Lessons from the Yale Model for Private Investors

In a previous article, we saw that the endowment model has performed poorly over the past decade, due to its focus on expensive alternative investments and too many asset managers used.

Institutional and private investors interested in replicating partly this strategy should focus on these cost and outsourcing aspects, as they can influence them through cost analysis and a reduction in the number of managers employed.

Other factors are less predictable, such as the relative performance of alternative investments versus the stock market: The relative poor performance of alternative investments and endowments in recent times is due to their own disappointing performance but also to the exceptional results of the stock market. In fact, alternative assets are suffering in comparison to the high returns of public equities (and bonds) because the low-beta strategy has not been successful during this period due to the high returns of the overall market.

However, a turnaround is possible and alternative investments (venture capital, hedge funds, high-risk debt, infrastructure, natural resources/commodities) could outperform traditional investments in the coming years.

The long-term outlook for the endowment appears more favorable due to its limited constraints, very long duration, and less positive expectations for stocks and bonds. Stocks are highly valued and there is mostly downside risk in the bond markets. Many market observers do not expect much from stocks and bonds over the next decade because of the current very high valuation of stocks, especially in the United States. At current levels, strong earnings growth in a low interest rate environment would be a prerequisite for continued growth. Otherwise, alternative investments could offer higher returns, but their lack of transparency and costs do not make them preferred instruments for individual investors.

Market imperfections exist and it is theoretically possible (for example, through superior trading infrastructure) to exploit them. However, asset managers who can consistently take advantage of these opportunities are difficult to select, and the private investor must be particularly cautious. In addition, there are few passive equivalents in the alternative investment space, making it difficult to control costs.

In closing, if you are confident in your selection of alternative investments, you can still hold a passive core and limit additional investment opportunities in number and volume (a few selected bets that won’t break the bank). In addition, if you are looking at a very long time horizon, such as leaving a legacy, a partial application of the endowment model can be considered, but the high costs and additional costs of alternative investments make it unlikely that asset values will be maintained in perpetuity. Overall, a fully or at least a partially passive approach has produced the best returns over the past decade and is likely to remain the best investment strategy in the future for individual investors.

Sources:
Strategic Asset Allocation for Endowment Funds, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Kathleen E. Jacobs and Adam Kobor
Failure of the Endowment Model The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Richard M. Ennis
Don’t Give Up the Ship: The Future of the Endowment Model Failure of the Endowment Model, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Richard M. Ennis