David Swensen is a pioneer in the investment management world. He is in the rarefied position of having only one client, the Yale University Endowment Fund, and his investment strategy, as articulated in his book Pioneering Portfolio Management, is uniquely tailored to meet his client’s twin objectives of capital preservation and growth over the long term. He has transformed the way university endowments and other long-term investors manage their assets.

When we learn that Swensen came to manage Yale’s Endowment Fund without prior experience in investment management, we can’t help but ascribe his achievements in part to the myth of the outsider–the individual who, motivated purely by his/her passion, transgresses boundaries unencumbered by the limits set by history, tradition, or established practice. We also can’t escape the implicit paradox that Swensen transformed the field of investment management from within the confines of the Yale institution. In this myth of the outsider, Swensen illuminates for us an authentic and trustworthy perspective on investing.

Equity orientation and diversification

Swensen places asset allocation at the centre of his investment process, subordinating the roles of market timing and security selection as determinants of long-term investment results.¹ We can learn a lot about Swensen’s approach by looking at the asset allocation of the Yale Endowment Fund portfolio since his inception as chief investment officer in 1985.

The most discernible trend is the decision to allocate increasing proportions of the portfolio to equities and “equity-like” assets, which exceeded 95 percent of the portfolio allocation as of 2008.² According to Swensen, the rationale for this allocation derives from his belief in the efficiency of markets and the principle that assets are priced in accordance with their risk. As riskier equities typically lead to greater long-term returns for an investor than less risky assets such as bonds, Swensen argues that long-term investors should approach the markets with an equity bias in order to achieve superior returns.³

The other dominant trend in the Yale Endowment Fund portfolio is the significant decline in the domestic equity component of the portfolio, from 61.6 percent in 1985 to 10.1 percent in 2008.⁴ This is matched by a concomitant increase in “equity-like” assets, which are diversified to include real assets, private equity, and absolute return strategies, from 11.7 percent to 74.6 percent over the same time period. Compared to other university endowment strategies, which as of 2005 allocated 45.8 percent to domestic equity and only 15 percent to “equity-like” assets, the Yale allocation represents a significant departure from the norm.⁵ Again, Swensen explains his motivations in terms of market efficiency. If markets are highly efficient and equity prices reflect all current information, then investors can more easily achieve superior long-term returns by investing in relatively inefficient, non-public, “equity-like” instruments instead of highly liquid domestic equities and bonds.⁶

The Yale “Policy Portfolio”

Swensen’s subversion of the academic theory of Modern Portfolio Theory exemplifies his challenge to traditional portfolio management. Modern Portfolio Theory (MPT) is a theoretical framework that argues that an optimally efficient portfolio–a portfolio that maximizes return for a certain level of risk–can be determined from the expected returns, variances, and covariances of its assets. Followers of this approach use a statistical tool known as a mean-variance optimizer to generate the optimal allocation of a portfolio, based on specific input assumptions about assets and how they relate to each other.

There have been many challenges to MPT, most notably to its dependence on historical data, and to its basic assumption that the risk of an asset is defined by the volatility of its returns, and that the returns of an asset correspond to a normal distribution. Certainly the market events of the past year demonstrate that one cannot ignore extreme events in any measure of risk. Moreover, the highly correlated nature of the markets over the past year, during which all assets fell precipitously in value, directly contradicts MPT’s assumption that the levels of correlation between asset classes will remain stable over time.

Swensen uses MPT as a first step in determining Yale’s asset allocation, or “Policy Portfolio,” but his subversion of its output is quite clearly articulated in the June 2008 Investment Policy of the Yale Endowment Fund. He writes (italics my own): “Because investment management involves as much art as science, qualitative considerations play an extremely important role…the definition of an asset class is quite subjective…returns and correlations are difficult to forecast…historical data provide a guide, but must be modified to recognize structural changes and compensate for anomalous periods. Quantitative measures have difficulty incorporating factors such as market liquidity or the influence of significant, low-probability events.”⁷ Clearly Swensen’s approach goes beyond the mechanistic application of MPT to portfolio management.

A role for active management

Market timing and security selection are subordinate to asset allocation in Swensen’s investment process, and play a role only for “those investors with the ability to make high-quality active management decisions.”⁸

He warns that very few institutions and even fewer individuals exhibit the ability and can commit the resources to produce risk-adjusted excess returns, especially once costs such as management fees, trading commissions, and dealer spreads are taken into account.⁹ In the absence of a high-quality active manager, Swensen strongly urges investors to passively invest in the market through equity index funds.

