Yale's portfolio is structured using a combination of academic theory and informed market judgment. The theoretical framework relies on mean-variance analysis, an approach developed by Nobel laureates James Tobin and Harry Markowitz, both of whom conducted work on this important portfolio management tool at Yale’s Cowles Foundation. Using statistical techniques to combine expected returns, variances, and covariances of investment assets, Yale employs mean-variance analysis to estimate expected risk and return profiles of various asset allocation alternatives and to test sensitivity of results to changes in input assumptions.
Because investment management involves as much art as science, qualitative considerations play an extremely important role in portfolio decisions. The definition of an asset class is quite subjective, requiring precise distinctions where none exist. Returns and correlations are difficult to forecast. Historical data provide a guide, but must be modified to recognize structural changes and compensate for anomalous periods. Quantitative measures have difficulty incorporating factors such as market liquidity or the influence of significant, low-probability events. In spite of the operational challenges, the rigor required in conducting mean-variance analysis brings an important element of discipline to the asset allocation process.
Over the past 25 years, Yale dramatically reduced the Endowment's dependence on domestic marketable securities by reallocating assets to nontraditional asset classes. In 1990, over seven-tenths of the Endowment was committed to U.S. stocks, bonds, and cash. Today, domestic marketable securities account for approximately one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment.
The heavy allocation to non-traditional asset classes stems from their return potential and diversifying power. Today's actual and target portfolios have significantly higher expected returns and lower volatility than the 1990 portfolio. Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. The Endowment's long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.
Supporting the University
The Endowment spending policy, which allocates Endowment earnings to operations, balances the competing objectives of supporting today’s scholars with annual spending distributions while promising to maintain support for generations to come. The spending policy manages the trade-off between these two objectives by using a long term spending rate target combined with a smoothing rule, which adjusts spending in any given year gradually in response to changes in Endowment market value.
Using the metrics of stable operating budget support and purchasing power preservation, the Endowment demonstrated substantial improvement over the past twenty years. As Yale improved diversification by allocating more of the Endowment to the alternative asset classes of absolute return, private equity, and real assets, risks plummeted for both spending and purchasing power degradation.
In 1990, when alternative asset classes accounted for only 15 percent of the Endowment, Yale faced a 40 percent chance of a disruptive spending drop, in which real spending drops by 10 percent over five years, and a 49 percent chance of purchasing power impairment, in which real Endowment values fall by 50 percent over fifty years. By 2000, when absolute return, private equity, and real assets accounted for nearly 60 percent of the Endowment, disruptive spending drop risk fell to 31 percent and purchasing power impairment risk declined to 27 percent.