What David Swensen’s Yale Model Teaches Us About the Benefits of Diversification
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.
According to the Yale Investments Office, in 1989, nearly 75 percent of the endowment was invested in U.S. stocks, bonds, and cash. Today, domestic marketable securities account for less than 10 percent of the portfolio. Foreign equity, private equity, absolute return strategies (focusing on actual returns rather than returns relative to a benchmark like the S&P 500), and real assets represent over 90 percent of the endowment. In terms of performance, over the past 30 years, Yale’s investments have averaged annual returns of 12.4 percent, and have added over $34 billion in value relative to other university endowment fund returns.
Let’s look at where some of the diversification benefits might come from. One type of investment, under the natural resources category, is in timber. What’s interesting about timber as an investment — and why many endowment and pension funds have embraced such an investment — is that the value of trees increases through biological growth, as the trees mature. This increase in value should be completely independent from how stocks are performing (often influenced by economic prospects), and how bonds are performing (influenced by interest rates).
What lessons can we take away from Swensen’s approach? For our forthcoming book (co-author, with Andrew Lo), In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, we interviewed Charley Ellis, who joined Yale’s endowment fund investment committee in 1992 and served as its chair between 1999 and 2008. Ellis had a front-row seat watching Swensen perform, and likened it to being a co-pilot sitting behind Charles Lindbergh as he flew across the Atlantic. Ellis reflected on what one could learn from Swensen and his experience at Yale: “First, understand who you are and what you’re trying to accomplish. Second, think comfortably about international activity. Third, you want to be diversified so that you aren’t heavy in one kind of equity, but on several different kinds. So, you have different characteristics of behavior, so your aggregate portfolio will be more consistent in performing over time than it would be if it was in any one component part.”
Ellis’s message was that, first, we need to know what type of an investor we are and establish goals. One of Swensen’s goals was to grow the endowment so that it would fund a much greater proportion of Yale’s annual expenses, and he succeeded in spectacular fashion. Second, think beyond domestic investments. There’s a well-known phenomenon known as the home-bias whereby investors over-emphasize domestic equities and therefore miss out on potential diversification benefits. And third, even within an equity investment bucket, there can be lots of additional diversification opportunities. Of course, different types of international equities have different return-risk trade-offs, with emerging markets and even frontier markets (less advanced economies than emerging markets) on the riskier end of the spectrum.
Let’s all take a moment to remember and thank David Swensen for expanding our investment thinking.
Stephen Foerster is a co-author, with Andrew Lo, of In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, Princeton University Press (August 17, 2021).