DATALAC & Yale’s investment model (P1)
Recently, a $20 million gift (from an anonymous donor) was given to Yale School of Management (SOM) to build the Swensen Asset Management Institute. This new organization is named after David F. Swensen, a renowned investor who led the successful Yale Endowment (the school’s investment/donation fund from alumni and donors). Under Swensen’s skilled management, Yale’s investment portfolio has gone from one success to another, with over $20 billion added to the endowment during his 23-year tenure. Specifically, from 1999 to 2009, the annual average return on the fund was 11.8%. This institutional investment achievement contributed more to Yale than any individual has ever done for any university in the world, especially extraordinary as it happened just before the Internet bubble burst.
This result came from pursuing values, ethical rigor, and a sense of mission. The new Swensen Institute sparkles with the underlying values that Yale pursues: “Asset management is the crucible in which social concerns and financial indices cannot be separated. The highest-skilled investment managers must promote social goals, specifically enhancing the endowments of universities, ensuring that the strength of the fund will protect the lives of individuals who have invested in it upon retirement, and efficiently allocating capital to businesses with high growth potential and deep influence.”
The Swensen Institute is built on the extraordinary academic tradition of SOM and the ability to positively influence, specifically emphasizing that effective, principle-based, and values-based asset management will greatly benefit both business and society.
This article will delve deeper into Yale’s investment model (or Swensen model) revolving around the three investment pillars: asset allocation, market timing, and security selection. You will gain a deeper understanding of how the Ivy League system manages a massive asset base (Yale’s scattered investments around the world), deeply influencing the world we are currently in.
The article is lengthy, so I will divide it into multiple parts.
The significant forces of investment management, especially the endowment, that Swensen created, have put him on par with such heavyweights as John Bogle, Peter Lynch, Benjamin Graham (the father of “value investing” and the mentor of legendary investor Warren Buffett) and David Dodd. Yale’s investment model has been studied by other endowments such as Harvard, MIT, Princeton, Wesleyan, and Penn (the Ivy League system). Specifically, thanks to Swensen, for over 30 years, Yale has reduced its dependence on the domestic stock market and diversified its portfolio with a focus on equity investments, minimum-yield bonds, and large investments in alternative asset classes such as venture capital, private equity, hedge funds, and international investments.
However, during the global financial crisis of 2007–2008 (the collapse of Lehman Brothers), Barron published a provocative article titled “Crash Course” criticizing Swensen’s investment approach, specifically stating that Yale’s model failed to diversify its investment portfolio and concentrated too much on alternative investment categories. Barron argued that Yale’s portfolio was too illiquid and lacked sufficient diversity.
Let’s go back to the time when Swensen arrived at Yale, specifically April 1, 1985. At that time, he had spent six years on Wall Street and had no significant experience in investment portfolio management. Before that, Swensen participated in structuring the first swap transaction in 1981 at Solomon Brothers (a form of derivative contract in which parties exchange cash flows or the value of some asset) — specifically the swap between IBM and the World Bank. As a result, Lehman Brothers hired him to build their swap department. Swensen’s career on Wall Street revolved around applying new financial technologies related to swap transactions in the early stages, when the market was very small, not hundreds of trillions like it is today. At that time, profitable transactions were made due to the market being less efficient, not with razor-thin margins like today.
James Tobin, a financial expert and economic advisor to President John F. Kennedy who also supervised Swensen’s thesis, urged his student to come to Yale to manage the university’s investment portfolio. This chance invitation led Swensen to dedicate himself to Yale for many decades, where his passion for academic pursuits merged seamlessly with real-world investment strategies. When Swensen took over as Chief Investment Officer, the value of Yale’s endowment was approaching nearly $1 billion. Upon observing how the fund was being operated, Yale, like other schools such as Harvard, Princeton, and Stanford, followed a similar formula: 50% allocated to US stocks, 40% to US bonds and cash, and only 10% to other alternative investments. This formula was devised by some of the smartest minds in the system.
First of all, Swensen notes that Yale’s endowment fund is very undiversified as 90% of its assets are in US marketable securities, such as stocks and bonds, which typically react similarly to interest rate fluctuations. For example, when interest rates are low, it is good for bonds, and it also lowers the discount rate used to calculate future earnings streams, making it good for stocks as well. This stems from the message deeply ingrained in Swensen from his teacher James Tobin, “don’t put all your eggs in one basket”, one of the fundamental principles of corporate finance formed somewhere in the 1800s (this is also a research achievement that helped Tobin win the Nobel Prize). Economist Harry Markowitz, an expert in modern portfolio theory at the Cowles Foundation (another research institute at Yale named after Alfred Cowles, an economist who was a member of the Skull and Bones Society) has also mentioned diversification as a “free lunch.” Diversification aimed at a certain level of return helps generate returns with lower risk, while aiming at a certain level of risk helps increase returns, which everyone should apply.
Next, Swensen believes that endowments should be open to equity risk due to its long time horizon. The fund may not reap short-term rewards with equity, but will reap sweet fruit in the long term. Therefore, as a fund manager, he believes that it is necessary to expand Yale’s exposure to equity in order to preserve the purchasing power of the prestigious university.
Swensen and his colleagues worked tirelessly to redesign the investment portfolio to have reasonable exposure to equity and ensure diversity. There are three basic tools that investors use to rotate the fund’s return.
Firstly, asset allocation decisions, or the proportion of assets put into the investment portfolio, such as how much goes into domestic stocks, how much into international stocks, and how much into real estate. In the case of institutional investors, the question revolves around how much goes into the timber industry, how much into leveraged buyouts, and how much into venture capital. Generally, it’s about how assets in the portfolio are allocated.
Secondly, decisions related to market timing involve setting goals for investment portfolios, such as allocating funds into domestic or international stocks. In the short term, investors may believe that international stocks are performing better than domestic stocks, and thus, invest more in foreign stocks. These short-term bets are known as market timing decisions, and the profits earned from deviations from long-term investment goals are called returns attributable to market timing.
Thirdly, security selection decisions involve choosing specific stocks to invest in. If an investor allocates funds into domestic equities and invests in an index fund that contains all the stocks on the market, the return on investment will be zero. The act of choosing specific stocks is an attempt to beat the market, and this series of bets is known as returns attributable to security selection. However, this is a zero-sum game. If one investor bets on the success of Ford, while another investor bets on GM, the winners will be balanced by the losers. Moreover, this game has a negative-sum, as Wall Street charges many fees and commissions for operating the game.
By Quan Nguyen Ha
