David Swensen, the visionary American investment manager, left an indelible mark on the world of finance through his pioneering work in endowment management. Serving as the chief investment officer of Yale University’s endowment from 1985 until his untimely passing in 2021, Swensen’s influence extended far beyond the confines of academia. He revolutionized the way institutions manage their funds and established the framework for what would come to be known as the “Yale Model.” This innovative investment strategy emphasizes diversification, equity orientation, and active management as key pillars for long-term success.
David Swensen’s Legacy: The Yale Model
David Swensen was an American investment manager who served as the chief investment officer of Yale University’s endowment from 1985 until his death in 2021. He is considered to be one of the most influential figures in endowment management and is credited with developing the “Yale Model,” a long-term investment strategy that emphasizes diversification, equity orientation, and active management.
Born in the modest town of Ames, Iowa, in 1954, Swensen’s journey through the realm of finance commenced with academic excellence. His pursuit of knowledge led him to earn a PhD in economics from Yale University. His investment journey began in the early 1980s, notably at Salomon Brothers, where he orchestrated the world’s first currency swap agreement.
In 1985, Swensen joined Yale University where he was appointed endowment manager. When he started Yale’s investment fund was worth less than a billion dollars. By 2021, it had grown to over $30 billion. Over the span of 36 years, Swensen achieved an impressive 15% annualized return for Yale’s endowment—a figure substantially eclipsing both market norms and the average returns of similar-sized endowments. This shows how skilled Swensen was at managing big sums of money over a long period of time.
The Yale Model: A Unique Investment Strategy
Swensen’s approach to endowment management was highly successful. He believed that endowments should take a long-term view and invest in a diversified portfolio of assets, including stocks, bonds, real estate, and private equity. He also believed in active management and the ability of investment managers to add value to the portfolio. David Swensen’s investment strategy is known as the “Yale Model.” It is based on three pillars:
- Diversification: Swensen believed that endowments should diversify their portfolios across asset classes, including stocks, bonds, real estate, and private equity, but also geographies, and investment styles. This helps to reduce risk and improve the long-term returns of the portfolio.
- Equity Orientation: The Yale Model champions a robust equity orientation, accentuating a considerable allocation to stocks. Swensen’s rationale rests on historical evidence that stocks outperform other asset classes over extended periods, offering prospects of significant returns.
- Active Management: Swensen’s belief in active management’s value underpins the model. It underscores the employment of skilled investment managers who select assets aimed at outperforming the market, constituting an avenue for enhancing portfolio performance.
The Power of Diversification
The Yale Model emphasizes the importance of diversification, a fundamental principle in finance. Swensen noted that diversification offers a “free lunch” in the investment world. His strategy aimed to construct portfolios that were reasonably diversified, ensuring exposure to various asset classes and reducing the risk associated with concentrating too heavily in a single asset type.
The Long-Term Horizon and Equity Risks
Swensen emphasized the significance of considering a longer time horizon when designing portfolios. He argued that endowments, with their extended investment horizon, should accept equity risks to capitalize on the potential for higher returns in the long run. He challenged the conventional allocation of portfolios, which often skewed heavily towards bonds and cash, advocating for greater equity exposure.
The Challenge of Negative-Sum Game
Swensen highlighted the impact of Wall Street on investment activity. He noted that while security selection might seem enticing, the associated costs turn it into a negative-sum game. Commissions, market impact, fees, and even consulting charges reduce the potential gains of active investment, making it a less favorable strategy for investors.
The Three Pillars of Investment Returns
Swensen outlined three key factors that drive investment returns:
- Asset Allocation: Deciding which assets to include in a portfolio and their respective proportions is a critical decision. Swensen’s strategy focused on constructing portfolios with thoughtful asset allocation to optimize returns.
- Market Timing: Deviating from long-term targets based on short-term market trends constitutes a market timing decision. Swensen cautioned against excessive market timing, which could disrupt long-term investment objectives.
- Security Selection: Choosing specific securities within each asset class defines security selection. Swensen acknowledged that if investors play the security selection game, it often turns into a zero-sum or even a negative-sum game, with Wall Street extracting fees and costs.
