Time to question if the Yale model is still worth copying

When reviewing the performance of its overall portfolio, Yale University’s endowment has much to be pleased about.

This week, New Haven, Connecticut-based university reported an annual return of 12.3 percent and an increase in its endowment value to $29.4 billion from $27.2 billion in 2017.

The university, which had the second-largest US endowment at $25.5 billion at the end of fiscal-year 2017, according to a Congressional Research Service report released in May, has consistently reported higher overall returns than its peers.

The endowment reported an annualized return of 6.6 percent during a 10-year period ending June 30, 2017. That return, net of fees, puts the endowment’s performance in the top 4 percent of colleges and universities, according to its 2017 investment report. And – notable for PERE readers – its success in investing heavily in alternatives, which it started doing nearly 30 years ago, has resulted in other university endowments adopting the same tactic.

However, not all universities that switched to the so-called Yale model have achieved comparable success. Harvard, the highest profile university to do so, has struggled with its investment performance over the last decade. It reported a 2 percent loss in 2016 and an 8.1 percent return in 2017, which Harvard Management’s chief executive Narv Narvekar reportedly called “disappointing.” The 10 percent reported this year was an improvement, but it still lagged behind Ivy League peers MIT, University of Pennsylvania and Yale, which reported 13.5 percent, 12.9 percent and 12.3 percent, respectively.

This relatively disappointing performance might have something to do with the type of managers Harvard is using. Certainly, former students believe so. In a February letter to the university, a group of Harvard alumni suggested the endowment was losing billions of dollars by investing in active management strategies rather than passive strategies that track the S&P 500 index. They expressed concern over the active management fees and argued the endowment would have grown faster if invested just in the S&P 500. The group pointed out the endowment would have returned 40 percent more if it invested wholly in the S&P 500 from 2009 to 2016. Indeed, none of the top performing university endowments surpassed the 14.4 percent returned by the S&P 500, for this fiscal year, ending June 30.

Harvard is not considering reducing its exposure to real estate specifically, but is deliberating whether accessing assets via passive strategies rather than actively managed hedge funds makes more cost-effective sense, according to media reports. While the alumni cited hedge funds specifically, the argument can be applied to the endowment’s overall use of managers that employ active strategies – and PERE would consider private real estate funds to be among the asset classes that are traditionally actively managed.

Actively managed funds tend to charge higher annual fees than index-based passive strategies. According to a Morgan Stanley report, actively managed domestic large, mid and small-cap funds reported average dollar-weighted expense ratios of 0.99 percent, 1.17 percent and 1.24 percent, respectively, as of June 2015. In comparison, the index version of the funds reported 0.14 percent, 0.17 percent and 0.22 percent, in the same period.

In the case of Yale, it is worth noting real estate was one of the worst-performing asset classes for the endowment, and the only one to lag both its passive and active benchmarks during the 10-year period spanning June 30, 2007 to June 30, 2017. In contrast, absolute return, domestic equity, fixed income, foreign equity natural resources and venture capital all surpassed both active and passive benchmarks over the same period. Leveraged buyouts performed in line with the Cambridge Associates’ pool of buyout and growth equity managers and outperformed the passive benchmark over the 10 years.

Meanwhile, the Ivy League university has continued to reduce its allocation targets to the asset, and plans to decrease the percentage of real estate in its overall portfolio in fiscal-year 2019 to 9.5 percent from 10 percent the year prior. Arguably, Yale too might have reason to weigh passive strategies, at least when it comes to its underperforming real estate investments.

Yale declined to disclose real estate specific fees and performance for this past year.

Of course, diversification and the business cycle backdrop must be considered when constructing the optimal portfolio. However, given the recent performance of some university endowments, it is reporting like this that should prompt the re-evaluation of the thesis that actively managed investments in real estate are worth the fees.

Contact the author at lisa.f@peimedia.com.