Yale Endowment Proves, Once Again, That A Free Lunch is Not a Thing of the Past

Sue BerginSue Bergin, President, S Bergin Communications

In 1952, Harry Markowitz, an unknown 25-year old graduate student at the University of Chicago, defined risk mathematically for the first time. He also explained how investors could lower volatility while preserving expected returns if they incorporated different investments that are not highly correlated. He went on to explain, “diversification is a kind of free lunch at which you can combine a group of risky securities with high expected returns into a relatively low-risk portfolio, so long as you minimize the covariances, or correlations, among the returns of the individual securities.”

YaleThe most prominent institutional investor in developing the multi-asset class investment model was, and remains, David Swensen, chief investment officer of the Yale University Investment Office. The power of diversification to act as a free lunch is described in his book Pioneering Portfolio Management. Swensen, the long-term Chief Investment Officer at Yale University and father of the Yale Endowment Model, believed in avoiding liquidity rather than seeking it, since it comes at a cost of lower returns. The Yale Endowment Model emphasizes broad diversification and makes the case for allocating only a small amount to traditional U.S. equities and bonds and more to alternative investments.

Today, multi-class investing means different things to different people. Initially the Yale Model was based on an asset class composition that included six asset classes. It currently uses seven asset classes: domestic equity, foreign equity, fixed income, absolute return, natural resources, real estate, and private equity.

When it comes to achieving purity of asset class composition, Swensen had to say this:

Purity of asset class composition represents a rarely achieved ideal. Carried to an extreme, the search for purity results in dozens of asset classes, creating an unmanageable multiplicity of alternatives. While market participants disagree on the appropriate number of asset classes, the number should be large enough so that portfolio commitments make a difference, yet small enough so that portfolio commitments do not make too much of a difference. Committing less than 5 percent or 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Committing more than 25 percent or 30 percent to an asset class poses danger of overconcentration. Most portfolios work well with around a half a dozen of asset classes [1].

Swensen’s views on diversification and asset allocation continue to pay off. According to the preliminary 2014 results of the NACUBO-Commonfund Study of Endowments, larger, better-diversified endowments have outperformed their smaller, equity heavy peers.

On average, the 426 university and college endowments in the study returned 15.8%, while endowments with more than $1 billion returned on average 16.8%, and endowments with between $500 million and $1 billion, saw investment returns of 16.2%.

Free LunchYale University led the group, posting 20.2% gains. Further proof that the free lunch concept is alive in well in 2014.

The principles and benefits of diversification are well supported by academic thought. When selecting an investment manager, advisors and investors should consider a firm that believes in the value of the free lunch by taking a multi-asset class investment approach.

[1] Swensen, D. (2009). Asset Allocation. In Pioneering Portfolio Management (p. 101). New York: Simon and Schuster.

The views expressed are those of Brinker Capital and are for informational purposes only. Brinker Capital, Inc., a Registered Investment Advisor.

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