Written by LGT Crestone Senior Asset Allocation Specialist Matthew Tan with contributions from LGT Crestone Deputy Chief Investment Officer Kevin Wan Lum
In 1985, a fresh-faced former investment banker named David Swensen became the manager of Yale University’s endowment fund. Over his multi-decade tenure, Swensen undertook a fundamental review and restructuring of the Yale endowment’s over-arching philosophy and investment strategy and pioneered a new approach to investing that is still emulated to this day—the Yale or endowment model.
The popularity of this approach stems from its indisputable results: from 1985 to Swensen’s passing in 2021, Yale’s endowment returned 13.7% per annum, growing its initial pool of available assets from USD 1 billion to over USD 40 billion, all while disbursing roughly 5% a year to support the mission of Yale University. Advances in investment knowledge over the years have further enhanced Swensen’s initial philosophy, and its influences can be clearly traced in the ‘total portfolio approach’ that some of the largest and most sophisticated investors in the world apply today.
In this Observations piece, we outline some of the key organisational and investment principles underpinning the endowment model. We detail our approach to endowment investing, including a total portfolio framework that underpins our entire investment strategy process. We also present some of the key benefits and considerations in applying this approach to building long-term investment portfolios.
There is much more to endowment-style investing than simply allocating large amounts of capital to alternative assets.
Commentary around endowment or total portfolio investing tends to jump straight to the investment and portfolio construction aspect. However, this skips what we believe are two cornerstone principles that underpin the entire approach. Before embarking on the journey, investors should have a strong understanding of their time horizon and a strong understanding of the value of liquidity.
Yale endowment’s case gives us a powerful example of this. At over 300 years old, Yale University and its endowment have an effectively perpetual time horizon and its stakeholders can measure their success over decades and across generations. This allows it to look through short-term market volatility and invest for the long term.
The second key pillar revolves around understanding the value of liquidity, both internally and externally. In Yale’s case, this involved extensive internal analysis and discussions with key stakeholders to clarify expectations around endowment disbursements (the aforementioned 5% spending target). Having an agreed-upon framework and clear governance around internal liquidity requirements allows investors to account for this in portfolio design and leverage the value of any excess liquidity to the external world.
This ‘illiquidity premium’ is a key return driver of the alternative investments (private markets, real assets, and hedge funds) that typically make up large portions of endowment-style portfolios. In exchange for committing capital for extended periods, investors can broaden their opportunity set and demand (or, at least, strive to achieve) a substantial return premium over and above publicly-traded markets. This is at the heart of the endowment model. Swensen’s argument is that illiquidity, when effectively managed, can provide a distinct advantage.
While not widely heralded, this combination of adopting a multi-generational investment horizon and holistically understanding the value of liquidity are key organisational pillars underlying the success of Yale and other endowment-style investors.
Two internal principles cornerstone the best long-term investors—a multi- generational time horizon and a strong grasp of the value of liquidity.
The over-arching philosophies we have outlined above are no easy feat to embed into an organisation or even an individual or family. It can take years to get key stakeholders across the line in truly adopting a multi-generational time horizon, and to think about liquidity not as a precious resource to be jealously guarded, but as a precious resource to be spent wisely to improve long-term outcomes.
Only once this internal hurdle is surpassed can the investment challenge truly begin. While large allocations to alternative assets are a headline feature of endowment-style portfolios, we think investors might be jumping the gun by simply allocating to illiquid investments without having a proper plan.
Rather, we believe investors are best served by adopting a sound framework for understanding and assessing the full investment universe and, consequently, building a thoughtful total portfolio that moves away from any existing biases and best utilises the opportunity set available to them. For example, this could include moving away from a home bias or familiar investments.
At LGT Crestone, our framework for tackling this rests on a proprietary multi-asset risk factor approach, as detailed in our June 2024 Observations piece Splitting the investment atom: Asset allocation through a risk factor lens. In a nutshell, our approach rests on the following principles:
Starting from these first principles gives us a fundamental rationale for taking on the illiquidity risk of alternative assets like private markets, real assets, and hedge funds, which typically don’t form part of many portfolios. As illustrated in the simplified table below, they provide investors with access to additional sources of return premia not available in publicly-traded markets, as well as a strong exposure to manager skill, also known as alpha.
A holistic multi- asset framework illuminates the attraction of alternative assets— they provide access to a wider total investment opportunity set.
It is important to note that, while we believe this framework (or a similar multi-asset construct) forms a necessary pre-requisite for constructing alternatives-heavy endowment-style portfolios, it is not exclusive to that domain. We are also of the strong belief that all investors can benefit from applying this investment discipline to their portfolio design. Even a portfolio with a conservative risk profile, which has a high need for liquidity and capital preservation, can be more thoughtfully constructed by having a deeper, more fundamental understanding of the underlying risk and return factors that it is exposed to. This is why our proprietary multi-asset risk factor framework forms the basis of all the strategic asset allocation and investment strategy work we do across our broad and diverse client base.
Armed with this holistic multi-asset lens, we can more easily understand the prevalence of alternative assets in long-term endowment-style portfolios. As summarised in the table below, a larger allocation to alternatives (and their more wide-ranging exposure to risk and return premia) improves the forward- looking return and risk metrics of an endowment portfolio compared to a more traditional growth- oriented portfolio.