Asset Allocation: The Cornerstone of Investment Strategy
In understanding investment strategy, the significance of asset allocation cannot be overstated. As David Swensen discusses the various elements that shape investment returns, it becomes evident that asset allocation plays a central role. Here are the main takeaways from his insights:
1. Asset Allocation’s Primacy
Swensen highlights that asset allocation is the most critical tool available to investors. While it might not be a universal law of finance, the behavioral tendencies of individual and institutional investors make it the dominant determinant of returns. Asset allocation involves deciding how to distribute investments across different asset classes, shaping the overall risk and potential returns of the portfolio.
2. Influence of Behavioral Choices
Swensen illustrates the impact of behavioral choices on investment outcomes. He humorously describes the unrealistic scenario of investing the entire portfolio in a single stock like Google or engaging in day trading with derivatives. While these scenarios might seem extreme, they emphasize how individual and institutional investors tend to adopt a stable and sensible approach to asset allocation.
3. Asset Allocation vs. Security Selection and Market Timing
Swensen explains that within the realm of asset allocation, investors tend to hold well-diversified portfolios within each asset class. While security selection (choosing specific securities within asset classes) and market timing (timing entry and exit from markets) can influence returns, they often come with additional costs and complexities. Swensen suggests that due to these costs and the zero-sum nature of these activities, asset allocation holds more sway over returns than security selection and market timing.
4. Asset Allocation’s Overarching Importance
Swensen cites the research of colleague Roger Ibbotson, which found that more than 90% of the variability of returns in institutional portfolios can be attributed to the asset allocation decision. He even argues that asset allocation can determine more than 100% of returns when accounting for the negative-sum nature of security selection and market timing.
5. The Long-Term Perspective
Swensen reinforces the importance of a long-term perspective in investment decisions. He references Ibbotson’s data on historical returns, demonstrating that equities have historically outperformed less risky assets like bonds and bills over extended periods. While the stock market has experienced crashes and downturns, the long-term rewards for accepting equity risk are substantial.
In essence, Swensen’s insights underscore that asset allocation is the keystone of any successful investment strategy. By thoughtfully diversifying portfolios across asset classes and maintaining a long-term perspective, investors can navigate the challenges of market fluctuations and enhance their chances of achieving their financial goals.
Market Timing and the Perils of Chasing Performance
The second pillar of returns, David Swensen delves into the concept of market timing and the challenges associated with trying to predict the right moments to buy and sell assets. Through insightful anecdotes and data analysis, he emphasizes the pitfalls of chasing performance and the negative impact it has on investment returns.
1. Keynes’s Wisdom on Timing
Swensen likes quoting economist John Maynard Keynes, highlighting the impracticability and undesirability of making wholesale shifts in investments. Keynes’s sentiment resonates with the author’s perspective that attempting to time the market often leads to poor decision-making.
2. Flawed Investor Behavior
Drawing on Morningstar’s study of U.S. mutual funds, Swensen demonstrates that investors tend to make counterproductive market-timing decisions. The study compared time-weighted and dollar-weighted returns, revealing that investors frequently enter funds after periods of strong performance and exit after periods of poor performance. This pattern results in systematically buying high and selling low, leading to suboptimal returns.
3. Tech Bubble Example
Swensen presents the case of the top 10 internet funds during the tech bubble. Despite the time-weighted return being a modest 1.5% per year, investors lost a significant portion of their investments, amounting to a 72% loss. This discrepancy was due to investors piling into these funds at the peak of the bubble and then selling after the crash, showcasing the damaging effects of market-timing behavior.
4. Institutional Investor Pitfalls
Swensen extends the discussion to institutional investors, referencing the 1987 stock market crash. He highlights that, even in the face of a market downturn, institutions often make poor timing decisions. For instance, they sold stocks and bought bonds during the crash, missing out on potential gains in both asset classes.
