Investment lessons from Yale — without the tuition
When calming clients amid vertiginous spikes and plummets in the market, it’s all about accentuating the upside. One way to help them feel more at ease is to present cold, hard evidence of why they should stick to their overall strategy through market cycle and storms.
To help you start those conversations, I’ve taken an in-depth look at the long-term performance of the Yale Endowment Fund, managed by David Swensen. This fund is a stout performance benchmark for pension managers, endowment fund managers and investment managers. For context, I’ll compare its performance against a multi-asset portfolio I’ve designed called the 7Twelve Portfolio, along with SPDR S&P 500 ETF (SPY) which mimics the S&P 500.
Remember that there are two varieties of volatility. Downside volatility is the type to avoid, not generally upside volatility.
Such a comparison is particularly timely after the late 2018 stock market downturn that may have rattled clients. Downside volatility often leads to rash demands to sell their investments during the emotionally traumatizing downturn. It’s hard to focus on the likely results 10 to 20 years down the road. That’s why an analysis like the one to follow is so important. If such foresight were common, clients would weather the storms and reap the benefits years later.
Why did I select these particular funds? While not publicly available, the Yale Endowment is a stellar investment fund and there are good lessons to be learned from its asset allocation philosophy. The 7Twelve Portfolio is a model that can be built using publicly available mutual funds and/or ETFs that are available to everyone. The SPY ETF is available to everyone.
The Yale Endowment Fund is a broadly diversified portfolio. For the fiscal year ending June 30, 2018, it had the following asset allocation targets: Absolute return, 26%; Venture capital,18%; Foreign equity, 15.5%; Leveraged buyouts, 15%; Real estate, 9.5%; Bonds and cash, 6.5%; Natural resources, 6.5%; and Domestic equity, 3.0%
It’s hard to miss the meager 3% allocation to domestic equity. Clearly, Swensen is not bullish on U.S. equity at present. By comparison, the multi-asset 7Twelve portfolio model allocates 25% to US equity (equally divided among large cap, mid cap, and small cap, 16.6% to non-US equity (divided among developed and emerging), 8.3% to real estate, 8.3% to natural resources, 8.3% to commodities, 16.6% to US bonds (aggregate and TIPS), 8.3% to non-US bonds, and 8.3% to cash. For this analysis, the 7Twelve portfolio’s performance was calculated using 12 underlying ETFs from various providers.
The performance of each portfolio (Yale, 7Twelve and SPY) were each measured over fiscal years that ended on June 30. This is atypical but was necessary because that is how the performance of the Yale Endowment Fund is reported. Thus, the first investment period was from July 1, 1998, through June 30, 1999. The last investment period was July 1, 2017, through June 30, 2018.
As shown in our accompanying chart, the Yale Endowment Fund turned an initial $10,000 investment on July 1, 1998 into $92,785 over the course of 20 years. That translates to an annualized return of 11.78%.
It’s hard to miss the meager 3% allocation to domestic equity in the Yale Endowment Fund. Clearly, manager David Swensen isn't a fan at present.
The 7Twelve Portfolio, which utilized 12 ETFs in this particular analysis, produced an ending balance of $38,505, which equates to an annualized 20-year return of 6.97%. SPY ended with $34,939, which represents an annualized return of 6.45%.
To put those performance figures into perspective, there were 4,243 mutual funds in existence over this same 20-year time frame. A total of 2,372 funds remained after culling out the bond funds and money market funds (which are not representative of the funds in this study). Of those 2,372 funds, only 46 produced a 20-year annualized return higher than the 11.78% return of the Yale Endowment Fund. The average return of all 2,372 funds was 6.72% (and the median return was 6.49%).
You will notice in the table that SPY has dominated the other investments over the recent past (three, five, and 10 years). Less diversified investments, such as the S&P 500, have the potential to materially outperform broadly diversified models (such as Yale and 7Twelve) when that particular asset class (in this case, large cap U.S. equity) is on a roll.
But when things head south for that particular asset class things can get ugly.
Notice the four large losses experienced by the S&P 500 during this 20-year period. Each loss was over 13%. The 7Twelve Portfolio also had four losses, but three of those losses were smaller than 3.9%. The Yale Endowment had only one 12-month loss — during the meltdown of 2008-2009.
Another advantage of building a broadly diversified portfolio that utilizes multiple (and different) asset classes is reduced volatility of returns. Volatility is often measured using standard deviation — a lower standard deviation indicates less volatility. And less volatility is better than more volatility — generally speaking.
Cost of volatility
This is where it gets interesting.
You will notice that the 20-year standard deviation of return for the Yale Endowment is 13.0%, which is the second-highest level among the three investments in this analysis. Thus, at first blush, it would appear that the Yale Endowment has great performance, but at the cost of higher volatility. That is technically true, but we must remember that there is upside volatility and downside volatility. It is downside volatility that bothers investors, not generally upside volatility.
There is one particular upside year in which the Yale Endowment handily outperformed the two other investments — and that was from July 1999 to June 2000. The Yale Endowment had a return of 41%, compared to 11.21% for 7Twelve, and 7.25% for SPY. If we remove the huge upside return that particular 12-month period, the 20-year standard deviation for Yale drops to 11.5%, or not much higher than the 10.4% standard deviation for the 7Twelve model. The 20-year standard deviation of returns for SPY is clearly higher than Yale and 7Twelve — which is not surprising given its 100% allocation to US equity.
Remember those 46 funds that outperformed the Yale Endowment over the past 20 years? The average 20-year standard deviation among those 46 funds was 26%—or exactly twice as high as Yale. Was it upside volatility among those 46 funds? Nope. On average, those 46 funds had five negative 12-month returns during this 20-year period. Yale had one. So, those 46 funds had higher performance than Yale, but with more downside volatility.
Bottom line: The cause of Yale’s higher standard deviation is frequent and impressive upside performance, and that is hardly something to be upset with. In other words, we should all want portfolios that have higher levels of upside volatility.