Endowments – Part A: Introduction to Endowment Model

Today, I’m going to disappear off down a strange tangent so apologies in advance for that.  The decision to start this blog came as a result of two things.  The first was that I started reading blogs in 2006, and felt I learned far more from them (with particular hat-tips to Calculated Risk and the now retired Macro Man) than I did through work.  The second was as a couple of non-investments related courses that I took at Business School during 2008, that somewhat bizarrely helped me finder greater comfort in my own investment style.  

Since, Our Man is currently among the unemployed and looking at jobs related to his pre-MBA employment, he’s hoping to get some interviews with Endowments.  What better time to stab himself in the eye and look back at his final paper from one of those ‘eureka’ classes.  The paper was tongue-in-cheek entitled – “A critique of the Endowment Model – preemptively; Why Harvard and Yale generated no investment performance from 2008-2017”.

Most endowments have two minimum objectives:
1. Disburse a sufficient level of assets to the associated institution in order to help meet the institution’s mission.  Legally, non-profits are required to disburse c5% of their total each year to the associated institution.
2. To maintain the “real” value of the endowment’s principal in order that the inflation-adjusted level of funding is unchanged going forwards.  Recent history shows that this has broadly been in the 2-3% range.

As such, most endowment’s target levels of return, not risk, and the requirement can be seen as:
Minimum Target Return (c7.5%) = Disbursement Requirement (c5%) + Principal Inflation-Adjustment (c2.5%)

The Yale or Endowment Model
If we look at Exhibit A, the performance of Yale and Harvard are noticeable; not only were they amongst the largest endowments (in 1986, as well as 2008) but they both generated amongst the highest compound annual growth rates over the 23-year period.   Yale’s phenomenal performance has largely been attributed to David Swenson, who became the University’s Chief Investment Officer in 1985.  Following his 2000 book, Swenson's investment style has come to be known as the “Yale Model”.

Exhibit A: From NACUBO Reports

The intuitive philosophy behind the “Yale Model” is as follows: the perpetual nature of University (and/or non-profit) endowments means that their investment horizon should be exceptionally long-term, giving them with the ability to ignore short-term market fluctuations while they maximize long-term returns.  As such, endowments should invest a smaller proportion of their assets in traditional investments (bonds and equities) and far greater portion of their assets into alternative and non-traditional investments, as due to their infinite time horizon the endowment could reap the illiquidity premium from investing in these illiquid assets.  Furthermore, by investing across numerous asset classes, in a diversified fashion and regularly rebalancing, the belief is that risk could be reduced.

The below graphs, from Yale’s Endowment 2007 and Harvard’s policy portfolio, show Yale’s allocation at FY-2007 and the evolution of Harvard’s endowment which shares a broad philosophy with Yale.

The “Yale Model” has become widespread amongst endowments, with NACUBO's 2008 report suggesting that by mid-2008 $1bn+ endowments, on average, allocated almost 50% of their capital to alternative assets.