Yale University has produced its fair share of Nobel laureates. It’s fitting that two of them – James Tobin and Harry Markowitz – should provide the philosophy that helped make Yale’s endowment one of the most successful funds in the world.
Over the last 30 years, the endowment has added a staggering $47.7 billion in value relative to the university’s benchmark, thanks to an annualised return of 13.1%.
Whether for Yale, Harvard, Stanford, Princeton or others, the model has very much proved its worth for larger funds with significant resources and lengthy time horizons, and it remains a relevant and enviable model for investors today.
Nevertheless, smaller funds with more limited resources, like many charities and non-profit organisations, may struggle to emulate Yale. Instead, they might want to consider strategies that can potentially deliver similar risk and return profiles but with fewer costs and more manageable governance requirements.
Does one size fit all?
Yale’s success is based on diversification, with tens of funds split across multiple asset classes. Indeed, across the sector, a typical large endowment fund delivers an equity beta to the MSCI World of c.0.8, based on approximately the following asset allocation:
- 35% public equities
- 30% private equity
- 15% hedge funds or public alternatives
- 10% real assets
- 10% fixed income
However, such an asset mix does not come without potentially substantial costs and governance requirements, driven in part by what is a comparatively large allocation to private markets and hedge fund strategies. While strategies like these can boost overall returns, they are also complex, illiquid, and sometimes opaque: features that may present challenges for anyone seeking to emulate the larger funds.
Often, traditional endowment portfolios will comprise a relatively large pool of underlying fund managers. This potentially raises questions about oversight and about the practicalities of governance. Emulating the above weightings, even on a smaller scale, could mean meeting 10 to 20 managers individually on a semi-regular basis, which, for smaller charities especially, could be a significant – perhaps unfeasible – drain on resources.
A tailored approach
For a trustee who likes Yale-style diversification and returns but perhaps has reservations about the complexity, cost and governance implications, the answer may lie in a more pragmatic and accessible portfolio.
A more suitable portfolio for a trustee with such constraints would provide the flexibility to deliver attractive returns and react promptly to opportunities – but without the level of costs and risk exposure outlined above, and all while offering wide diversification across and within different asset classes.
- Public equities: gain access to complementary styles and varied geographical exposures.
- Private equity: allocate a lower proportion of overall assets – this will remain a key contributor to performance. Irrespective of the scale of this allocation, a solutions-based approach brings a more bite-sized governance burden, meaning trustees could be asked to meet with one or two managers rather than 20 or 30.
- Hedge fund or public alternatives: diversify the allocation across a range of sub-strategies such as trend following, equity market neutral, or merger arbitrage.
- Real assets: allocate to a series of infrastructure and renewables strategies as well as property holdings.
- Fixed income: choose to favour specific market segments such as direct lending or structured illiquid credit.
This way of approaching portfolio design acknowledges much of what makes the endowment model so successful but dials down some of the less accessible opportunities for smaller institutions.
Ultimately, it is aiming to deliver similar risk and return profiles, but with fewer costs and more manageable governance requirements.
A quality private equity strategy may charge up to 2% a year, plus 20% on performance above a predefined benchmark (known as the 2-and-20 model). Similarly, the hedge fund component in the original asset mix is likely to bring average fees of 1.5-and-15.
This setup works for Yale and others because the net returns from these components are significant. Smaller schemes, however – perhaps with little or no historic allocations to such assets – may find these expenses harder to swallow and hard to justify to stakeholders.
The other factor to consider is hidden volatility. In the first model, much of the realised performance will be driven by the private equity allocation, and while PE has experienced a very successful last 15 years, there is no guarantee that this will continue as we enter a higher interest rate environment.
Given that precedent, the true risk of a private equity allocation may be easily underestimated. And while larger funds have ample resources to monitor, anticipate and act in the event of unexpected volatility, smaller institutions may find that harder.
For some, finding the optimum mix of assets isn’t the primary challenge. Often, a large component of our discussions with trustees focuses on alignment with sustainability, governance, and liquidity requirements – for these trustees, achieving a high level of comfort in their portfolio, its management and monitoring, and how it achieves its goals is vital.
A simpler portfolio that’s tailored to an individual fund’s needs – with clear objectives and constraints and well-thought-out allocations – can really deliver.
 2021 NACUBO-TIAA Study of Endowments