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Created: Thu Mar 21 09:09:13 2002
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Equity Research
Global
Overview Global
Investment Research
Excerpt from 3/20/02 European Investment Perspectives
Global 3/18/2002
Contrary Asset Allocation
Barton M. Biggs (barton.biggs@morganstanley.com) was sacrificed for the present. Fortunately, a huge bull
market, great investment results, and massive fund-raising
Foundations and educational institutions are the bedrock of in a time of prosperity saved the day. However, if this
America and crucial in our quest to be a just and fair as well happy confluence hadn't occurred, the long-term viability of
as a great society. Charitable giving is bound to be affected a great university could have been permanently impaired. It
by the destruction of wealth and the weak economy. The is a sobering story.
bear market has also taken its toll on the market value of
endowment funds. What will happen to charitable funds Foundations and educational institutions are going to be
spending patterns and the operating budgets of charitable faced with similar problems in the years to come unless
institutions remains to be seen. Wise spending and stock market miracles continue. I find many institutions are
investing decisions will be essential. retaining earnings and spending assumptions that are based
on the past decade's results and are, in my opinion,
One of the best investors in the world labors in relative unrealistic. They hope the last few years are an aberration.
obscurity. His name is David Swensen, and he runs the If they are wrong and returns are going to be lower in the
Yale Endowment. Although the results had been reported future, in effect they are sacrificing the purchasing power of
earlier, the endowment just released its annual report for the future generations. Others, by spending a pre-specified
fiscal year ended June 30, 2001. The fund's performance is percentage of beginning market value, transmit portfolio
remarkable because Yale posted a gain of 9.2% in spite of a volatility directly to the operating budget. Either way, at
25% allocation to private equity and a 41% surge in the some point spending from the endowment or operating
value of the portfolio the year before. In fact, the budgets will have to be reduced. If, in addition, giving
endowment over the last ten years has grown from $2.6 declines, the hit will be even more painful.
billion to $10.7 billion with annual investment returns of
18.3%, which places it in the top one percentile of An endowment has two masters: providing cash flow to the
comparable funds. The comparable median fund in institution's current operating budget, and preserving
Wilshire's TUCS benchmark rose 11.6% over the same purchasing power for future generations. Many institutions
period. are maintaining spending growth and depleting their
endowments even as falling markets take their toll on the
In my opinion, Yale ought to give Swensen an honorary corpus. If in addition the institution has a large number of
degree with a blue sash on it. Spending from the employees and an under-funded pension plan with too high
endowment has grown from $95 million in 1991 to $405 an earnings assumption, there could be serious trouble.
million this year, and the endowment's contribution has
grown from 13% of total university revenues to 28% of a Yale follows a disciplined approach to spending. Its rule
much higher base. What this does for the financial uses a long-term spending rate of 5%, combined with a
flexibility of Yale is obvious but still astounding. Between smoothing formula that adjusts spending gradually to
1968 and 1982, the combination of bad decisions by former changes in the endowment's market value. The amount
investment managers, inflation, and continued spending released under the spending rule is based on a weighted
reduced the purchasing power of the endowment by 60%. average of prior spending adjusted for inflation (70%
Even though maintenance was deferred, spending was weight) and the amount that would have been spent using
maintained because of the hostile environment. In effect, 5% of current endowment market value (30%). This
the university continued to live in the style it was formula works to reduce spending volatility, and by using a
accustomed to at the expense of the endowment. The future
European Investment Perspectives - March 20, 2002
Please see the important disclosures at the end of this report.
Page 2
Strategy
long-term rate of 5%, it ensures spending will be sensitive Swensen believes that publicly traded equity markets are
to preserving long-term purchasing power. relatively unattractive areas because they are so competitive
and efficient. Yale has only a 25% base allocation to
How did Swensen and his team escape the bursting of the
domestic and international stocks, compared with 56% for
private equity bubble? The fund's value orientation
the average endowment. His philosophy of hiring relatively
certainly helped, but the story was around that he hedged
small, owner-operated boutique investment management
his private equity exposure by selling NDX futures short.
