Kate Rogers: How the Yale model has shaped our profession

Our columnist reflects on the influential views on diversification of the investment guru David Swensen

Kate Rogers
Kate Rogers

Recently I was lucky enough to hear David Swensen, the godfather of endowment asset management, speak at Cazenove's annual charity lecture.

Swensen is the chief investment officer of the $24bn Yale University 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 more than 30 years ago, it struck me how these principles still apply today. Back then, the average US endowment had an asset allocation of about 50 per cent domestic US equities, 40 per cent US bonds and 10 per cent alternatives, which included overseas equities.

This structure didn't seem right to him, for two main reasons. The first was that it was undiversfied – diversification being, as the economist Harry Markowitz once said, the only free lunch when seeking investment returns. So if diversification could be shown to be an unalterably good thing, why would Yale want to hold 90 per cent of its assets in US marketable securities?

The second reason was that the structure was too risk-averse. Endowments are fortunate to have investment time horizons measured in decades and even centuries. It is clear from historic analysis that long-term investors are rewarded for equity risk, so why the lack of equity orientation?

Diversified approach

Swensen 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 per cent of the variability of returns of institutional portfolios.

Higher-risk equity markets might have delivered the best returns historically, but the long-term figures mask periods of considerable volatility. The Yale model views diversification as the ideal marriage partner to an equity bias, allowing charities to survive a downturn in markets.

Quoting John Maynard Keynes, Swensen 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," he said. The Yale model does not attempt to market time, but rebalances regularly; according to Swensen, investors detract from overall performance if they buy high and sell low.

He did, however, believe that the selection of investments to include in the portfolio provided opportunities to enhance returns. His advice was 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.

The Yale model has influenced many investment professionals. Few UK charities, foundations or endowments could rival Yale for size or tolerance of illiquidity, but we share much common ground with our friends across the pond.

Kate Rogers is client director at Cazenove Charities

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