Charity Lecture 2015 - David Swensen
The Model Portfolio
We were delighted to welcome David Swensen, Chief Investment Officer of the $24bn Yale Endowment to speak at our 2015 Charity Lecture at the British Museum in May 2015. The Yale model of endowment management has been very influential and we share much common ground.
30 years ago David Swensen joined Yale University as the investment manager of their then $1bn endowment, having moved from a job on Wall Street (for a significant pay cut). At the time, the average US endowment had an asset allocation of roughly 50% domestic US equities, 40% US bonds and 10% ‘alternatives’. These alternatives included overseas equities. This structure did not seem right to David, for two main reasons:
1. It was undiversified
In 1952 Harry Markowitz, Nobel Prize winning economist, described diversification as the only 'free lunch' when seeking investment returns. So if diversification can be shown to be an unalterably good thing why would Yale wish to hold 90% of its assets in US marketable securities?
2. It was too risk averse
Endowments are fortunate to have investment time horizons measured in decades or centuries. It is clear from historic analysis that long term investors are rewarded for equity risk, so why the lack of equity orientation?
As a consequence he constructed a diversified approach often now referred to as the ‘Yale model’. His approach sought to identify the three sources of potential returns in investment management; asset allocation, market timing and security selection.
His conclusions were and remain as:
Asset allocation is the key determinant of returns
In a single stock portfolio, the most important factor for returns is which stock you have chosen; whereas in day trading market timing is the key. However, for the majority of institutional investors a relatively diversified, less volatile approach is more appropriate. Roger Ibbotson, a colleague of David’s at Yale, researched the variability of returns of institutional portfolios and found that 90% can be explained by asset allocation. Even more dramatic is to consider the community of investors as a whole, where the average return is the market return. In this scenario asset allocation is responsible for over 100% of the total return, as the average investor generates a return of the market less costs. Market timing and security selection can be costly endeavours.
Rebalance but don’t attempt to market time
John Maynard Keynes wrote in a King’s College Investment Committee memo that ‘the idea of wholesale shifts [in asset allocation] is for various reasons impracticable and indeed undesirable.
Most of those who attempt this, sell too late and buy too late, and do both too often, incurring heavy expenses and developing too unsettled and speculative a state of mind.’ The Yale model does not attempt to market time and David pointed to evidence that investors systematically detract from the performance by buying high and selling low.
Stock market corrections are by their very nature unpredictable in their timing and scale. Based on a normal probability distribution the stock market crash of 1987 was a 25 standard deviation event. To put this into context, an 8 standard deviation event would only happen once in six trillion observations. It is clear that these extraordinary events are more common than predicted by a normal distribution, a characteristic known as ‘fat tails’. Institutional investors reacted by selling stocks after the market falls, and buying bonds after the gains a really difficult way to make money. In fact it took almost six years for equity allocations to reach the levels pre-crash, despite the strong subsequent bull market.
In contrast, Yale rebalanced after the crash, buying $100m of stock and prompting two emergency meetings of the investment committee, highlighting the governance challenge in any organisation. Rebalancing is the opposite of market timing and means sticking to the long term asset allocation targets that the institution has agreed, whatever the market conditions. The disciplined implementation of this asset allocation policy is incredibly important and needs to be supported by the correct governance to stay the course through such ‘financial disruptions’.
Investment selection provides opportunities to add value
The selection of investments to include within the portfolio provides opportunities to enhance returns. In order to focus management time, energy and cost, concentrate first on those assets where active management can make the biggest difference, the areas that have the largest dispersion of returns, and where your expertise lies.
After 30 years at Yale, David Swensen has not only delivered attractive investment returns but the Yale model, - with its disciplined approach to asset allocation and investment selection with a focus on rebalancing rather than market timing - has influenced many investment professionals. At Cazenove Charities our investment process is built on similar principles. and we commit to working with our charity clients to identify the asset allocation strategy that is expected to fulfil their long term objectives. Although there aren’t many UK charities, foundations and endowments that rival Yale for size ($24bn) or with its tolerance for illiquidity, made possible by the success of their on going fundraising efforts and generous alumni, we share much common ground with our friends across the pond.
- Focus on long term asset allocation strategy
- Strong preference for diversification
- Less emphasis on short term market timing
- Belief in the benefits of active management, particularly in alternatives
- Tactical asset allocation allows some divergence from long term strategy
- Typical UK charity has less exposure to illiquid private equity
For more information, please contact your Portfolio Director or:
Tel: 020 7658 3104
The opinions contained herein are those of the Charity team at Cazenove Capital Management and do not necessarily represent the House View. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital Management does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital Management has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital Management is a trading name of Schroder & Co. Limited 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.
The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Limited 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored.