Diversification is key, Yale shows

by Stephen Butler

According to the Jan. 17 New York Times, Yale's endowment fund, run by David Swensen, posted fiscal year-end results ending June 30 that beat all other college endowments in the country. The return was 28 percent --not bad.

Swensen's book "Unconventional Success: A Fundamental Approach to Personal Investment" establishes him in my mind as the Warren Buffet of investment managers.

Before getting all excited, however, I thought it would be interesting to see how the overall stock market had done during the same period. During the same July 1 to June 30 period, it had earned 20.3 percent including reinvested dividends. Foreign funds, such as Dodge and Cox International, were up 29 percent.

A mix of one-third foreign and two-thirds domestic equities would have generated a weighted average return of about 23 percent. This mix describes a typical allocation for many retirement plan investors over the past several years. Why isn't the New York Times writing stories about the investment success of us little guys? A 23 percent return is certainly nothing to sneeze at. For the ultimate indignity, it was exactly equal to what Harvard's endowment earned.

Digging deeper, Yale's fund has earned an average of 17.8 percent per year for the past 10 years. Now this is a track record that would be harder to beat -- but not impossible. Vanguard International Explorer has earned an average of 16.8 percent over 10 years. Hindsight, of course, is always 20/20. It would have been next to impossible to know prospectively 10 years ago what fund of about 11,000 possibilities would have even come close to Yale's results. Then again, who knows? Maybe Yale got lucky.

The important lesson from all this, and the message from Swensen's book, is that diversification and keeping fees low have been the primary engines driving Yale's success. Yes, Yale has ventured into alternative investments such as real estate, oil and timber to the tune of 28 percent of assets. (We could do the same thing with a T. Rowe Price New Era fund earning 30 percent per year for the past three years.) For another similarly large percentage, Yale has invested in those hedge funds that invest in private equity opportunities and which own businesses outright.

Of Yale's money, currently about half is invested in these alternative investments. The balance allocates just 11 percent to U.S. stocks, 15 percent to foreign stocks and 4 percent to fixed-income bonds. There is a "missing 10 percent" in these numbers that I'm not able to determine from published reports. And, this begs anther question: When an investment portfolio has such an eclectic mix of non-standard private investments, how does anyone know for sure what they are worth, including their increased value, in any given year?

I'm sure there can be appraisals, but we all know from the sub-prime mess what appraisals are worth compared with the number we get when a willing seller accepts a check from a willing buyer.

I don't mean to cast aspersions on the Yale people, even when they are such bitter rivals of my alma mater, but when half of your assets are not marked-to-market, this makes the reported return figures anyone's guess. The term marked-to-market, by the way, is the process of valuing an entire asset based on the price that some portion of it sells for on a given day. The stock market values every share of General Electric at the price a single share sells for at any time in the stock market.

When it comes to bonds, Swensen favors government bonds because there is no investment risk, and in anticipation of inflation, he leans toward Treasury inflation-protected bonds whose interest payments will rise with what we can assume will be the coming inflation.

Meanwhile, for those of us who don't have access to alternative investments and arcane strategies of the private equity industry, I would say we're not missing much. Many of these investments are about to tank (starting with Chrysler.) The industry as a whole earns an annual average return of only 6 percent.

In short, there's no need for endowment envy. With a broad diversification across different fund types and by keeping a sharp eye on fees and costs, we can come close to what may have been a lucky 20 years for Yale.

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