WTT: The Real Yale Model

0:05A few weeks ago, somewhere on a sunny beach, I sat down with David Swenson's revised edition of pioneering portfolio management that he wrote just before the financial crisis and published in 2009, nine years after his original work. I found a few gems in his words that struck me as quite different from how his teachings were interpreted by the industry. This blog highlights those differences. The real Yale model. Investors following David Swenson too often miss the mark in their interpretation of his theory. Like children playing the game telephone, they listen to other voices and echo beliefs with shakier foundations than Yale's.

0:47Anyone adopting the Yale model is well-served to revisit David's writing from time to time. I had a chance to do that and found perspectives on illiquid investments, asset allocation, active management, private equity, and rebalancing that differ from the conventional wisdom that defines the Yale model. The Yale model in David Swenson's words. David's ability to articulate and act on an investment philosophy based on academic research was the foundation of his greatness. Reading the revised edition of Pioneering Portfolio Management reminded me of the clarity of his ideas and depth of his insight.

1:28David put forth a framework for thinking about the investment problem and shared how he applied that framework to managing Yale's endowment. He wrote about an investment strategy for educational endowments with a perpetual time horizon, articulating a series of first principles. This core of the Yale model, in his words, are as follows. One, equity bias. Sensible investors approach markets with a strong equity bias since accepting the risk of owning equities rewards long-term investors with higher returns. 2. Diversification. Significant concentration in a single asset class poses extraordinary risk to portfolio assets.

2:12Portfolio diversification provides investors with a free lunch since risk can be reduced without sacrificing expected return. 3. Alignment of interest. Nearly every aspect of fund management suffers from decisions made in the self-interest of the agents at the expense of the best interest of the principals. By evaluating each participant involved in investment activities with a skeptical attitude, fiduciaries increase the likelihood of avoiding or mitigating the most serious principal-agent conflicts. And four, search for inefficiency. Focus on asset classes with a wide dispersion between top and bottom performers and employ external managers to exploit opportunities.

2:59David's words of warning. David preached an investment philosophy and a mission-driven purpose. Many others read his words and inferred a prescriptive recipe for investing broadly. Interpretations of David's beliefs generally follow his principles, but his philosophy included three obstacles to investment success that most institutions and individuals are unable to overcome. As a result, David warned investors against playing follow the leader. One, rigorous investment framework. David stresses the importance of taking actions within the context of an analytically rigorous framework implemented with discipline and undergirded with thorough analysis of specific opportunities.

3:48Two, agency issues. Agency issues interfere with the successful pursuit of investment goals. Culprits range from trustees seeking to make an impact during their term on an investment committee to staff members acting to increase job security to portfolio managers pursuing steady fee income at the expense of investment excellence to corporate managers diverting assets for personal gain. Three, active management challenges. Investors hoping to beat the odds by playing the game of active management face daunting obstacles ranging from the efficiency and pricing of most marketable securities to the burden of extraordinary fees in most alternative asset investment vehicles.

4:33Success also demands substantial staff resources and contrarian behavior not typically practiced by institutions. What I also found worth consideration are the contradictions between David's words and others' interpretations of his work. It's where the students fall short of the master. What David said on illiquidity. Embracing illiquidity is not a first principle of the Yale model, despite many misinterpreting David's beliefs as such. David discusses his tenets in the first pages of the book. He does not focus on the topic of liquidity until page 82. Illiquidity is neither a feature nor a bug in David's model.

5:21It serves as both necessary for diversification and a potential source of alpha. Before pioneering portfolio management, institutions typically only held public equity and bonds in their portfolios. In the U.S., asset owners tilted heavily towards domestic stocks and bonds. David believed in diversifying away from U.S. equity market risk. To diversify away from the most liquid equity market in the world, an investor necessarily accepts illiquidity. David described illiquidity as the inevitable cousin of diversification and high-return investment opportunities. In that sense, illiquidity is a bug, not a feature.

6:07When David wrote about illiquidity, he saw it as an innovation, an opportunity to go where others did not. He said,

6:30By moving against the crowd, David saw opportunities to take advantage of mispricings in less efficient markets. He said, because market players routinely overpay for liquidity, serious investors benefit by avoiding overpriced liquid securities and by embracing less liquid alternatives. To the extent David tilted towards illiquid assets, it was primarily because others did not. For those like him willing to look in dark corners, opportunities to add value were plentiful. Investing in illiquid markets requires a long duration and an ability to lock up capital, which Yale has in spades. Further, David's desire to take advantage of market inefficiencies requires attractive prices.

7:19Without underpriced assets, illiquid markets would not offer strong risk-adjusted expected returns. The illiquid markets today are far more efficient than they were in 2000 or 2009 when David published his groundbreaking work. What David said on asset allocation. Investors often cite a landmark study by Gary Brinson, Bryan Singer, and Gil Bebauer from 1991 to defend asset allocation as the most important driver of returns. Is asset allocation essential to investment success? Of course. Is it the driver of returns according to David? Not at all. He said, asset allocation is not the driver of returns.

8:06Investors often treat asset allocation's central role in determining portfolio returns as a truism. It is not. The study describes investor behavior, not finance theory. Investor behavior causes policy asset allocation to dominate portfolio returns, since institutions tend to hold stable commitments to a broadly diversified portfolio of marketable securities. David was a staunch proponent of asset allocation, but he recognized that asset allocation drives returns in the rearview mirror. If investors choose equities, and equities outperform over time, then asset allocation mathematically dominates long-term return attribution.

8:51It's as simple as that. What David said on active management. While Yale's approach relies on active management, David believed most should not try. He said, investors wishing to beat the market by actively managing portfolios face daunting obstacles. Intelligent investors approach active strategies with a healthy sense of skepticism. Active management strategies, whether in public markets or private, generally fail to meet investor expectations. While he sought opportunities in private markets, David was fully aware of the massive hurdle to success created by the high cost required to participate.

9:34He said, while illiquid markets provide a much greater range of mispriced assets, private investors fare little better than their marketable security counterparts, as the extraordinary fee burden typical of private equity funds almost guarantees delivery of disappointing risk-adjusted results. Those following the Yale model may presume David promoted active management for all. He did not. He believed that the chance of success is low and most who try will fail. What David said on private equity and venture capital. It's ironic that pioneering portfolio management became ignition fuel for capital flows to private markets.

10:16Readers followed an approach of do what I do, not what I say, as David essentially begged all but the most well-resourced and sophisticated investors to play a different game. He said, in the absence of truly superior fund selection skills or extraordinary luck, investors should stay far, far away from private equity investments. David cites data that concludes most private equity and venture capital investors are better off investing in the public markets. He said, in aggregate, buyout investments failed to match public market alternatives. After adjusting for the higher level of risk and the greater degree of illiquidity in buyout transactions, publicly traded equity securities gain a clear advantage.

11:02Over reasonably long periods of time, aggregate venture returns more or less match marketable equity returns, indicating the providers of capital fail to receive compensation for the substantial risk inherent in startup investing. Importantly, David saw private equity and venture capital as opportunities to generate high returns without corresponding diversification benefits. He said, because of the strong fundamental links between private equity investments and marketable securities, private equity provides limited diversification to investors. In other words, if just showing up doesn't add diversification and you can't play to win, you better be careful playing at all.

11:46What David said on rebalancing. David believed rebalancing was an important risk management tool to ensure a faithful adherence to a policy portfolio. However, he saw rebalancing as a cost center, not the return enhancer many believe it to be. He said,

12:33followers of the Yale model preach the importance of rebalancing. I suspect those who also understand David's rationale behind the activity will be better positioned to implement effectively without a goal of return enhancement. What David didn't say. The well-followed gospel of Swenson changed the face of the investing world. Internalizing and implementing his approach, however, is as difficult as outperforming the markets. I wish David was here to revise his work again. His revised edition includes valuable applications of his principles to market events in the decade after the original publication.

13:13The lessons he could have taught from the financial crisis and the 15 years since would be worth their weight in gold. I would love to know what he thought about social media, artificial intelligence, chat GPT, private credit, late-stage venture, and everything else new under the sun. Sadly, we can no longer benefit from David's updated wisdom. Throughout pioneering portfolio management, David alternately refers to those who follow his approach as sensible investors, serious investors, careful investors, thoughtful investors, and effective investors. Where can we find words of wisdom from practitioners who have demonstrated those adjectives over the test of time?

13:57There are many who can fill that void, even among guests on the podcast. I'll suggest two who both learned at David's feet and have spent decades honing their adaption of the model, Andy Golden and Seth Alexander. Andy, who will retire next year after 30 years at Princeton, shared his approach on an Early Capital Allocators podcast. Seth, whose only two jobs have been at Yale and MIT, commemorated 10 years and 15 years at MIT, and recently wrote an introduction to a chapter in the seventh edition of Graham and Dodd's security analysis. Each piece is a brilliant, personalized extension of David's first principles.

14:38I drafted a follow-up blog reading into David's words to learn how he might have approached topical issues like inflation, hedge funds, and private credit. But my dear friends, former colleagues at Yale, and thoughtful investors Casey Whalen and Paula Valente reviewed the draft and both warned me for making any attempt to channel David from above. They were exactly right. I'll leave the game of telephone to you. Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more.

15:23Have a good one, and see you next time.