The Model Portfolio?
The Model Portfolio?
Kate Rogers, Portfolio Director and Head of Policy at Cazenove Charities shares her thoughts on issues faced by the charity sector in Third Sector Magazine every other month.
Last month I was lucky enough to hear the ‘godfather’ of endowment asset management speak at our annual Charity Lecture. David Swensen is the Chief Investment Officer of the $24bn Yale Endowment and his model of endowment management has been incredibly influential in the management of charitable assets. As he described his thought process in creating the Yale model over 30 years ago, it struck me how the principles still apply today. At the time, the average US endowment had an asset allocation of roughly 50% domestic US equities, 40% US bonds and 10% 'alternatives', the latter of which included overseas equities. This structure didn't seem right to him, 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 and centuries. It is clear from historic analysis that long term investors are rewarded for equity risk, so why the lack of equity orientation? It became clear that he didn't want Yale to follow this type of investment strategy, so instead constructed a diversified equity biased approach often now referred to as the 'Yale model'. This approach recognises that asset allocation is the most important determinant of returns, explaining 90% of the variability of returns of institutional portfolios.
Although examining the history of asset class returns shows that higher risk equity markets have delivered the best return, the long term figures mask periods of considerable volatility that would prove unpalatable to many charity investors. The Yale model views diversification as the ideal marriage partner to an equity bias, allowing charities to live through the trauma of a downturn in markets. Quoting Keynes, the renowned economist, he also highlighted the danger of attempting to market time. ‘Most of those who attempt to, 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, but rebalances regularly, and David pointed to evidence that investors systematically detract from the performance by buying high and selling low.
He does, however, believe that the selection of investments to include within the portfolio provides opportunities to enhance returns. His advice is to focus the active management time, energy and cost, by concentrating first on those assets where active management can make the biggest difference, the areas that have the largest dispersion of returns (such as illiquid investments) and where the expertise lies.
After 30 years at Yale, David Swensen has not only delivered attractive investment returns but the Yale model, its disciplined approach to asset allocation and investment selection with a focus on rebalancing rather than market timing, has influenced many investment professionals. And although there aren't many UK charities, foundations and endowments that could rival Yale for size ($24bn) or tolerance for illiquidity, we share much common ground with our friends across the pond.
A version of this article first appeared in Third Sector in June 2015. For this and other articles by Kate Rogers, visit thirdsector.co.uk
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