By Timothy J. Keating
For many years, the Ivy League has been known for its traditions, its gothic buildings, and, until recently, the mystique of its mammoth-sized endowments that consistently generated incredibly high returns in bull and bear markets alike. Ivy League and other large endowments, weighing in at billions of dollars, were able to achieve these extraordinary results by following what is often called the “Yale Model” for endowments developed by Yale University’s Chief Investment Officer, David Swensen, under which they invested heavily in alternatives such as private equity and hedge funds. Until very recently, it seemed to some that the Yale Model was invincible.
This all came to a grinding halt, however, in the past year when the largest university endowments—those of Harvard and Yale—stunned the investment world when they announced losses of 27% and 25%, respectively, for the fiscal year ended June 30, 2009. This shocking news led many to declare that modern portfolio theory, the intellectual underpinning of the Yale Model, was dead. Upon closer inspection, however, it becomes clear that the problem is with neither modern portfolio theory nor asset allocation, but rather with the endowments’ policies of holding shockingly small amounts of cash in their portfolios relative to the amounts needed to finance the day-to-day operations of their respective universities.
This white paper will argue that the melt down at certain endowments had nothing to do with purported flaws in modern portfolio theory. Instead, the breakdown was caused by a failure to model for truly extreme events. Given the enormous obligations of many Ivy League endowments to fund general university operations, their portfolios were positioned on the wrong point of the efficient frontier. In other words, given their liabilities, they simply invested far too little in cash and liquid assets rather than too much in alternatives like private equity.
Conclusion
Given the immense and ongoing cash needs of the large university endowments, it is shocking how little cash they actually had in their portfolios. The fault, however, is not that the endowments invested too much in alternatives like private equity, but that they invested far too little in cash and liquid assets.
Modern portfolio theory and asset allocation are not dead, and alternatives can and do play an important role in a well-constructed and well-diversified portfolio. The difficulties the large endowments faced this past fiscal year do not reflect a breakdown of the principles of asset allocation, but rather a failure on the part of the endowment managers to properly diversify their portfolios and plan for extreme events. In the future, the endowments must model and prepare for extreme events, evaluate whether the classification of their assets genuinely reflect true diversification, and perhaps most importantly, appropriate a much larger portion of their portfolios to cash and other liquid assets.
