How to Beat Other Investors

For a number of years, institutional investors have been cheerleaders for what is known as the “Yale model” of investing. Generally, this involves choosing asset classes other than basic stocks and bonds and also changing that allocation periodically to reflect changes in markets and the economy. The latest research, however, indicates that the Yale model isn’t what it appears to be. First, a lot of Yale’s outperformance is attributable to investments not available to regular investors, especially private equity. The returns from private equity aren’t what they appear to be, because they aren’t calculated the same way that returns from basic asset classes are.

Second, and more important, Yale’s real advantage came from its ability (or luck) in selecting asset managers that do better than their benchmarks and than their median competitor. So, if you want to earn superior returns, focus somewhat on asset allocation but also focus on picking active managers that consistently will generate superior returns. See details here.

Building a hypothetical model to replicate the returns, Dr Philappou is able to reproduce a from-inception IRR of 30 per cent, but as he concludes:

It is evident that the 30 per cent that is so often cited is unlikely to be anywhere close to the true rate of return. That true rate of return could be anywhere from single digit to maybe 20 per cent. Hence making Yale Endowment a model based on what is in their annual report is rather premature.

Now we expect that a response to this will be: of course a 30 per cent a year return is unrealistic, but there is still value to extensive diversification in alternatives. Yale has performed reasonably well since 2000.

What this line of argument, and the many reports advocating the endowment model tend to gloss over, is the central fact of Yale’s performance: it is only marginally about asset allocation. Yale has actually been unusually and exceptionally good at picking investment managers.