What Can We Learn from Yale Endowment’s 28% Annual Return?
Early last week, the Yale endowment, one of the nation’s largest college fund, reported an annual return of 28% from its investment for the fiscal year ended June 30th. According to YaleDailyNews.com, the Yale endowment has returned 17.8% annually over the past decade (in 2000 the fund returned 41%), leading other large rivals such as Harvard and Princeton.
So what can we learn from Yale’s staggering return? The answer, I found, is diversification.
Let’s take a look how Yale endowment allocates its investments. The following is the asset allocation chart generated according to an article on International Herald Tribune (see also a NY Times report). The fund’s largest holding is real estate (28%) which includes investments in timber and property. The second largest asset category is hedge fund (what Yale called Absolute return) at 23%, followed by 19% stake in private equity. The three largest asset classes are considered as alternative asset classes.
Comparing to the portfolio’s heavy weight on alternative assets, it’s domestic equity and fixed income (bonds) exposures are very small, at only 16% in total. What’s the reason for Yale to hold such a small portion of US stocks while the national average of university’s investment in domestic equity is more than 29%? It’s for a little more returns, as noted in their endowment report:
Despite recognizing that the U.S. equity market is highly efficient, Yale elects to pursue active management strategies, aspiring to outperform the market index by a few percentage points annually. Because superior stock selection provides the most consistent and reliable opportunity for generating excess returns, the University favors managers with exceptional bottom-up fundamental research capabilities.
The debate between passive and active has been going one for a long time. For small investors like you and me, the conventional wisdom is to go with low-cost index funds and stay away from actively managed funds because of their higher fees and inconsistent performance. The reason Yale can use the active management approach is that it’s backed by their massive assets (total $22B) so they can negotiate a better price when investing and heir talented managers to find attractive investments. That’s not the case for us. We don’t have the leverage and can only use whatever is available on the markets and pay the price everybody is paying. While cost is always one of the biggest concerns when choosing which fund to invest, there are quite some fund managers with proven track record out there and the funds they are managing have delivered above-the-average returns at reasonable costs. Should we avoid those funds all together?
I myself use a lot of actively managed funds in my taxable investments. I don’t expect these funds to beat the market year-in and year-out. If the fund outperforms the index this year by 20%, I won’t be bothered if it lags the average by 18% next year. It’s fine for me as long as over time the average return acceptable (I don’t really know what an acceptable return until I have it). Indexing is simple, but that idea isn’t getting more popular these days and there must be a reason.
In addition, the Yale portfolio also has a significant portion in foreign equities for the same reason of seeking higher return:
Investments in overseas markets give the Endowment exposure to the global economy, providing substantial diversification along with opportunities to earn above-market returns through active management. Emerging markets, with their rapidly growing economies, are particularly intriguing, causing Yale to target more than one-half of its foreign portfolio to developing countries.
Overall, the Yale endowment earned the top ranked return with a well diversified portfolio. For us small investors, hedge funds and private equities may not be within our reach, but we can still build our own portfolio that include alternative investments and go beyond the nation’s border.
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