The (Easily Misunderstood) Yale Model
This outstanding piece from the legend that is Charles Ellis provides a far deeper understanding of Yale’s famous endowment investment model – helmed by the equally famous David Swensen – than anything else we have read to date on this iconic investment model.
Ellis starts with the basics by telling us why Swensen is a living legend. “His gifts to the field of endowment investing have been numerous and substantial. First, of course, Swensen has set the example with his career commitment. Second, with his splendid book Pioneering Portfolio Management. Third, through the clarity of his moral compass when addressing complex questions of good governance. Fourth, by explaining complexities such as how to determine how much liquidity is optimal when investing in private equity. The list of crucial innovations goes on. Intergenerational equity is assured by using a sophisticated formula originated by Nobel Laureate James Tobin, who is also Swensen’s dissertation adviser and personal friend.”
Then Ellis starts telling us what the rest of us don’t understand about Yale’s model. “Curiously, many investment managers and many members of the institutional investment community appear not to understand fully the great importance of risk management and risk control in the investment management process used at Yale. Adjusted for risk, certainly, the Yale endowment’s record of achievements would be shown to be even stronger.
Risk controls in the Yale Model — important in several dimensions — start with the selection of members of the investment committee, center on diversification of the total portfolio and within each asset class, and extend to the careful selection of custody banks.”
Then he delves into the qualitative aspects of the Yale Model which are not properly appreciated by outsiders. “The selection of managers has long been dominated by detailed assessments of character; the diversified structure of the total portfolio is designed to withstand the stresses of disruptive capital markets; diversification within each asset class is carefully designed; cash flows in venture and private equity are modeled to avoid “inconvenient” demands for funding; and once each year a soup-to-nuts review of the portfolio structure is undertaken in a rigorous search for imperfections….
Swensen recruits from Yale College. Dozens apply. Only the best students get interviews. Of these, the most promising are invited to intern for a summer, and of those, a handful are invited to work with Swensen’s permanent staff for a few years after graduation. One or two may be invited to join the staff for the long term.
Start with a factor already listed on the objective side of the ledger: risk control. Clearly a qualitative discipline, recognizing the centrality of risk control is a subjective factor and begins with the investment committee. At Yale members of this salient group are not chosen from those serving as trustees. The process is the reverse: Committee members are selected by Yale’s president, the chair of the investment committee, and Swensen for their ability to add value to the governance of the management of the endowment. Then, of those chosen for the committee, some are asked to serve as trustees, a sequence that ensures first-things-first.
Committee members will long remember their responsibilities. Consistent attendance at all meetings is mandatory. At least as important is thorough preparation for active participation. Ten or more hours of reading and study before each meeting is normal. The depth and rigor of the due diligence done on managers are surely unusual and set a high standard for discussion during the quarterly meetings….
One of Yale’s secrets is to regularly send a CPA (armed with a cheerful smile, a bow tie, and a helpful disposition) to spend a day or more with each manager to kick the tires and inspect all those internal aspects of an investment organization — reporting lines, compensation policies and practices, risk controls, information resources, etc. — that are rarely mentioned, let alone probed in-depth in conventional new-manager write-ups. Though new managers may be somewhat intimidated by the prospect, all experienced managers find the actual process congenial and the results helpful — and look forward to the next visit.
Another qualitative Yale “secret” is the annual weekend outing when Yale hosts the managers for two special days. The first is spent on Yale’s iconic golf course, mixing managers with coaches and members of the varsity team. The second day is round-robin tennis with Yale’s president, provost, and several vice presidents, plus the varsity players and coaches. At dinner the president gives a short talk expressing gratitude, emphasizing how important it is to Yale’s fulfilling its mission to have such superb investment managers. (Note the difference from the usual attitude toward managers as mere “suppliers.”) Goodie bags filled with Yale paraphernalia are given out as reminders of a great time and a chance to get to know the whole team as real people with a deep commitment to the endowment and its mission of serving Yale University.
A significant qualitative aspect of the Yale Model is not only that manager relationships are unusually long (averaging more than a dozen years)…”