Endowment Model: Investing in Alternative Asset Classes
University endowments receive money and financial assets primarily from donations, which universities use to fund research, teaching, and public missions. The goal of an endowment is to perpetuate and grow a pool of money through investment returns. Generated income then finances a portion of the institution’s capital requirements.
Historically, most university endowments — including the Yale Endowment — have invested primarily in traditional investments: stocks, bonds, fixed income securities, etc. That all changed when David Swensen took the position of Yale’s chief investment officer in 1985, a position he retained until his death in 2021. In the 35 years that Swensen oversaw the Endowment, it grew by approximately $40 billion.
In 1985, Yale’s endowment was worth approximately $1 billion, and alternative asset classes accounted for only 11 percent. The Endowment faced a 10% chance of a disruptive spending drop and a 21% chance of purchasing power impairment. In response, Swensen suggested the Endowment should diversify from traditional assets to lower risk and raise return. His asset allocation philosophy was successful and became known as the Yale Endowment Model.
Today, Yale’s portfolio is well-diversified and equity-oriented, with a minimum 30% allocation in market insensitive assets and a 50% limit on illiquid assets. These are its asset allocation targets for the 2021 fiscal year:
Real Estate in the Yale Model
Investors seeking to diversify their portfolios should note that the Yale Endowment allocates 9.5% to real estate, which protects against inflation. As an illiquid investment, real estate can spare investors from the temptation of reactive selling and may provide a source of increased cash flow, even in times of high inflation.
A diverse portfolio built on the Yale Endowment Model can shield an investor from the risks of public markets while providing an opportunity for higher returns. By reducing dependence on stocks and bonds, and employing absolute return strategies, investors can achieve a high-performing portfolio.
Major Metrics of the Yale Model
The Yale Endowment invests heavily in alternative investments, with domestic marketable securities accounting for less than 10% of the portfolio. Foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment.
The Yale Endowment Model can be expressed through three major metrics:
1. Emphasis on private equity investments. With only 2.25% allocated to domestic equity and 11.75% allocated to foreign equity, the Yale Endowment invests minimally in public equity. In contrast, the Endowment invests heavily in private equity, and recent reports indicate it allocated nearly 40% to private equity in the last fiscal year.
2. Minimal bonds. Whereas a typical investor may invest primarily, or even solely, in stocks and bonds, the Yale Endowment allocates a mere 7.5% to bonds and cash. Yale’s portfolio suggests that bond investments exist only to provide sufficient liquidity in the event of unpredictable variations in cash requirements.
3. Commitment to venture capital. The Endowment’s long time horizon allows it to capitalize on illiquid, less efficient markets like venture capital, which accounts for 23.5% of its investments. Institutional endowments are well-suited to long-term strategies, as they generally don’t need the liquidity and prioritize annual returns.
How a Diversified Portfolio Utilizing Yale Endowment Model Will Look
Individual investors hoping to model their portfolios after the Yale Endowment Model may be unable to match allocation percentages.
However, that doesn’t mean individual investors can’t successfully employ the Yale Model’s philosophy to their own portfolios. In fact, David Swensen — architect of the Yale Endowment Model — designed a portfolio for individual investors based on the same principles of the Yale Model. This portfolio is called the Swensen Portfolio, and the asset allocation is as follows:
- 30% total stock market
- 15% international stocks
- 5% emerging markets
- 30% intermediate bonds
- 20% REITs
Whether or not an investor chooses to follow a prescribed portfolio model, they can use the Yale Endowment Model philosophy to effectively diversify their portfolios. A high-performance portfolio should have the following qualities:
1. Ability to withstand stresses of disruptive capital markets
2. Carefully designed diversification within each asset class
3. Venture and private equity cash flows modeled to avoid inconvenient funding demands
4. Portfolio structure that is rigorously reviewed annually to catch imperfections
How a Smart Investor Utilizes the Yale Endowment Model to Optimize their Investment
If you’re wondering how to prepare for inflation, remember this: even in times of high inflation, investors are not powerless. Real estate investments can be a reliable way to diversify and grow your investment portfolio. Even in an inflated market, there are methodologically sound approaches that can yield healthy returns. Reducing dependence on domestic marketable securities can help investors avoid some inflation-related losses. To successfully diversify, investors should consider reallocating funds to a bond alternative, such as real estate.
To protect your portfolio in an inflated market, consider alternative real estate investments.