The two prominent universities in the Ivy League are Havard and Yale. Besides being famous for their academia, they have large and profitable endowment funds that pay for a large part of the universities’ expenses. How well? From 1985-2008, S&P 500 returned 11.98% and while most fund managers could not beat the market, Yale and Harvard endowments returned 16.62% and 15% respectively. What did they do right that retail investors like you and me can follow? In this book, the authors dissected the portfolio of these Ivy League schools and analysed the sources of excess returns.
The challenge of these endowments is that besides having to focus on long term growth of the capital (to outpace inflation at 3%), they must afford to spend on the universities in the short term (to outpace expenditures of 4-5%).
Similarly to the mutual fund industry, for the few endowments that succeed, many endowments did poorly. And this was often due to the large positions in a few stocks. As the authors put it,
In the early 1970s, the University of Rochester had the third largest endowment after Havard University and the University of Texas. Due to poor returns (including losing 40% in one year), it now ranks 39th. High on the list of unfortunate decisions were large allocations to stocks of local companies like Kodak and Xerox. The stocks performed poorly, and the school had to massively downsize its faculty and academic programs in the mi-1990s. (One of the top mistakes that individual investors make is investing all of their money in a local company or an employer’s stock. You could get rich, but the risk will be very high – just ask former Enron and Bear Stearns employees.)
Reasons for out-performance
- Compared to the smaller endowments, the bigger and better performing endowments own fewer stocks and bonds, and more real assets and alternatives (hedge funds, private equity, and venture capital).
- Active security selection and market timing as compared to buy-and-hold indexing approach
- Other advantages include economies of scale in fees, a team of managers and analysts, and access to profitable investment opportunities that are out-of-reach to smaller endowments.
Seeking alpha in inefficient markets
I was drawn to Table 2.7 in the book where it measured the degree of efficiency in the markets. The table showed the different asset classes and their associated returns in the first quartile, median and third quartile. The last column, Range, is simply the delta between the first and third quartile. For example, if you constantly pick good US large cap stocks, your returns will be 11.3%. But if you constantly pick something in the third quartile, you will end up with 9.4%. An approximate 2% difference. The more efficient the market, the smaller the range will be.
| Asset Class | First Quartile |
Median | Third Quartile |
Range |
| U.S. Bonds | 7.2% | 6.9% | 6.7% | 0.5% |
| U.S. Large Cap Stocks | 11.3% | 10.4% | 9.4% | 2.0% |
| U.S. Small Cap Stocks | 15.3% | 13.2% | 19.5% | 4.7% |
| International Stocks | 9.7% | 8.2% | 5.7% | 4.0% |
| Absolute Return | 15.6% | 12.5% | 8.5% | 7.1% |
| Real Estate | 17.6% | 12.0% | 8.4% | 9.3% |
| Leveraged Buyouts | 13.3% | 8.0% | -0.4% | 13.7% |
| Venture Capital | 28.7% | -1.4% | -14.5% | 43.2% |
Yale actively manage investments in inefficient markets. As the Yale Endowment Fund Manager, David Swensen puts it,
An inverse relationship exists between efficiency in asset pricing and appropriate degree of active management. Passive management strategies suit highly-efficient markets, such as U.S. Treasury bonds, where market returns drive results and active management adds less than nothing to returns. Active management strategies fit inefficient markets, such as private equity, where market returns contribute very little to ultimate results and investment selection provides the fundamental source of return.
Even though the U.S. stock market is efficient, Yale still conduct bottom-up fundamental analysis to pick value small cap stocks. One reason is that these stocks are less covered by analysts and are relatively less efficient. For international exposure, Yale also prefers stocks in emerging markets that are less researched.
Although the endowment funds diversify risks away by investing in uncorrelated assets, the 2008 was a good example where most assets went down together. Correlations change. While Mohamed El-Erian was managing Havard Management Company, he said
It’s getting very crowded, not only in terms of asset allocations, but in terms of finding the right implementation vehicles. There’s a limit to how much superior investment expertise is out there. So the asset allocation is going to be less potent because there are more people doing it. And then the global liquidity situation is changing as well. So our view is that performance in the future needs something more – two things more: first, better risk management, because correlated risk has become a big issue, and diversified asset allocation no longer gives you the risk mitigating characteristics it used to. Second, is identifying new secular themes that will play out over the next five years, and trying to be a first mover in those, and that’s what we’re working very hard at doing.
To simulate the Harvard and Yale endowment funds’ asset allocation, the authors set out the following weightage for the Ivy Portfolio.
- Domestic Stocks – 20%
- Foreign Stocks – 20%
- Bonds – 20%
- Real Estate – 20%
- Commodities – 20%
How did this portfolio fare from 1985 to 2008? The Ivy Portfolio returned 11.97% per annum. Some of the ETFs that were mentioned in the book were Vanguard Total Stock Market ETF (VTI), Vanguard FTSE All-World ex-US ETF (VEU), Vanguard Total Bond Market ETF (BND), Vanguard REIT Index ETF (VNQ) and PowerShares DB Commodity Index ETF (DBC).
Difficulty in picking the right stocks
Blackstar Funds studied every stock in the Russell 300 from 1983 to 2008 and reported that “40% of the stocks had a negative return over their lifetime, and about 20% of stocks lost nearly all of their value. A little more than 10% of stocks recorded huge wins over 500%.” This is where Nassim Taleb talked about the fat tails in the stock market. Instead of normally distributed profile, there are more stocks that appear at the both ends of the tails – ultimate losers and winners. Statistically, the odds are against you picking a winning stock. Even though Yale got most of its excess returns from active management, David Swensen discourages individual investors to select stocks and time the market.
Boost your portfolio with greater returns and lesser volatility
Research shows that your portfolio returns will reduce significantly if you missed out the best days of the market. The converse is true too – missing out the worst days will improve the portfolio returns. Hence, the authors suggest the individual to incorporate a mechanical way to help your portfolio sit out the worst days in the market.
One way is to use a moving average to time the market. You will buy when the monthly price is above the 10-month moving average (equivalent to 200-day), and sell when monthly price is below it. For the period of 1973-2008, this method enhances the returns of Ivy Portfolio from 9.79% to 11.33%. Most importantly, the maximum drawdown reduces from -35.67% to -9.53%. The authors found that 70% of the best and worst days occur below the 200-day average. As they put it “[t]his increase in volatility and its clustering is one of the simple reasons the timing model works – when markets are declining people become more fearful and use a different part of their brain than during periods when markets are going up.”
The authors also provided the shortcoming of the timing model – market timing can underperform buy-and-hold in a strong bull market. This was evident in the 1990s where U.S. stocks had phenomenal growth.
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