We believe this total portfolio approach to investment strategy is universally applicable to all investors.
Almost 40 years after David Swensen began his revolution at Yale, the body of evidence is backing his approach. We have already recounted the 13.7% annualised growth in Yale’s endowment fund. Other sophisticated investors who adopted this approach can boast similar strong long-term performance. From 2006 to June 2024, the Future Fund has compounded at a 7.7% annualised growth rate. In doing so, it has grown an initial contribution of AUD 60.5 billion into a valuable sovereign wealth store of AUD 224.9 billion. The average US endowment has also achieved similar annualised returns of around 7.3% over the past 20 years to 2023.
Importantly, these equity-like returns have been achieved with low levels of realised volatility. The Future Fund’s annualised volatility of returns since 2006 was around 4.7%. This compares extremely favourably to the 14.3% annualised volatility of the S&P/ASX 200 Index of Australian shares over the same period. It also illustrates a key characteristic of the endowment model—that it has the ability to generate strong long-term returns at a lower level of overall portfolio risk, providing a smoother journey for investors.
An important caveat to note with the historical evidence is that because of their heavy allocation to illiquid assets, endowment-style funds do tend to lag when listed equity markets are rallying. Two recent examples of this are the equity market rallies in 2021 and 2023. Despite this, the same funds do tend to preserve capital better in down markets, such as 2022.
Endowment-style portfolios have stood the test of time.
One of the key trade-offs with alternatives-heavy endowment-style investing is the potentially lengthy pace of deployment and the low liquidity that is a natural characteristic of these types of assets. These considerations can be particularly important for smaller institutional investors (such as charities and other not-for-profit entities) or sophisticated individual or family investors.
However, the industry has evolved significantly over the past 10 years. We wrote extensively about these changes in our May 2024 CIO monthly entitled A new breed of private markets: Accessing liquidity through evergreen funds. In a nutshell, the rise of evergreen vehicles across the suite of alternative assets has gone a long way towards addressing both inbound and outbound liquidity concerns.
Evergreen or open-ended vehicles are available to buy and own on a perpetual basis, and typically offer quarterly or even monthly liquidity terms (for reasonable redemption requests). This is a drastic improvement on the sometimes multi-year lock-up periods of closed-end funds. In addition, the perpetual nature of these funds means that an investor buying into these funds can gain immediate access to a diversified portfolio of alternative assets at a relatively modest cost compared with a truly locked-up investment. This stands again in stark contrast to closed-end funds, which may take many years of capital calls to achieve a fully invested position, and require investors to actively manage and recycle distributions to maintain target allocations.
An evolving ecosystem is making it easier for smaller investors to construct robust and diversified alternatives portfolios.
One challenge with investing in alternatives that has intensified over the years is the importance of manager selection and active management. Because of the relatively opaque and idiosyncratic nature of alternative assets, the potential for outperformance (and underperformance) in alternatives is far greater than in traditional asset classes. Analysis from JP Morgan Asset Management shows that manager return dispersion within alternative asset classes can be an order of magnitude higher than for traditional asset classes. This makes it incredibly important to be able to identify and access the best managers.
It is vitally important to ensure you partner with the right managers.
There are two answers to this question. On a conceptual basis, as we have noted, we believe a total portfolio approach to investing is applicable to all investors, regardless of their time horizon, investment objectives, or risk tolerance. Adopting a more thoughtful and holistic approach to understanding the underlying risk and return drivers across asset classes allows investors to better align their investment strategy with their ultimate objectives. We think it also gives investors of all stripes a better sense of what could go wrong and what could go right with their portfolios, helping identify potential problem areas in advance and encouraging investment discipline in times of market stress.
In terms of an alternatives-forward, endowment-style portfolio, we encourage investors to first interrogate themselves and gain a strong understanding of their ultimate investment time horizon, liquidity requirements, and tolerance for illiquidity in return for potentially greater risk-adjusted returns. We think it makes sense for investors with a long (ideally, multi-generational) time horizon, consistent and predictable (or flexible) liquidity requirements, and a tolerance for investment complexity and illiquidity to consider thoughtfully emulating the example of some of the largest and most sophisticated investors in the world, such as the Future Fund.
The historical record and our forward-looking analysis both point to the potential for these portfolios to deliver more consistent, reliable, and superior risk-adjusted returns over the long term, while the rise of evergreen funds has improved the availability and practicality of alternative assets for a wider range of institutional and sophisticated investors.
A thorough understanding of their internal time horizon and liquidity tolerance can help investors decide if an endowment-style approach is right for them.
Yale University’s endowment and its large allocation to alternative assets have been the standard bearer for endowment-style investing and a worthy subject of emulation among long-term focussed institutional and sophisticated investors for decades. However, we believe investors tempted to simply dive straight into allocating large sums of money to illiquid investments are missing a trick. We think the real secret behind Yale’s success lies within. Notably, it has a thorough grasp of its investment time horizon and the value of liquidity—both internally and externally.
Armed with this knowledge, we encourage all investors to consider whether their time horizon, liquidity requirements, and tolerance for complexity might enable them to adopt the compelling benefits of such an approach.
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