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What David Swensen’s Yale Model Teaches Us About the Benefits of Diversification
In memory of an investment legend
David Swensen, Yale University’s endowment fund long-time chief investment officer, recently passed away after a long battle with cancer. A dedicated man who believed in giving back, two days before his passing, he taught the last class for the term for his Investment Analysis course at Yale University. He grew Yale’s endowment fund from $1 billion when he started in 1985, to over $31 billion in 2020. He embraced a diversification model that became known simple as the Yale Model, but should probably be called the Swensen Model. While he applied the model to an endowment fund, all investors can learn important lessons from his approach.
When Swensen started at Yale, the conventional thinking was that endowment funds should invest primarily in traditional assets like stocks and bonds. Swensen embraced the modern portfolio theory of Nobel laureate, Harry Markowitz. Markowitz’s seminal 1952 article, Portfolio Selection, was the first mathematically rigorous modelling that showed the benefits of diversification. His key insight was that in order to optimize return-risk trade-offs, investors should build portfolios rather than try to find the single most promising investment. Lower correlations in price movements among securities or even across asset classes allowed investors to form portfolios that optimized return-risk trade-offs.
Swensen’s idea was that by deemphasizing traditional assets like stocks and bonds, the endowment fund could achieve better long-term performance. The nature of an endowment fund is that it effectively has an unlimited horizon. By replacing assets with historically lower returns (albeit with lower risk) like bonds with alternative investments that were riskier but with higher expected returns, so long as those alternative investments had low correlations with other investments like stocks, then there would be a potential payoff, with higher returns over the long-term, and without undue additional risk. Here’s a chart that shows the evolution in Yale’s endowment fund asset allocation over time.
