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Lessons from the Yale Endowment
Every year Yale produces an excellent report on their endowment fund (found here). This Endowment has arguably been one of the best performing investment pools over a sustained period, so we therefore take stock of their views and processes on an annual basis, and see if there is any relevance for Seed or our clients.
The definition of a typical endowment is a pool of investments bequeathed to an institution to provide an income stream (for a stated cause) into perpetuity. An endowment typically needs to provide a level of income to the institution while retaining real purchasing power.
The first striking quality that is evident is the Endowment’s extremely long term investment horizon (they discuss an investment horizon measured in decades or even centuries). Clearly the nature of an Endowment fund requires the long term horizon, but it is pleasing to see that the managers are matching this long term horizon with long term decisions. Yale’s long term horizon has enabled them to generate superior returns.
Investors that take a longer term horizon can invest a greater portion of their assets into more volatile growth assets than those with a short term horizon. Over short periods long term investors could have worse performance than short term investors, but as your investment horizon increases the likelihood of the short term investor outperforming the long term investor decreases.
Through gifts, Yale has been able to grow the size of the Endowment far quicker than through natural market growth. The difference in amounts in the chart below is a result not only of the additional gifts to the endowment, but also growth on the gifts.
It is important for investors to consistently add to their investments (while they are still generating income). While the above example is an extreme illustration, the difference between an investor who purely reinvests an early pension payout and one who continues to save for retirement (in addition to reinvesting the payout) will be significant over a 30 year period.
The annual withdrawal (drawdown) percentage from one’s pool of investments will give a good indication of the longevity that can be expected from that pool. The lower the drawdown rate, the longer one can expect the portfolio to last and vice versa. Since the Endowment should retain its purchasing power into perpetuity it will typically have a lower drawdown than most investors – who can eat into their principle.
Yale has recently set their drawdown limits at 4.5% and 6% of Endowment assets. Any drawdown below this should result in real growth of the investment portfolio, and higher than 6%, on a sustained basis, will most likely result in the portfolio losing purchasing power. Investors should attempt, where possible, to limit the rate of the drawdown from their portfolios.
Setting a targeted drawdown rate is important, but investors need a large degree of certainty in their income levels. Large fluctuations in portfolio value (notably decreases) coupled with a fixed drawdown rate can result in an unpleasant experience for investors dependant on income from their portfolio. The Endowment therefore applies a smoothing method to its distributions which gives Yale relative certainty in the amount of income they will receive from year to year.
While the drawdown percentage is an important metric, income stability is arguably more important. Investors need to balance getting a dependable income from their investments while not eroding their capital aggressively. By blending the prior year’s income with a percentage of current investment size, investors will be able to blend these two (often competing) needs. The Yale Endowment pays out 80% of last year’s income (adjusted for inflation) plus 5.25% of the Endowment’s current market value. This gives the university a smooth income profile without putting undue pressure on the real value of the Endowment.
An important part of any portfolio is to have some sort of diversification. In this way one is able to reduce the idiosyncratic risks inherent in specific asset classes/securities. Yale’s Endowment targets asset class weightings of between 4% and 33% across 6 asset classes. Of these 6 asset classes, 5 can be considered as growth assets (i.e. produce significant real growth over time) and the lone ‘diversifier’ is US Bonds – with a target of only 4%. Interestingly they only target a weighting of 11% to traditional US marketable securities (i.e. US Equity and Bonds)
At Seed we invest the majority of medium to high risk clients across a broad range of assets that we expect to generate positive real returns. Ideally there is a low correlation between the performances of the asset classes which will mitigate, to a certain extent, the risk of large capital losses. Asset classes like cash and bonds have a tactical place to preserve capital in the event that expected returns from the growth assets is low – there will also be isolated times where these assets will offer good prospective returns, which the manager needs to take advantage of. When looking at valuations we believe that an investment’s domicile isn’t important. We seek to find undervalued assets irrespective of their domicile – regulations clearly limit our ability to implement these ideas across some of our portfolios.
There are many other lessons that we have taken from this report, and we will most likely review some of them in the future. Chief among the lessons is that nothing in investments is static, from alterations in optimal asset allocation to changes in drawdown level and methods.
At Seed we realise that this is the case and while our investment principles and processes are unlikely to change we will look to continually improve them on an incremental basis. Equally it is important for investors to regularly assess their portfolio versus their goals and aspirations – ensuring there is a decent fit is important to avoid disappointment.
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