2013 was a phenomenal year for the stock market.  Nothing seemed to derail the rapid ascent of the market– not even a government shutdown or a near default on U.S. debt.  Major indexes in the United States posted solid double digits gains, with the S&P advancing 29.6% and the Dow increasing 26.5% (source: www.yahoo.com/finance).  While many investors have benefited from the recent bull market, the truth is that this rate of growth cannot continue forever.  At some point, stocks are bound to return to some long-term equilibrium growth rate, often via a correction, or pullback (note: this does not necessarily mean a full blown bear market).  We saw a glimpse of this in January, with all major indexes trimming a few percentage points off their previous highs.  With reversing trends comes a great deal of day-to-day volatility, which has the potential to cause undue stress for many investors.  To mitigate some of the inherent risk and volatility in the investment process, many investors, where appropriate, employ a strategy similar to that of the Yale Endowment Model when constructing portfolios.

The Yale Endowment Model (YEM) has gained worldwide recognition as an effective method of diversification that, in theory, reduces risk yet increases the potential for higher returns when compared to more traditional portfolio strategies.  The model is credited to David Swenson, the manager of Yale University’s endowment since 1985.  Under his management, the value of the endowment has increased more than twenty-fold, to $20.8 billion as of June 2013 (source: www.investments.yale.edu).

The underlying goal of the YEM is to reduce excess exposure to traditional asset classes, i.e. domestic stocks and bonds.   Modern Portfolio Theory suggests that, in order to reduce unsystematic risk, it is necessary that investors choose assets with low price movement correlation.  Swenson took that thinking a step further and expanded the endowment portfolio to include low correlated asset classes, not just the assets themselves.  Instead of having a portfolio comprised solely of U.S. stocks and bonds (and cash), the new model also included real estate, private equity, natural resources, foreign equity, and absolute return.  Many of these “alternative investments” are illiquid, meaning that they cannot be easily bought or sold on short notice.  With the understanding that these investments are designed to be held over the course of years or decades, their values tend to not be as strongly impacted by short-term fluctuations in the financial markets.  Of course, it is never possible to reduce all risk.

For some more affluent investors, sometimes that means investing in Direct Participation Programs (DPPs).  DPPs typically have a distinct theme (i.e., oil and gas, commercial real estate, private debt, etc.) and are illiquid.  For smaller investors, the same objectives can be met by investing in mutual funds and ETFs that focus on strategies similar to the alternatives stated above.  In the end, users of the model are ultimately seeking to reduce market risk while still leaving room for positive risk-adjusted returns.

Another unique philosophy observed in the YEM is the use of outside active money managers.  An excerpt from the 2009 Annual Report from Yale Investments states:

“Because superior stock selection provides the most consistent and reliable opportunity for generating excess returns, the University favors managers with exceptional bottom-up fundamental research capabilities. Managers searching for out-of-favor securities often find stocks that are cheap in relation to current fundamental measures such as book value, earnings, or cash flow.” (www.investments.yale.edu)

Many financial advisors employ an array of money managers that they use to meet various portfolio objectives for their clients.  These managers are well positioned to act upon changes taking place in the market; however, no manager is perfect for every economic climate.  Some managers specialize in absolute return strategies, some in emerging markets, some in quantitative directional strategies…there really are no limits.  Many advisors are “managers of managers,” meaning they can recommend hiring or firing an outside money manager if they feel it will put the client in a better position for success in forecasting upcoming market conditions.

There are other aspects that distinguish the Yale Endowment Model, but diversification via alternative assets and the use of outside money managers are by far the most commonly used tools by financial advisors that follow the model.  Again, the idea behind using this model is to reduce some of the risk and volatility of client portfolios when compared to more traditional asset allocations.  This does not mean that your portfolio is safe from negative returns from time to time, but it does mean that, over the long term, your success is drawn from multiple investment sources, some of which do not directly correlate with the U.S. stock market. Again, no portfolio is immune to decline, but there are many reasons why the Yale Endowment Model has performed so well over the past 25+ years.  As the old saying goes, “don’t put all your eggs into one basket.”