Is The Yale Portfolio In The Investing Ivy League?

Is The Yale Portfolio In The Investing Ivy League?
Stéphane Renevier, CFA

about 2 years ago5 mins

  • The retail-adapted Yale model emphasizes the right asset mix, and making sure you don’t deviate too much by rebalancing periodically.

  • The asset mix consists of 50% stocks (30% to domestic, 15% to international, and 5% to emerging markets), 20% REITs, 15% T-bonds, and 15% TIPS

  • If you can handle a long-term horizon, risk, and a passive approach, the Yale portfolio could be an interesting alternative to the 60/40.

The retail-adapted Yale model emphasizes the right asset mix, and making sure you don’t deviate too much by rebalancing periodically.

The asset mix consists of 50% stocks (30% to domestic, 15% to international, and 5% to emerging markets), 20% REITs, 15% T-bonds, and 15% TIPS

If you can handle a long-term horizon, risk, and a passive approach, the Yale portfolio could be an interesting alternative to the 60/40.

In the space of three decades, David Swensen grew Yale’s university endowment fund from $1 billion to $30 billion. His investing approach – known as the Yale portfolio – inspired generations of investors, and established itself as a go-to for institutions around the world. But it’s not just professionals who can use it: you can too. Here’s how.

What is the Yale Model?

Swensen got famous for his punchy allocation to risky assets, his unshakeable belief in diversification, his focus on long-term investments, and his preference for alternative assets like venture capital (VC) and hedge funds. Not all the tools he had at his disposal are available to retail investors, true, but Swensen himself wrote an entire book on how individual investors could benefit from his approach.

In his book, Swensen explains that investors have three ways to make money: asset allocation (selecting the asset mix you should target over the long term), security selection (picking the individual stocks that will outperform the market), and market timing (when exactly to buy and sell).

In his view, retail investors should focus all their attention on asset allocation, which explains a whopping 90% of returns from the portfolio. The relatively minor importance of security selection and market timing – not to mention the fact that they require skills and resources individual investors simply don’t have – means investors like you and me are better off avoiding them altogether. Concentrate your efforts instead on selecting the best mix of assets.

What is the best mix of assets?

The right asset allocation, in Swensen’s view, is stock-centric but diversified, takes into account personal circumstances, and must only contain assets that are liquid enough and can generate long-term positive returns without the need for active management. So stocks, real estate, and treasury bonds are in; commodities, hedge-funds, VC, and currencies are out (all three of which fail on the latter requirement).

This is what the Yale Model portfolio – adapted to retail investors – looks like:

Yale Model portfolio adapted to retail investors. Source: Finimize
Yale Model portfolio adapted to retail investors. Source: Finimize

Stocks receive half the total allocation, since they have the highest historical (and expected) long-term returns of the assets available to you. Domestic stocks should form the core of your stocks holdings, but you should also include international and emerging markets stocks – albeit with a lower weight due to their higher risk – for the diversification benefits they provide.

Real estate is the second-biggest component, with a weight of 20%. Swensen likes real estate investment trusts (REITs) both because of their attractive long-term returns and the inflation protection they provide. In a crisis, they might go down along with stocks, but they provide a diversified source of returns in every other environment – and certainly over the long term.

US treasury bonds (i.e. government bonds) are there mostly to add defensiveness to the portfolio. “T-bonds” are unlikely to return as much as stocks and real estate, but they should help make returns less volatile when markets are rising and reduce the impact on your portfolio when they’re on the way down. Swensen excludes corporate bonds and other fixed-income instruments, arguing that they provide neither the defensiveness of treasury bonds nor the attractive returns of stocks.

Finally, treasury-inflation protected securities (TIPS) are added to the mix to provide an additional layer of diversification and some extra protection against inflation. If inflation is high enough to hurt both stocks and T-bonds, TIPS should help soften the blow.

Now it’s important to remember that this representative portfolio is just a starting point, and Swensen emphasizes that individual investors should adapt the initial asset mix to their personal circumstances. Homeowners, for example, should probably reduce the weight of REITS, while business owners should reduce their allocation to stocks. Time horizon matters too: if your horizon is, say, less than eight years, you should keep a significant proportion of your portfolio in cash – arguably around 40%, leaving 60% for the Yale portfolio.

Swensen argues that periodically rebalancing your portfolio is another crucial factor. By periodically rebalancing your asset mix to fit your target allocation, you’ll essentially buy more when prices are lower and less when they’re higher, improving your entry prices and long-term returns. That should also mean you’re not over-invested at the top of the market, and help make sure you’re buying in when prices reach a bottom. It also means you won’t have to wonder what to do when markets move sharply: just mechanically execute your rebalancing plan.

Is it the right strategy for you?

The retail-adapted Yale Model is a good fit if you can handle:

  • A long-term investment horizon (ideally 10 years or more)
  • Reasonable returns (you’ll probably make less than you would if you invested it all in stocks)
  • Risk (the high allocation to risky assets means you’ll suffer significant losses when markets turn sour, which they will if you’re investing for long enough)
  • A predominantly passive approach (no fancy trades, no security selection, no exotic assets)
  • Being a contrarian (rebalancing will force you to buy assets that are falling and sell the ones performing well)

How can you replicate the Yale portfolio?

Arguably the most efficient way of implementing the approach in your portfolio is by using exchange-traded funds (ETFs). I’ve researched cheap, liquid, and well-diversified candidates for each component, and I’ve added the tickers you should use to try the strategy for yourself using portfoliovisualizer’s backtesting tool (those tickers go further back than the ones you need for implementation).

How to replicate the Yale portfolio. Source: Finimize
How to replicate the Yale portfolio. Source: Finimize

Let’s face it, the unrestricted Yale model – the one Swensen ran so successfully at the college – has a lot more to show for itself than the one adapted for individual investors.

Swensen added multiple layers of returns by investing in private illiquid assets, selecting the right hedge funds and VC managers, and constantly adapting his approach to market conditions. But if you’re worried inflation could break the 60/40 portfolio or if you’re looking to diversify your expensive US stock-centric portfolio, I still think the retail-adapted version is an interesting alternative.

Finimize

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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