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Lessons from the Yale Endowment
and from my favorite investor David Swensen
Investors perform alchemy: they create palaces of profit out of nothing but insight. Take venture capitalists. Startup connoisseurs, these backers scour the world for the next great corporation (eh ok, they scour Stanford’s campus). Or look at hedge funds, the unprosecutable smart alecks who debate CEOs to sniff out winning stocks. Buy a stock for $100 and sell it for $1,000 - that’s alchemy. Investors bask in the glorious sunlight of the financial world. What Warren Buffett or Peter Thiel think matters because these people are investors. Pay close attention to them and you might be graced with a golden ray of insight that leads to a fortune of your own. Even when some demonstrably incompetent stockpicker pops up on CNBC, people listen as the goon prattles on because that goon is an investor. These are masters of the universe, alchemists, fortune-tellers. They must know something, they must be able to help me get rich. Look at how we lionize these characters:
Here’s the problem: these people can’t help us. In fact, trying to imitate them is a bad financial move. First off, the overwhelming majority of professional investors are terrible at their jobs. But even the good ones can’t help us. Professional investors have access to resources that normal investors don’t. Regular investors using complex derivatives to recreate Michael Burry’s billion-dollar trade in The Big Short should expect the same results as Buzz Lightyear when he tried to fly off Andy’s bed with a plastic jetpack:
More importantly, these professional investors are usually specialized, focusing on one narrow slice of the investing world. The goal of a high-yield debt trader is to understand a pool of assets that make up less than 1% of 1% of the world’s investable assets. The goal of a regular person, on the other hand, is to be diversified across a broader market in order to maximize risk-adjusted returns.
Specialists aren’t the best people to look for advice on investing - what we actually want are the generalists, the people whose expertise is in constructing broad, diversified portfolios. The world’s premier class of generalist investors are endowments.
What are endowments and why do they matter?
Nonprofit organizations run a lot like normal businesses. They have employees, they pay rent, they offer services, they streamline stuff, they synergize. Unlike normal businesses, nonprofits are…nonprofit. They spend money to offer goods and services, but aren’t always compensated for those goods and services. To support their operating expenses, many large nonprofits pool all their extra cash (like donations) and form endowments, financial entities that are responsible for investing the money and sending the proceeds back to the nonprofit. A typical endowment works something like this:
Endowments, like most people, are just trying to manage their money so that it funds their lifestyle. They want to live their best life! Whether that means distributing free polio vaccines to underprivileged children in war-torn countries (endowment goals) or whether that means being able to backdoor brag about owning a Vitamix (people goals), it really doesn’t matter. Endowments and people have overlapping financial goals.
Endowments, of course, aren’t the only institution investing their money. Insurance companies, regular corporations, sovereign wealth funds, pension funds, and of course the goblins of Gringott’s Wizarding Bank all manage portfolios as part of their business. A handful of large endowments, though, have emerged as the gold standard of portfolio construction. The superstar endowments have the following in common:
They’re institutionalized, meaning they have a team of professionals fully dedicated to all aspects of investing.
They have large pools of money, which gets them access to all sorts of fancy shmancy opportunities.
They are investing on an infinite time horizon (most nonprofits intend to exist in perpetuity) which means they have fewer constraints on what they can invest in.
They tend to support mission-based organizations, which has helped them attract really talented people.
This list, despite having the Yale Endowment at the top, underrates the Yale Endowment. The Yale University endowment has one of the greatest track records in the history of investing: 14% annual returns over a >30 year period. That may seem modest, but over time it is a super-compounder. Consider Yale’s endowment since its’ formalization:
Yale & the endowment model
Endowments, even the Yale endowment, weren’t always super portfolios. For many years endowments managed their finances as well as an F. Scott Fitzgerald character. That changed in 1985, when David Swensen took the helm of Yale’s Endowment. David Swensen is the greatest investor you’ve never heard of. Many great investors find great assets; Swensen finds great investors. He completely reimagined what it means to manage a portfolio, and his vision is now known as the Endowment Model. In a nutshell, the Endowment Model seeks to use every available tool to maximize the risk-adjusted returns of a portfolio. If that sounds like the bare minimum that a professional money manager should be doing, well, the bare minimum was exceptional in 20th century financial services. Haven’t you seen Wall Street?
Swensen is on MoneyLemma’s Mount Rushmore of investors. For the 36 years he ran Yale’s endowment (until his death last year) he was heads and shoulders above the market. He was also a great guy (by all accounts): he was engaged in the community, he kept a low profile, he was a great professor, and he was an all-time great mentor. How do we know he was a great mentor? Revisit the list of endowments in the last section that collectively manage half a trillion dollars. Half of them worked for Swensen, and a few more worked for people who worked for him:
While there are some critics of Yale’s Endowment (its sometimes called a hedge fund that operates a school), anyone who follows Swensen’s work can’t deny that he ran a principled organization. In an industry that generally rewards swaggering douchebaggery, Swensen is an oasis of thoughtfulness and citizenship. All of that is nice, but what really matters is that, unlike all the cocksure moneyballers of the finance world, Swensen and his work can actually help us invest better.
What can we learn from Swensen & Yale’s endowment?
Unfortunately, we can’t just copy what Yale is doing because Yale has access to a lot of investment classes normal people don’t. When you have $50 billion and the best reputation in all of finance, doors open up.
However, we can approach investing the way Swensen & Yale do, because Swensen laid out his entire philosophy in a series of books, papers, and lectures like this one. Here are some of the key tenants of the Yale Model that will work for anyone who applies them:
Diversification is the only free lunch in finance
Swensen actually uses the term sensibly diversified. If you scoop up the shit of ten different dogs, you still have dog shit. Likewise, if you invest your money in ten different US stock funds, you aren’t diversifying: you’re only investing in US stocks. If you want true diversification, go for international stocks, real estate, bonds, and other assets that are truly different from US stocks. In other words, spread your money across different asset classes (MoneyLemma’s post where the money in world pt 2 explains and defines asset classes).
Stick with passive index funds
There are three ways to make money investing: asset allocation, timing, and security selection. Swensen believes spreading money across asset classes (asset allocation) is by far the most powerful tool because that’s how you get diversification. Asset allocation can (for the most part) be cheaply obtained using passive index funds, meaning that whoever manages the fund is simply a broad basket of securities and not trying to keep winners. Swensen’s advice for us is to keep it simple and stick with passive, low-fee index funds wherever possible.
Market timing is Susie holding football for Charlie Brown
Market timing means buying low and selling high, and security selection means buying winners and selling losers. Swensen points out that both these activities are zero-sum games that have transaction costs. In addition, Swensen says (and I’m paraphrasing here) people are absolute apes who don’t have the emotional discipline to pass up the second half of a Twix bar let alone dive into a crashing stock market. You’d sooner find a mouse who can resist a cheese trap than you would an investor who can resist selling at the wrong time. Don’t time the market.
What about security selection?
Yale isn’t all passive index funds - sometimes they invest in active managers (who beat the market through security selection) and they pay those managers handsome fees. However, there’s no way to match the due diligence on managers he does invest with: we are talking thousands of hours of research by a staff of experienced professionals. Swensen says that the average individual has “almost no chance” of beating the market, which is why he suggests sticking to index funds.
Looking to learn more about portfolio management? Portfolio science is a field that specializes in creating optimal investments. You can read Swensen’s book Unconventional Success for the absolute best explanation available.
Looking to learn more about David Swensen? The Yale Endowment issued a really nice report dedicated to Swensen and his teachings after his passing in 2021.