The Yale Endowment is one of the most successful institutional investors in the world, averaging an 8.1% annual return over the last decade; through June 2013, Yale’s 25-year average annualized performance topped 13%.
The Yale Endowment’s latest annual letter, however, doesn’t simply discuss its performance but also makes a pointed attack on Warren Buffett’s favorite bit of investment advice, and a strategy the endowment itself does not follow: stick to low-cost index funds.
“In recent years, a broad range of market commentators have decried excessive fees paid to hedge funds and private equity funds,” the endowment writes.
“A couple of years ago, when a New York Times op-ed piece compared the estimated fees earned by Yale’s private equity managers to financial aid distributions from the Endowment, Malcolm Gladwell infamously tweeted, ‘I was going to donate money to Yale. But maybe it makes more sense to mail a check directly to the hedge fund of my choice.’
“More recently, Warren Buffett joined the chorus, suggesting that endowments (among others) suffered from behavioral biases that preclude them from ‘meekly’ investing in index funds and that cause them to believe ‘they deserve something ‘extra’ in investment advice.'”
And Yale’s response is that Buffett and others are wrong about how Yale earns its returns, but not entirely off the mark when it comes to everyone else.
Yale has resources that you don’t
In criticizing a low-cost index approach advocated by Buffett, Yale actually endorses its efficacy.
“[Low-cost passive index strategies] make sense for organizations lacking the resources and capabilities to pursue successful active management programs, a group that arguably includes a substantial majority of endowments and foundations,” Yale writes.
“However, Yale has demonstrated its ability to identify top-tier active managers that consistently generate better-than-market returns, after considering performance fees.”
Simply stated, Yale thinks low-cost index funds are good, they are just not good for Yale.
David Swensen, chief investment officer of the Yale Endowment. (Source: YouTube)
At the heart of the passive vs. active investing debate that has been raging on Wall Street is a version of what financial advisors call the “suitability standard.” And a discussion about whether active (read: expensive) or passive (read: cheap) investments are the right choice for an investor often misses that when it comes to suitability, size does matter.
If, for example, you are an individual trying to save for retirement and have $100,000 in an investment account, you are very unlikely to beat the market and therefore the amount you save on fees will be a major factor in whether this nest egg grows large enough to allow for a multi-decade retirement.
As this chart from Vanguard — which has become the face of low-cost investing — shows, fees can be a huge drag on performance over the years. Over a 30-year period, high fees can take upwards of $100,000 in returns away from an investor.
Source: Vanguard
An institutional investor like Yale, however, will need not be so focused on lowering their gross fees if these fees aren’t going to blended large cap mutual funds but a top venture capital firm’s latest fund.
A top VC firm, for example, provides access to investments that could be worth either $0 or many times your investment, but which ultimately offer an optionality to the portfolio that can only be gained through (relatively) high fees.
And so for the individual investor, paying up for exposure to most equity or fixed-income investments to which this investor’s capital gives it access will likely not justify itself. And this is what sits at the heart of the Buffett line of advice and critique: most investors cannot and will not pick investments or investment managers that will justify their fees over time.
But Yale argues, it does have the ability to pick superior managers and the cost of getting into the far less liquid investment like real estate, venture capital, and private equity that these managers offers will require higher management fees. Its performance backs this up.
Yale endowment growth through time. (Source: Yale Endowment)
Yale has access to investments that you don’t
Yale argues that net return — or what investment vehicles can return to its investors after fees and expenses — is what matters, not how much that vehicle paid to make its investments.
“At its core, Yale’s investment strategy emphasizes long-term active management of equity-oriented, often illiquid assets. Performance-based compensation earned by external, active investment managers is a direct consequence of investment outperformance,” the endowment writes.
“Yale’s strong investment returns, the highest of all colleges and universities over the past twenty and thirty years according to Cambridge Associates, result in external managers earning large performance-based fees. Weak or negative returns would result in low or no performance-related fees, but would be a terrible outcome for the University.”
And with $25.4 billion dollars in assets, Yale has the kind of size that allows it access to investments which are likely to justify their fees.
For example, Yale’s size could allow it avoid publicly-listed shares of a private equity firm like KKR and instead be a limited partner in one of its buyout funds. Over the last decade, Yale’s leveraged buyouts investments, for example, have generated an annual return of 11.2%, topping both its passive and active benchmarks for the sector. The university’s venture capital investments have been even more successful, and it is surely a combination both of Yale’s size — allowing access to most any and all deal — as well as its manager selection that creates the conditions for this success.
Source: Yale Endowment
Yale argues that investing simply based on its lowest-fee option would’ve led to significant underperformance relative to itself over the last several decades.
Had the endowment invested in a classic portfolio of 60% stocks and 40% bonds over the last 30 years, it would have had $28 billion less to give to the university over that time. Even compared to Buffett’s preferred portfolio of 90% stocks and 10% bonds, the endowment has made more than $26 billion available to the university that otherwise would not have been.
Trouble at Harvard
Yale’s critique of emphasizing lower fees over all else comes at a time when the university’s closest rival — Harvard — has seen its own endowment struggle and come under fire.
In September 2016, an article in the Harvard Crimson criticized Harvard’s endowment and noted its recent underperformance relative to Yale. Harvard’s endowment returns have trailed Yale in all but two of the last ten years. “Yale’s winning streak in financial markets is almost as dominant as Harvard’s on the gridiron,” Crimson staffers Andrew Duehern and Daphne Thompson wrote.
An October 2016 report from Bloomberg cited a report on Harvard’s endowment published by McKinsey which harshly criticized practices at Harvard.
In January, half of the endowment fund’s 230 employees were laid off and Harvard said more money would be transferred to outside firms. As the Boston Globe noted in reporting the layoffs, Harvard’s 5.7% annualized return through its 2015 fiscal year trailed a 60/40 portfolio of stocks and bonds, which returned 6.9% over the same period.
And as Ben Carlson, director of institutional asset management at Ritholtz Wealth Management, noted on Sunday, it seems likely Yale’s attack on passive management has less to do with investing styles and more to do with heading off fee-related issues raised by members of the Yale community.
