On June 30, 2008, the Yale endowment had a jaw dropping $22.9 billion in assets. Previously, it had a stellar record of outstanding returns. It earned 28% in fiscal 2007 and an astounding 41% in fiscal 2000. From 1998-2008, it trounced its benchmarks in every asset class.
Many believed the success of Yale's investment strategy was its access to "alternative assets". These include private equity holdings in leveraged buyouts, venture capital and energy investments. Yale's endowment managers had extolled the virtues of alternative investments as evidence of the value of active management. In its 2001 annual report, they stated:
"Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management."
Really? These investments also have high fees, are generally illiquid and have risks that are difficult to measure. The fact that Yale had enjoyed such extraordinary returns should have caused it to question the amount of risk it was taking.
So what happened in fiscal 2008, which ended on June 30, 2009?
The endowment had a loss of 24.6%. That's $5.6 billion!
Well, the endowment's investments in alternative assets let it down. Private equity holdings in leveraged buyouts and venture capital lost 24.3%. Energy investments were a disaster, losing 47.4%.
So much for "exploit[ing] market inefficiencies through active management."
What if the entire endowment had been invested in a globally diversified portfolio of low cost stock and bond index funds, with an asset allocation of 60% stocks and 40% bonds? This allocation is used by most endowments.
For the one year period ending June 30, 2009, this portfolio would have lost approximately 14% of its value.
Yale can take cold comfort from the fact that it fared better than its rivals at Harvard. Harvard's endowment, which followed a similar investment strategy, lost 27.3% of its value, representing $11 billion. If it had followed a 60/40 asset allocation, its losses would have been 50% less.
Maybe the Yale and Harvard endowments will outperform a passively managed, globally diversified portfolio over the next decade and maybe they won't. It is statistically likely they won't.
The trustees of the Yale and Harvard endowments lost sight of a basic rule of finance: When you take more risk, you increase the potential for both higher returns and higher losses. There is no free lunch in investing.
Individual investors make this mistake every day. The smart people at Yale and Harvard should have known better.Dan Solin is the author of The Smartest Retirement Book You'll Ever Read.
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