5. Performance Chasing and Portfolio Returns
The section concludes by emphasizing the pervasiveness of performance chasing and the damaging impact it has on portfolio returns. Swensen underscores that both individual and institutional investors tend to buy assets after they’ve appreciated and sell after they’ve declined, ultimately hurting their overall returns.
In essence, the section serves as a cautionary tale against attempting to time the market. Swensen’s analysis showcases that market timing tends to be counterproductive, and investors are better off adopting a disciplined, long-term investment strategy that focuses on diversification and avoiding emotional reactions to short-term market movements.
Security Selection and the Elusiveness of Alpha
David Swensen discusses the challenges and limitations of security selection as an investment strategy. Using data and analysis, he presents a compelling case against the effectiveness of active management and sheds light on the difficulties of outperforming market benchmarks.
1. Diminished Odds of Beating the Market
Swensen begins by citing a study conducted by Rob Arnott, indicating that historically, investors have had only a 14% chance of beating the market after accounting for fees and taxes. This probability is far lower than a simple coin toss, due to factors like the costs associated with active management.
2. The Impact of Survivorship Bias
The author introduces the concept of survivorship bias, explaining that performance data is skewed due to the exclusion of failed funds from analysis. He illustrates how the failure of funds, often due to poor performance, distorts the perception of success rates.
3. The Importance of Investment Opportunity
Swensen suggests an analytical approach to identifying attractive investment opportunities based on the efficiency of various asset classes. He hypothesizes that more efficiently priced markets will have tighter distributions of returns, emphasizing that in such markets, it’s challenging to consistently outperform. On the other hand, less efficiently priced markets offer more opportunity for skilled managers to generate excess returns.
4. The Reality of Manager Skill
Swensen presents a range of asset classes, from bonds to venture capital, and highlights the disparity in potential returns generated by the top versus bottom quartile managers. In the bond market, which is more efficiently priced, the difference between top and bottom quartile managers is minimal. However, in less efficient markets like real estate, leveraged buyouts, and venture capital, the differences are substantial.
5. Implications for Investors
David Swensen concludes by suggesting that investors should be cautious about spending excessive time and resources on attempting to beat the bond or stock markets. Instead, Swensen advocates for focusing on asset classes with greater market inefficiencies, where skilled managers can potentially add substantial value.
In essence, Swensen underscores the challenges of security selection as a reliable source of outperformance. Swensen’s data-driven analysis encourages investors to be realistic about their expectations and to allocate resources strategically, recognizing the varying degrees of opportunity across different asset classes.
The Yale Model: A Strategy for the Long Run
The Yale Model, with its smart way of spreading money and thinking long-term, is a strong plan for managing endowments. It likes the idea of spreading investments across different things and focusing on company shares, even if they can be risky. However, it’s also important to remember that trying to guess short-term market changes can be risky. As people and groups try to deal with the ups and downs of money markets, David Swensen’s ideas remind us how important it is to have a plan that makes sense and can stand the test of time.
1. Diversification in Times of Crisis
Swensen begins by acknowledging that diversification might seem to fail in times of extreme market panics, where safety becomes paramount. However, he highlights that such periods are temporary and argues that, in the long run, maintaining a well-diversified portfolio is the best strategy for investors. He contrasts this with the opportunity cost of holding a significant amount in low-risk assets like U.S. Treasuries during normal market conditions.
2. Overemphasis on Alternatives
Responding to the criticism of an overemphasis on alternatives in the Yale Model, Swensen presents data from the past decade, showing the strong performance of various alternative investments compared to domestic equities and bonds. He suggests that these results support the effectiveness of the Yale Model’s diversified approach, particularly when looking at a sensibly long investment horizon.
3. Evaluating Performance
Swensen underscores the importance of evaluating investment performance over an appropriate time horizon. He points out that Barron’s criticisms focused on a short-term perspective, while the Yale Model aims for consistent long-term success. He shares Yale’s impressive track record over the past 10 and 20 years, which has outperformed the average returns of colleges and universities.
4. Differences Between Institutions and Individuals
Swensen explains the differences in managing investments for institutions like Yale versus individual investors. He highlights that institutions have advantages such as not needing to worry about taxes and having the resources to make high-quality active management decisions. On the other hand, he recommends that individual investors follow a more passive approach due to the challenges of beating the market and the tax benefits of index funds.