What defines a “high-quality active manager”? In the equity markets, Swensen presents a case for an investment approach based on bottom-up, fundamental, value-driven analysis. Crediting Benjamin Graham as a formative influence on his investment philosophy, he argues that the contrarian principle of buying an asset at a discount to its fair value, or with a margin of safety, generates consistent and superior performance over the long term.¹⁰ Within the value approach, he favours value investors that look at fundamental criteria such as the quality of management and future earnings prospects, over “naïve value” approaches that neglect to look at the quality of the business. In the alternative asset classes, Swensen is equally specific as to the types of investment approaches that will produce long-term investment returns.

There is something of a paradox in Swensen’s admonition of active management strategies, given that the Yale Endowment Fund is predominantly managed in this manner. We would expect Swensen to heed his own advice. However, it makes sense when we consider the specific advantages involved in managing a portfolio of Yale’s status and size. In a Harvard study of the Yale University Investments Office, the author points out that Yale had access to top-tier private equity funds that otherwise would be closed to investors, simply because of the desirability of having Yale as a client.¹¹ Yale’s clout also allowed it to actively shape the investment strategy and organizational structure of its outside managers. After the collapse of the real estate market, Yale used its networks to find new real estate management firms who might be “hungry for funds” and therefore willing to accept the kinds of value-added strategies and incentive structures that Yale deemed integral to success in active management.¹² Finally, part of Yale’s success comes from establishing strong partnerships with their outside managers, implying a substantial commitment of assets across time as well as across funds, and giving Yale an important competitive advantage in the field of active management.

Culture is critical

Early on, Swensen recognized that a firm’s investment culture is a necessary ingredient for generating superior investment returns. Because the Yale University Investments Office hires external managers for all but its passively managed investments, Swensen has spent a lot of time identifying the elements that enable an active management firm to beat the market. Overwhelmingly, Swensen believes that a successful active investment management firm is one that can demonstrate a disciplined and contrarian investment philosophy, an independent organizational structure that fosters rigorous research and independence of thought, and compensation structures that align the interests of the investment manager to the clients’ interests.¹³

Swensen and his team faced enormous challenges when looking for investment management firms outside the U.S. market that passed Yale’s rigorous selection process. As discussed in the Harvard Case Study, the leading foreign equity fund managers worked for larger financial institutions, which created numerous conflicts of interests for Yale as a client. Not only would the financial institutions demand asset gathering at the expense of fund performance, but also the fund managers’ lack of independent ownership would decrease their incentive to perform.¹⁴ In the emerging markets, Yale was faced with a limited selection of managers who followed a disciplined, research-oriented investment approach; moreover, those that did were either too small to effectively research the emerging markets universe, or too big, in terms of assets under management, to find attractive investment opportunities.¹⁵

In the real estate asset class, Yale refused to compromise on the kinds of incentive structures it was willing to accept from its managers. Unable to find a suitable real estate manager, it forged relationships with firms that were willing to adapt their organizational structure to accommodate Yale’s requirements for significant co-investment and for compensation structures that were linked to investors’ returns.¹⁶

Conclusion

The success of the Yale investment strategy led many investors, both institutional and individual, to follow Swensen’s approach. However, with the Yale Endowment Fund losing about a quarter of its value during the current market crisis, Swensen is once again positioned as an outsider, defending his strategy against criticism that it doesn’t work. This is familiar territory for Swensen, who sees truth in John Maynard Keynes’ statement that “it is better for reputation to fail conventionally than to succeed unconventionally.” For Swensen, judgment of his strategy can only be made after the crisis is over, and in the context of how traditional investment strategies performed.

In the meantime, Swensen’s contrarian approach is keeping him invested, based upon the fundamental principles of equity orientation and diversification across “equity-like” assets. Certainly his impressive track record with the Yale Endowment Fund teaches him that he knows how to succeed in the markets, if unconventionally. And there is no greater incentive to achievement than the knowledge that one’s investment decisions will determine the future of Yale, an institution which has the potential to raise the standard of human life, culturally, technologically, and economically.

¹ David F. Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment (New York: Simon & Schuster, 2009), 52.
² Yale University Investment Office, The Yale Endowment (2008), 5. www.yale.edu/investments
³ Swensen, 55.
⁴ Josh Lerner, “Yale University Investments Office: August 2006,” Harvard Business School (Boston: Harvard Business School Publishing, 2007), 17.
⁵ Ibid., 17.
⁶ Swensen, 63.
⁷ Yale University Investments Office, The Yale Endowment (2008), 5. www.yale.edu/investments
⁸ Swensen, 2.
⁹ Swensen, 7.
¹⁰ Swensen, 89-93.
¹¹ Lerner, 9.
¹² Ibid., 14.
¹³ Swensen, 245-347.
¹⁴ Lerner, 7.
¹⁵ Ibid., 8.
¹⁶ Ibid., 14.