University endowment models: A tale of two missions

It is not often that the death of a university employee is a lead story in the Wall Street Journal’s business section. That honour went last weekend to David F Swensen, the creator of what came to be known as the Yale Model. This was not an academic programme like the Dalton Plan or some exquisite combination of theory and practice, but the diversified investment strategy that in 35 years took Yale’s US$1 billion endowment to US$31 billion.

The Yale endowment is about 5% of the combined endowments of all US universities and is roughly US$5 million for each of the 6,000 undergraduates currently enrolled. Last year the endowment contributed over one-third of Yale’s annual operating budget – about US$1.5 billion. Of that, 20% went to scholarships, fellowships and prizes and 25% was unrestricted and could be used for general purposes.

These are not trivial amounts, especially when there is a stated priority of “meeting the full financial need of every student enrolled in Yale College”.

Starting in 1985, in pursuit of more capital gain, Swensen and his team moved a good portion of Yale’s endowment away from investments in stocks and bonds to areas like hedge funds, real estate and timber.

This was a significant shift. In 1993 nearly half of the funds were in US stocks, bonds and cash. Twenty years later, just over 10% was in US marketable securities.

As they diversified Yale’s holdings, reducing its investments in US equities in favour of real assets and private equity, Swensen’s team also put a lot of effort into finding and investing in superior fund managers, people whose judgement they believed would produce better returns than the market indexes.

For about 25 years the Yale model did better than the traditional US stocks and bond portfolio, which depended in part on what they described as high-priced fixed income investments. The Yale team did well out of the tech share boom in the late 1990s and even better when that bubble burst and they had a hedged investment that fuelled a 40% growth in 2000.

Returns were strong in the early 2000s, exceeding 20% in the run up to financial tightening in 2008 when the endowment grew by only 4.5%. In the financial crisis of 2009, without the protection of US Treasury securities, the Yale endowment had a 25% loss.

But the next 10 years all produced positive returns with some volatility, returns ranging from 3.4% in 2016 to 20.2% in 2014, but averaging around 11% per annum.

Higher risk, but higher returns

The Yale model has its critics. Some of the criticism comes from those who favour a more cautious approach to capital investments. Swensen and his colleagues made a fundamental choice to accept more risk in pursuit of much higher returns.

In practice that meant investing in different regions and in more sophisticated instruments and aiming to earn more because of their choices of skilled fund managers. It also meant being able and willing to sustain some losses while pursuing extraordinary returns; a bit like investing in Nantucket whalers in the 1800s where 35% of voyages incurred losses and less than 2% made investors very rich.

Just as those early whale oil investors favoured successful captains, the directors overseeing the Yale endowment sought out high-performing fund managers. This approach was emulated by other universities, some of whom recruited endowment managers from Yale. It also stimulated the suggestion that the Yale model saw an endowment as a venture capital firm with a university to support.

In contrast, many smaller or more cautious endowments tended to forgo the chance of higher returns by investing more heavily in the US stock market, in public equities and index funds. Returns would be solid if seldom spectacular, but losses would be rare.

A choice between university missions

Choosing between the two strategies was really a choice between a university’s aspirations. The Yale model would open the way to higher peaks of excellence and innovation, even better infrastructure and the creation of new fields and products. These institutions would wait for and accumulate high returns to support projects that would allow them to leap further ahead of their competitors.

The more conservative strategy looked for resources which would help attract the best students regardless of their financial circumstances by using the endowment revenue to subsidise participation. This meant securing reliable returns so the cost of tuition would not change during a student’s programme of study, but minimising risk meant more modest returns.

The choice was really between different missions and how to realise them, between seeing your future in creating new programmes and new fields or in attracting and serving talented students, regardless of their capacity to pay.

If you choose the high return model you need an appetite for risk and to be willing to sustain that appetite over time. In the Yale model this has meant consistently betting against US equities for the last 10 years.

One view of the returns from various baskets of investments is that, in the last 10 or 15 years, Yale model adherents might have done better just following the S&P 500.

But 10 years ago, they probably did not foresee that US equities would benefit from unprecedented fiscal and monetary stimulus packages. Nor did they imagine that corporate tax rates would be cut or that there would be effectively zero interest rates for successive years.

All these policy actions pushed up the US stock market, benefiting investors who opted for ‘plain vanilla’ strategies and did not chase more exotic investment mixes or believe in their capability to select high-performing fund managers.

What do we learn from this? One lesson is that hubris haunts all of us, regardless of past success in selecting high performers. Another is that it is hard to beat the market in the long term.

Perhaps more importantly is the lesson that in managing a university’s money, even when you have a lot of it, mission matters. Mission and values embedded in the way an institution operates should shape the choices its leaders make between chasing the next big thing and investing in individuals, in people.

Alan Ruby is a senior fellow at the Alliance for Higher Education and Democracy in the University of Pennsylvania Graduate School of Education, United States.