Whither the Yale model?

By Peter Rudegeair
April 4, 2012

David Swensen has been called “Yale’s $8 billion man” for outperforming the average university endowment by that amount during the first 20 years of his tenure as Yale’s Chief Investment Officer. Chalk that outperformance up to the success of what’s become known as the “Yale model,” or the insight that institutional investors like endowments or pension funds can achieve outsize returns by allocating a large chunk of their assets to hedge funds, private equity, real estate, and other alternative investments.

As Swensen explained in a lecture he gave to Yale MBAs in 2008 , the Yale model rests on two core tenets: 1) “an equity bias for portfolios with a long time horizon,” because equities and equity-like alternative investments tend to rise in value in the long run; and 2) diversification, because by spreading investments among several asset classes with varying degrees of liquidity, ”for any given level of risk, you can increase the return.”

These days, though, it seems both of Swensen’s credos have become passé in the community of corporate pension fund managers, as Reuters’ Sam Forgione reported late last week:

For the first time in over a decade, more of the $1.246 trillion assets represented by the 100 largest U.S. corporate pension funds is now in bonds instead of equities, according to pension consulting firm Milliman…

“There will definitely be less demand for equities from corporate pensions if you look out the next several years,” said Aaron Meder, head of U.S. pension solutions for Legal and General Investment Management America. Corporations are “tired of the volatility in the stock market, so they want to de-risk their pensions,” he added.

What’s striking here isn’t that pension funds no longer share Swensen’s fondness for allocating money to hedge funds or private equity — after all, Swensen himself believes that the majority of institutional investors who can’t match the resources or qualifications of Yale’s Investment Office “should be 100 percent passive.” Rather, it’s that Swensen’s golden rules of asset management — stocks for the long run and diversification — seem to be out of fashion. Pension-fund managers that have years to ride out losses on their stock portfolios until they turn into gains are increasingly throwing in the towel in favor of less volatile, lower-returning bonds. The advantage of endowments and pension funds that Swensen has touted for years — a near-infinite time horizon — is being ignored.

This risk aversion among institutional investors is trickling down to the retail level, too. Mom-and-pop investors withdrew $4.43 billion from equity funds last week, the largest amount since the start of the year, data from the Investment Company Institute showed today. These investors are also showing a preference for fixed income: bond funds saw with $6.12 billion in inflows that same week, for a total of over $26 billion in the previous three weeks.

The question institutional investors are now asking is whether the events of the past few years require a re-appraisal of principles underpinning the Yale model. Hedge funds, one of Swensen’s darling asset classes, had a particularly bad 2011, with the average fund down nearly 5 percent and some stock-picking funds down 19 percent. The New York Times published a story earlier this week that claimed that over the past five years, a set of public workers’ pension funds that had more of their assets in hedge funds, private equity, and real estate posted lower returns and paid higher fees than those with stodgier portfolios.

For what it’s worth, Yale’s target allocation for fiscal year 2012 includes having over 70 percent of its portfolio in private equity, real estate, and hedge funds and only around 10 percent in U.S. stocks, bonds, and cash; for fiscal year 2011, Yale’s endowment returned 21.9%.

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