23 June 2022

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To diversify or not to diversify

Author: Luigi Campopiano

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David Swensen was a large American investor, manager of the Yale University investment fund that guarantees extra money for the management of the university. American universities survive thanks to donations from wealthy benefactors, which are grouped into an endowment that is in turn invested in funds. The success of these investments guarantees the future of academic institutions. Swensen began managing it in 1985 and continued until his death increasing its endowment from about $ 1 billion to about $ 30 when he died (not counting the sums taken in the meantime for university buildings or services) with a average yield of more than 12% a year (he was also called "the $ 8 billion Yale man" for making nearly $ 8 billion in the college endowment from 1985 to 2005. According to the former president of Yale, economist Richard Levin, Swensen's "contribution" to Yale was greater than the sum of all donations made in more than two decades).

But how did he achieve these results? It was common opinion at the time that university funds should concentrate their investments in classic assets such as bonds and stocks. Swensen, a follower of Markowitz's portfolio theory (Nobel Prize in Economics in 1990), decided to implement the advantages of diversification and worked while managing him from a portfolio perspective, rather than in the search for returns in each individual investment.

Swensen noted another important thing (perhaps what was the key to his success the most): the fund's time horizon was the very long term and this allowed it to insert asset classes hitherto neglected as alternative investments, replacing them. to asset classes such as bonds that had lower yields (provided, however, that these had low correlations with equities). He was thus able to bring home more consistent returns without too many additional risks. An example are REITs: real estate companies that finance the construction of properties which they then rent out. The profit of these companies comes from periodic rents. Assets characterized by less liquidity such as REITs tend to be priced less efficiently and in this way offer the manager the opportunity to take advantage of market inefficiencies and maximize profits.

The Yale investor model consists of dividing a portfolio into five or six more or less equal parts and investing each in a different asset class. At the heart of this model is a broad diversification and an orientation towards stocks and alternative investments, avoiding asset classes with low expected returns such as bonds and commodities.

Revolutionary for the time was the recognition that liquidity is a bad thing to avoid rather than a good thing to look for, as it comes at a heavy price in the form of lower yields. It identifies core and non-core asset classes, expressing the belief that non-core ones are sub-optimal choices (eg. High Yield bonds and commodities for correlation with equities and poor inflation protection).

Swensen was not a seer: the result was achieved by passing from significant and prolonged declines over time (-45% in 2008, taking about 18 months to recover the decline; -16% during the COVID health crisis). For Swensen, the focus of the activity was not the short term, but the construction of an efficient asset allocation: he had very clear his goal (to increase the endowment so as to finance a much greater percentage of Yale's annual expenses) and time horizon (no short-term reversal could scare him).