Unconventional success from an investment strategy leads to failure for most investors. The excess gains earned by the early adopters of a new investment idea quickly dissipate as growing crowds become increasingly unsophisticated and push down returns. It doesn’t take long before the average return from the strategy falls well below a simple portfolio of index funds.
A recent example of unconventional failure is the Yale Model, also referred to as the Endowment Model. This strategy, which combines traditional stock and bond investments with alternative investments such as hedge funds and private equity, was popularized by the success of the Yale Endowment Fund in the early 2000s.
From July 2000 through June 2003, the S&P 500 fell 33% while the Yale Endowment fund gained 20%. That’s all it took for a revolution to occur in the way large and small institutions managed their endowments and public pension funds.
David F. Swensen, chief investment officer of Yale University, fanned the flames of enthusiasm in his bestselling book, Pioneering Portfolio Management [Free Press, 2000]. The book provided a blueprint for people who wished to implement this new way of investing.
To his credit, Swensen repeatedly warned in the book that only a handful of the largest organizations have the depth of knowledge to successfully implement such a strategy. That was a nice suggestion by Mr. Swensen, but it was about as useful as telling a freshman college student to avoid parties where alcohol is being served.
Data compiled from 831 U.S. colleges and universities that manage over $400 billion in aggregate have not performed well using the Yale model. National Association of College and University Business Officers (NACUBO) data for the most recent fiscal year ending in June 2012 shows that large, medium and small endowments have all fallen well short of investments that are less complex and less costly.
I compared the average endowment fund performance reported by NACUBO to two index fund strategies. The first was a Core-4 portfolio and the second was a single balanced index fund available through Vanguard.
The Core-4 is a simple yet popular strategy used by many individual investors. It’s comprised of four index funds shown in Table 1. The average asset allocation of the endowments was approximately 30% in fixed income and cash, and 70% in U.S. and foreign equity and alternative investments (of which 7% was in real estate). I replicated this allocation as closely as possible using the Core-4 fund strategy and rebalanced once per year on June 30.
Table 1: Core-4 Portfolio with a Typical Endowment Asset Allocation
The second strategy was a single balanced index fund. The Vanguard Balanced Index Fund Investor Shares (VBINX, ER .24%) seeks to track 60% of the investment performance of overall U.S. stock market and 40% of the investment performance of a broad, market-weighted bond index. There isn’t a separate allocation to foreign stocks or real estate.
Most Vanguard index funds are available in three share classes: Investor Shares, which have a low investment minimum; Admiral Shares, which have a slightly higher minimum; and ETFs, which have no minimum investment. To be as fair to the endowments as possible, I used the highest cost Investor Shares in the analysis. Table 2 highlights the results.
Table 2: Comparison of Three Strategies through June 2012
The numbers speak for themselves. Despite hundreds of millions of dollars spent on consultants, management fees, and incentive fees for alternative investment gains, endowment fund portfolios did not keep up with these simple index fund strategies. To add insult to injury, I looked at this same comparison for an article I wrote on this topic last year (The Curse of the Yale Model) and endowment performance has become worse.
John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” When unconventional thinking becomes conventional thinking, failing is imminent. That’s where most endowments and public pension funds are. The trustees who oversee these funds are failing their beneficiaries by intentionally ignoring the obvious.
I don’t think this will ever change. There are too many reputations and too many jobs at stake for trustees to do the right thing for fund beneficiaries. The obvious right thing is to cut most consultants, cut most active managers, cut alternative investment funds, cut the burgeoning internal staff needed to track the quagmire, and convert to all index funds.
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