firms for publicly traded equities and avoiding large firms
Swensen told me last week that was not the case. What he
in general and the investment management arms of
did do was sell all private equity share distributions as soon
investment banks in particular is not exactly music to my
as they were received. Diversification also paid off, and
ears, but it has paid off for Yale. His US equity managers
Yale received superb relative performance from the
are biased toward value and small caps and have beaten the
managers of its other asset classes.
benchmark by 500 basis points a year on average since
Yale's six asset classes are defined by differences in their 1991.
expected response to economic conditions, such as changes
Yale's target and actual portfolio asset allocation are shown
in inflation or interest rates, and are weighted in the
below, along with the average educational institution's
portfolio by considering risk-adjusted returns and
allocation, as well as Yale's expected real return and
correlations. Yale's manager selection has been superb,
standard deviation projections. Note the huge allocations to
with outperformance versus the benchmark achieved in
private equity, real assets, and absolute return, compared
every asset class over the last ten years.
with the pittances of most institutions. The international
Yale's portfolio is structured using a combination of allocation uses an unusual benchmark of 50% EAFE and
academic theory and informed (contrary) market judgment. 50% emerging markets. Yale is intrigued with emerging
Swensen described his investment philosophy for long- markets and expects real returns of 8%, with a risk level of
horizon money in Pioneering Portfolio Management, a 30%. Real assets include real estate, oil and gas, and
wonderful book published by the Free Press in the spring of timberland. Swensen remarked to me that real estate is a
2000. In essence, it goes something like this: particular favorite of his right now. As far as I know, Yale
does not use hedge funds.
· Be an owner rather than a lender.
Asset Allocation at Yale
· Have 8085% of your portfolio in high-return, Current Actual Avg. Expected Std.
ownership assets. Target Alloc. Alloc. Real Rtn. Dev.
· A small percentage of high quality, long term, non- Domestic Equity 15.0% 15.5% 43.3% 6.0% 20%
Fixed Income 10.0 9.8 23.1 2.0 10
callable bonds should be held as a disaster reserve. Foreign Equity 10.0 10.6 12.4 7.0 25
Absolute Return 22.5 22.9 9.1 7.0 15
· Risk control requires regular re-balancing. (Many Private Equity 25.0 18.2 6.1 12.5 25
institutions practice an implicit form of market timing by Real Assets 17.5 16.8 2.8 5.5 15
failing to maintain allocations at long-term policy targets.) Cash 0.0 6.2 3.2 - -
Source: 2001 Annual Report, Yale Endowment
· Strategic asset allocation and market timing usually
don't work. Increase the probability of success by focusing As a result of this very different allocation, Yale's portfolio
on inefficient markets and indexing efficient ones. is far less liquid than the average institution's. As of June
· If you have a long horizon, accept illiquidity because it 30 of last year, the endowment was 35% in illiquid assets
pays outsized rewards. and 23% in "quasi-liquid assets." The average endowment
has 8.9% in illiquid assets. Yale was a pioneer in private
· Approaching markets with a value orientation provides equity, and its program since inception has generated a
a margin of safety. 32.9% annualized return to the university, in other words,
· Add to asset classes on weakness and trim on strength. after carry. Again, it avoids funds sponsored by financial
institutions "because of the conflicts of interest and staff
· Sensible investment strategies require time horizons of instability inherent in such situations."
three to five years, and it is likely that even ultimately
successful decisions will appear foolish in the short run. Yale's target mix asset allocation produces a long-term
expected real return of 6.8% with a standard deviation of
European Investment Perspectives - March 20, 2002
Please see the important disclosures at the end of this report.
Page 3
Strategy
11.9%. As noted, over the last ten years the nominal return
has been 18.3% with the real return around 15%. Warren
Buffett said last week that he was reducing the expected
return of his companies' defined benefit pension plans from
8.3% to 6.5% nominal, which might be 4.5% real. So
considering Yale's very different asset allocation and past
record, a 6.8% long-term expected real return sounds
reasonable. I just wish other institutions were following
rational earnings assumptions and spending rules, too.
European Investment Perspectives - March 20, 2002
Please see the important disclosures at the end of this report.
Page 4
Strategy
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European Investment Perspectives - March 20, 2002
Please see the important disclosures at the end of this report.