There’s a lot of talk in the world of university endowments about David Swenson’s “Yale Model.” It worked well from 1999 to 2009, yielding annual growth of almost 12%. In 2010 the value of Yale’s endowment fell off a cliff. After that horrific year, Yale dropped into the bottom half of its peers (as the scatter chart below shows).
Swenson’s insights were twofold. One, expand the definition of asset classes and diversify broadly across them. So it’s not just a mix of large cap, small cap and bonds; instead, spread your bets across the Wild West of real estate, private equity and hedge funds. Two, long-term investors shouldn’t embrace liquidity. They should avoid it. On average, the more illiquid the asset class, the higher the return. Nobody gets rich buying T-bills.
What went wrong in 2010? Couple of things. When markets go south, everyone runs for the exit at once. A balanced portfolio won’t help you when the correlation across asset classes approaches one. Second, as more money flows into alternative investments, it becomes harder for them to outperform. Hedge funds fell 9% last year when the S&P 500 was flat. The managers still do well – “Where are the customers’ yachts?” as the saying goes – but for many, their days are numbered.
Any system that outperforms the market will eventually be arbitraged back to the mean. That’s the ultimate problem with the Yale Model. In fact, that’s the problem with modern portfolio theory. Fortunately, it’s a very long-term problem. A friend of mine is busy scouting out companies in Cambodia for private equity investments. Want to diversify? Maybe it’s time to look in Cambodia.