The venerable Yale Endowment Fund serves as a performance benchmark for pension managers, endowment fund managers and money managers. Many of the assets it uses so successfully aren't available to the public-and those that are may carry prohibitive costs-but it offers lessons nonetheless.

The Yale Endowment Fund is so successful because it has two kinds of diversification-deep and wide. We wondered how close we could come to replicating that performance and diversification within a reasonably low-cost, systematically managed portfolio.

This article compares the performance of the Yale Endowment with a multi-asset portfolio of ETFs over the past 10 years. The comparison also includes the Vanguard Balanced Index, a classic 60/40 balanced fund. The 60 represents a 60% allocation to equities, and the 40 represents a 40% allocation to fixed income. The Vanguard 500 Index Fund represents the performance of the S&P 500 Index.

The performance of each portfolio in this study covers years that end on June 30, the date on which the Yale Endowment reports its performance. Some of the raw data utilized in this study was obtained from Morningstar Principia.

AND THE WINNER IS...

Over the past decade (2000-2009), the Yale Endowment Fund turned an initial $10,000 investment on July 1, 1999 into just over $30,000 by June 30, 2009 (see "Ivy League Winner" on page 70). Second place went to the multi-asset portfolio, which deploys 12 passively managed ETFs to create exposure to seven distinct asset classes and had an ending balance of $18,412. Vanguard Balanced Index had a final balance of about $12,000, and Vanguard 500 Index was underwater with a balance of $7,930.

Yale's fund usually maintains a 15% to 25% allocation to private equity in its portfolio. The multi-asset portfolio, on the other hand, is built with publicly available components and is therefore available to everyone. Vanguard Balanced and Vanguard 500 Index are universally available too, but they fail to include the wide variety of asset classes needed to provide true diversification.

The importance of broad asset-class diversification is evident in the year-to-year returns of the four different portfolios (see "Diversify, Diversify, Diversify," page 72). The broadly diversified multi-asset portfolio and the Yale Endowment had only one 12-month period with a negative return over the past 10 years. Not surprisingly, that negative return occurred for the 12-month period ending on June 30, 2009.

By contrast, Vanguard Balanced Index experienced four negative 12-month returns. Vanguard 500 Index also had four negative 12-month returns, but in each case they were at least twice as large as the losses in Vanguard Balanced.

DEEP AND WIDE

Comparing these four portfolios illustrates two vitally important principles when building investment portfolios: They should have diversification depth and diversification breadth.

First, a diversified portfolio needs to use diversified ingredients. The multi-asset portfolio uses 12 different ETFs that are themselves individually diversified-that is, each individual fund holds hundreds of components (stocks, bonds, commodities, etc.). Each separate component of the portfolio is a diversified basket of stuff. This type of diversification represents depth. Investors who use mutual funds to build their portfolios usually have sufficient diversification depth because mutual funds are collections of hundreds or thousands of one type of specific asset (large U.S. stocks, small non-U.S. stocks, etc.).

Second, a diversified portfolio needs to invest across many different asset classes. This represents diversification breadth. Most portfolios lack sufficient breadth because investors (or their advisors) assume that diversification depth is all that is needed. But that deeply diversified portfolio does not protect you from an equity shock, as investors discovered the hard way in 2008 and 2009.

The best way to achieve diversification depth and breadth is to build a portfolio with a wide variety of individually diversified components. The Yale Endowment Fund and the multi-asset portfolio represent blueprints for achieving diversification depth and breadth.

The breadth of the Yale Endowment covers the following seven asset classes: absolute return, domestic equity, fixed income, foreign equity, private equity, real assets and cash. Seven asset classes also comprise the breadth of the multi-asset portfolio: U.S. equity, non-U.S. equity, real estate, resources, U.S. fixed income, non-U.S. fixed income and cash. Beneath the seven core asset classes in the multi-asset portfolio are 12 ETFs in the following sub-asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, global real estate, resources, commodities, U.S. aggregate bonds, U.S. Treasury inflation-protected securities, non-U.S. bonds and U.S. money markets. The 12 ETFs have equal weights and are rebalanced annually.