees of active managers. Hedge funds are thought to typically charge an annual 2 percent asset management fee and take one-fifth of the profits generated, whereas the Vanguard group, one of the largest providers of index strategies, charges a total of about 0.2 percent of assets invested on average.
The claim that many investors should pursue an index strategy has been advanced by financial experts for decades. In recent years, however, as active managers have struggled to outperform markets, skepticism over the value of this costly system has grown. Critics of active investing now include billionaire businessman Warren Buffett and renowned journalist Malcolm Gladwell.
“Since the financial crisis, it has been very difficult for active managers like hedge funds to be able to earn their keep,” said Andrew Lo ’81, a finance professor at the Massachusetts Institute of Technology. “There is a broad feeling that these managers are charging high fees but not producing commensurate returns.”
Hedge funds, which account for about 22 percent of Yale’s total investments, have come under particular scrutiny. In 2016, average returns from hedge funds lagged behind the returns from index funds for the seventh consecutive year, according to data compiled by the Financial Times. Large institutional investors, including the managers of pension funds for public employees of New York City and the state of California, have announced their intention to divest from hedge funds as well.
William Jarvis ’77, executive director of the Commonfund Institute, an institutional investment consulting firm, noted that policy decisions made by global central banks to support equity markets in the aftermath of the 2008 financial crisis — including the maintenance of “ultra-low” interest rates — distorted traditional risk and return relationships. As a result, investment strategies that would have made sense before the crisis are no longer as profitable, he said. Nonetheless, Jarvis claimed that the argument for indexing does not apply in Yale’s case, “regardless of what Warren Buffett and Malcolm Gladwell say.”
The YIO has not completely refuted what it terms the “fee-bashers’” case for investing in less expensive index strategies. Indeed, in a book released in 2009, University Chief Investment Officer David Swensen argued that individual investors should avoid “the ephemeral promises of market-beating strategies” offered by mutual funds, and should instead reap the benefits of the “ironclad reality of market-mimicking portfolios.”
The annual report released last week suggested that index strategies might also make sense for a “substantial majority” of institutional investors that possess neither the resources nor the capability needed to seek out successful active managers.
Yale, however, does not suffer from this resource predicament, the report claimed — the University can identify and invest with top-tier active managers who consistently produce better-than-market returns. The report also noted that pursuing a portfolio strategy similar to what is commonly promoted by advocates of low-cost passive indexing would have reduced the endowment’s gains over the past 30 years by more than $25 billion.
“I don’t see why Yale feels the need to defend itself,” said Roger Ibbotson, a hedge fund manager and finance professor at the School of Management. “Most of the active management industry needs to defend itself, but Yale’s Investments Office has had a great run of success. They are the first people that the best investment managers go to for funds.”
Despite helping oversee the University’s investments in active managers for 16 years, former Yale Corporation Investment Committee Chairman Charles Ellis ’59 has been one of the most prominent advocates for pursuing index strategies since 1975, when he wrote an article arguing that the premise that professional money managers can consistently beat the market “appears to be false.”
In January, he told Bloomberg Radio that “winning” and “passive investing” in index strategies are essentially synonymous. In an interview with the News, Ellis said there is no conflict between recommending that investors pursue index strategies and suggesting Yale need not do so.
“If I go to the Ringling Brothers Circus I can find terrific acrobats, but that doesn’t mean I could be one. Most people today would be well-advised to set aside trying to find a way to be even smarter than the extraordinarily talented people who have instantaneous access to an extraordinary amount of information,” Ellis said. “But David Swensen and his team are so good at it, and are able to find some managers who are so good that they can be successful even though most of the rest of us actually can’t do it.”
According to Ellis, under Swensen’s leadership, Yale has made itself the best client an investment manager could have by creating a culture of institutional support for the endowment’s external managers that extends across the University. He recounted attending annual retreats organized by the University for the managers investing the endowment’s funds, stressing that high-level administrators and University figures would “stop whatever they were doing” and join Swensen in welcoming the managers and encouraging them to work hard for the University. To Ellis, such support helps explain the University’s towering reputation among many in the community of investment professionals — which in turn helps explain Yale’s success.
Ellis also commended Swensen and former University President Richard Levin’s efforts to institutionalize a robust set of practices for the Yale Corporation committee that manages the endowment, noting that the University’s superior governance and risk management strategies will ensure that it sees off any temporary tumult in the financial markets.
The University’s endowment outperformed all of its peers in the Ivy League last year, and was one of the few higher-education endowments to generate a positive return in a difficult year. After planned payouts to support the University’s long-term mission, the endowment declined in value for the first time in five years, going from $25.5 billion to $25.4 billion. Still, according to University Chief Financial Officer Stephen Murphy ’87, the endowment’s 3.4 percent return in fiscal 2016 fell about 5 percentage points short of the University’s target.
Jarvis noted that amid uncertainty regarding the future direction of the financial markets, many institutions have been considering changes to their investment policies, including taking on more risk and lowering the annual rate at which they spend the money from their endowment.
According to Lo, Yale’s investment committee has set in place a spending rule that gives the University a tremendous advantage in difficult economic conditions, and allows the University to avoid the “rude awakenings” that lie ahead for the many schools that do not adequately account for market risks and fluctuations in their spending policies.
“Most people make the mistake of thinking about investing in terms of a quarter or a year or three years. Everybody is focusing on the higher rates of return, but what nobody sees because nobody talks about is that the Investments Office and the committee do a super job at anticipating and managing all kinds of risk,” Ellis said. “There’s nothing surprising about how good they are — but it takes 30 years of excellence to get there.”