The(Easily Misunderstood) Yale Model
What pretenders overlook, according to Yale’s former longtime chair.
A large majority of investment professionals admire the achievements of David Swensen and the Yale Model over more than three decades. Wisely, many managers have studied the chief investment officer’s book wherein Swensen explains clearly why and how to invest according to the Yale Model, which he developed from first principles.
Understandably, more and more endowments seek to replicate Swensen’s results by following the major quantitative metrics: an emphasis on equity investments with minimal bonds and large commitments to venture capital, private equity, hedge funds, and international investments. (Swensen helps by publishing a rigorous annual report on the asset mix and new developments in his theory and practice.)
His gifts to the field of endowment investing have been numerous and substantial. First, of course, Swensen has set the example with his career commitment. Second, with his splendid book Pioneering Portfolio Management. Third, through the clarity of his moral compass when addressing complex questions of good governance. Fourth, by explaining complexities such as how to determine how much liquidity is optimal when investing in private equity. The list of crucial innovations goes on. Intergenerational equity is assured by using a sophisticated formula originated by Nobel Laureate James Tobin, who is also Swensen’s dissertation adviser and personal friend.
Curiously, many investment managers and many members of the institutional investment community appear not to understand fully the great importance of risk management and risk control in the investment management process used at Yale. Adjusted for risk, certainly, the Yale endowment’s record of achievements would be shown to be even stronger.
Risk controls in the Yale Model — important in several dimensions — start with the selection of members of the investment committee, center on diversification of the total portfolio and within each asset class, and extend to the careful selection of custody banks.
The objective metrics of the Yale Model include an unusually heavy commitment to equity investments — with bonds relegated to providing only enough liquidity to meet the inherently unpredictable variations in cash requirements of a major university that has many independent inflows and outflows. Because Yale has been around for three centuries and plans to be around for at least as long into the future, the investment portfolio is unusually long-term in its composition and in the way it is evaluated.
Although unified in their admiration of the Yale Model and its architect, observers are divided between those with objective and those with subjective views — or quantitative versus qualitative perspectives. To the question “Which is more important to Yale’s success?,” the correct answer is “Both.” Let me explain.
The quantitative answer is widely known by readers of Swensen’s book, which explains the process by which the Yale endowment has been managed over the past 35 years of deliberate success. Alternatively, many have, often with self-confessed envy, examined Swensen’s annual reports. The quantitative results accomplished are quite properly esteemed.
The selection of managers has long been dominated by detailed assessments of character; the diversified structure of the total portfolio is designed to withstand the stresses of disruptive capital markets; diversification within each asset class is carefully designed; cash flows in venture and private equity are modeled to avoid “inconvenient” demands for funding; and once each year a soup-to-nuts review of the portfolio structure is undertaken in a rigorous search for imperfections.
These are the main components of the objective view of the Yale Model. Any endowment would be advantaged by examining and adopting the core principles underlying this version. But to assume that this is the whole truth about the model would be a serious underestimation of the real thing. At least as important to its great success are a whole slew of other contributing factors. These factors are “soft,” not hard, subjective rather than objective, and are easily missed by those focused on the quantitative factors.
Another way of describing the Yale Model would be dominated by a series of essential qualitative factors seldom noted or emphasized by those who focus on the objective aspects. Fortunately, the lessons to be learned can be applied to any endowment and are all low-cost.
Careful observers soon recognize that Swensen’s investing process is integrated into the university itself, particularly the development of the investment staff or team.
Swensen recruits from Yale College. Dozens apply. Only the best students get interviews. Of these, the most promising are invited to intern for a summer, and of those, a handful are invited to work with Swensen’s permanent staff for a few years after graduation. One or two may be invited to join the staff for the long term.
Start with a factor already listed on the objective side of the ledger: risk control. Clearly a qualitative discipline, recognizing the centrality of risk control is a subjective factor and begins with the investment committee. At Yale members of this salient group are not chosen from those serving as trustees. The process is the reverse: Committee members are selected by Yale’s president, the chair of the investment committee, and Swensen for their ability to add value to the governance of the management of the endowment. Then, of those chosen for the committee, some are asked to serve as trustees, a sequence that ensures first-things-first.
Committee members will long remember their responsibilities. Consistent attendance at all meetings is mandatory. At least as important is thorough preparation for active participation. Ten or more hours of reading and study before each meeting is normal. The depth and rigor of the due diligence done on managers are surely unusual and set a high standard for discussion during the quarterly meetings.
Devotion to the mission of serving a great university permeates every meeting (and the various non-meeting ways in which committee members are expected to contribute). One of Yale’s secrets is to regularly send a CPA (armed with a cheerful smile, a bow tie, and a helpful disposition) to spend a day or more with each manager to kick the tires and inspect all those internal aspects of an investment organization — reporting lines, compensation policies and practices, risk controls, information resources, etc. — that are rarely mentioned, let alone probed in-depth in conventional new-manager write-ups. Though new managers may be somewhat intimidated by the prospect, all experienced managers find the actual process congenial and the results helpful — and look forward to the next visit.
Another qualitative Yale “secret” is the annual weekend outing when Yale hosts the managers for two special days. The first is spent on Yale’s iconic golf course, mixing managers with coaches and members of the varsity team. The second day is round-robin tennis with Yale’s president, provost, and several vice presidents, plus the varsity players and coaches. At dinner the president gives a short talk expressing gratitude, emphasizing how important it is to Yale’s fulfilling its mission to have such superb investment managers. (Note the difference from the usual attitude toward managers as mere “suppliers.”) Goodie bags filled with Yale paraphernalia are given out as reminders of a great time and a chance to get to know the whole team as real people with a deep commitment to the endowment and its mission of serving Yale University.
A significant qualitative aspect of the Yale Model is not only that manager relationships are unusually long (averaging more than a dozen years), but that many of them start at or even before the beginning of a management firm itself, when Swensen is tipped that a new organization of first-rate investors is being formed and would be well worth his consideration. Given these opportunities, Swensen has helped numerous new managers design themselves and their strategies.
Close observers of the Yale Model of endowment management will appreciate that the core of it is both qualitative and personal: Swensen’s own career commitment to serving the institution Swensen loves, beginning with the obvious and substantial financial sacrifice of not making a large personal fortune. He goes farther, teaching a challenging and popular course to undergraduates and participating actively in university events and undergraduate activities.
Permeating every subjective aspect of the Yale Model is, of course, its originator and leader. Personally warm and engaging and professionally tough when it comes to the rigorous discipline of every aspect of the investment process, David Swensen has for 35 years been developing the real Yale Model. He is the one aspect of the qualitative model that is impossible to replicate . . . except perhaps by other unusually talented, professionally disciplined, and mission-centered exemplars ready to devote their careers to the success of a great institution and its inspiring mission of service to our nation and the world.