5. Market Valuations and Rebalancing
When asked about the current state of the stock market and technology stocks’ valuations, Swensen emphasizes the benefits of diversification and disciplined rebalancing. He explains that the relative valuation of asset classes matters less when an investor’s portfolio is well-diversified. Additionally, he discusses how rebalancing ensures that a portfolio’s risk exposure remains consistent with the desired asset allocation.
Addressing critiques concerning the limitations of the Yale Model, Swensen provides nuanced insights, reaffirming the model’s core principles of diversification, disciplined investing, and focusing on the long-term horizon. He also stresses the importance of evaluating investment strategies within their appropriate contexts and timeframes.
Lessons from the Past
Now that we’ve looked at different chapters of this story, we can pick out some important things to remember:
1. Choosing Investments Isn’t Easy
Deciding where to put your money is a big challenge. Studies show that beating the market and making money after considering fees and taxes is quite hard, historically only about 14% of the time. And this gets even harder when you consider extra costs and the impact of survivorship bias. This tells us that active fund managers have a tough job trying to do better than the market consistently.
2. Real Data Matters
Survivorship bias makes us focus on investments that succeeded and ignore the ones that failed. But it’s important to look at the whole picture. Having unbiased and clear data, like what’s provided by the Center for Research in Securities Prices, helps us make better decisions. Knowing that many investments that failed aren’t around anymore reminds us to look at the bigger picture when we judge investment strategies.
3. Diversification is a Strong Choice
Even when things seem bad during a market crisis, having a mix of different investments helps in the long run. Over time, the value of diversification becomes clear. It helps us stay strong during tough market times and lowers the risk of losing a lot of money. The drop in the Japanese stock market over 20 years shows why it’s smart to spread your money across different types of investments.
4. Looking Beyond the Norm
Some people criticized the Yale Model for focusing too much on different kinds of investments, but the data shows something different. Private equity, real estate, absolute return, timber, and oil and gas did better than regular company shares and bonds over the past decade. This tells us that considering many different investment choices helps us make more money and manage risks.
5. Success Comes with Patience
When we look at Yale’s story over the years, we see a clear pattern. The endowment grew a lot and did better than average consistently. This shows us that focusing on a mix of investments and giving importance to company shares can work well in the long run. Even when people criticized it in the short term, the results over the years prove its success. It also shows us that thinking long-term is important, especially when we compare Yale’s story to other groups.
6. Preparing for Tomorrow
As we wrap up this journey, we can see that having a good investment plan means thinking about many things. Knowing how data works, avoiding biases, spreading money out, and thinking about the long future all help in making good investment choices. In the future, these lessons will keep guiding us to make smart choices and understand the complex world of money better.
The Bottom Line
In conclusion, as we’ve journeyed through David Swensen’s legacy, we’ve discovered the challenges and possibilities investors face when seeking successful investment plans. The Yale Model, with its focus on spreading investments, valuing company shares, and thinking long-term, shines as a model of good sense and success.
The Yale Model, characterized by an equity and alternative oriented asset allocation completed by a long-term outlook, presents a robust framework for endowment management. Its emphasis on diversification and exposure to stocks aligns with Swensen’s belief in the value of risk-adjusted returns over extended periods. However, the cautionary tales surrounding market timing underscore the challenges of chasing short-term trends. As institutions and investors navigate financial markets, David Swensen’s contributions serve as a reminder of the importance of disciplined, well-thought-out investment strategies that stand the test of time.
What to find more information about David Swensen and his investment strategy, here are some references:
- Books by David Swensen:
- “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” by David F. Swensen – Get a copy of the book here
- “Unconventional Success: A Fundamental Approach to Personal Investment” by David F. Swensen – Get a copy of the book here
- Yale University’s Endowment Management:
- Yale University’s official website or their investment office publications
- Yale Course
- Financial Markets (2011) with Robert Shiller – Guest Speaker David Swensen