Yale University recently released their 2017 annual report for the Yale Endowment, and while normally this would pass without much notice they appear to have made a few waves by continuing an ongoing feud with Warren Buffett. In his 2016 investor letter, Buffett criticized how university endowments pursue market-beating returns through active management and suggested they might be better off investing in index funds instead. Of course the CEO of Berkshire Hathaway follows none of that advice himself, but he has consistently said that most investors including his own wife would be better off with a low-fee S&P500 index fund rather than paying expensive active managers so it’s certainly not out of character. In any case, Yale appears to have taken that a little personally and they dedicated an entire section in their annual report to dispute his claim and promote their own success.
To support their belief in active management, Yale provides data that proves their managers have exceeded stock market returns for the past two decades. For example, over the past 20 years they posted an average return of 12.1% versus 7.5% for the total US stock market which gives them confidence to say they “crush the returns produced by US stocks”. Ending with a flourish, they conclude that “not only has the model worked for the past two decades, it will work for decades to come.”
That’s bold. And it caused a bit of a tizzy in the financial blogosphere with several stories on the topic. So are they right?
The thing that first got my attention was not the flowery language or beef with Buffett (who has a habit of making index bets with fund managers), but the exclusive choice of the most recent 20-year average for comparison purposes. As any regular reader of Portfolio Charts already knows, long-term averages hide a lot of important information. Luckily, I have a lot of unique tools for evaluating these types of claims from a timeframe-independent perspective. So I took the time to extract the approximate annual returns* of the Yale Endowment back to 1970 from their annual reports so that we can put it through its paces in the calculators.
How did the Yale Endowment perform relative to the total US stock market not just in the last 20 years but in every investing period since 1970? Let’s look at it from a few different perspectives. Note that all of these charts adjust the returns for inflation.
Here you can already find the first major issue. When you look at the past 48 years instead of the past 20, a simple US stock market index outperformed the Yale Endowment by about 0.2% a year. To be fair, though, Yale did do a much better job of managing downside risk and overall portfolio volatility so that average return doesn’t tell the whole story. So let’s look more closely at the downside performance.
Yale definitely did a good job of avoiding deep drawdowns, and the Ulcer index (a composite measure of investing pain accounting for the depth and length of all drawdowns) is notably better. Given similar average returns, a portfolio that minimizes drawdowns does usually have higher compound returns. But I also don’t remember seeing a reference to a 13-year extended loss in the annual report. When did that happen?
Here you can start to see the problem with that recent 20-year average. The Yale Endowment truly did a terrific job of avoiding the stock market doldrums in the decade starting in 2000, but comparing returns exclusively from 1998-2017 just happens to coincide with one of the single most advantageous periods to make you look good compared to the stock market. Flash back to the 1970s or forward to the most recent decade and the comparison doesn’t look so rosy. Any 20-year period prior to 2000 would have come up in favor of stocks, and the most recent 10-year period also favors stocks by 2.2% a year.
In fact, lets get right down to it. Looking at every rolling timeframe since 1970, here’s how often the Yale Endowment beat the total US stock market depending on the length of the timeframe you use:
- 1 year: 50% of the time
- 5 years: 48% of the time
- 10 years: 46% of the time
- 15 years: 52% of the time
- 20 years: 62% of the time
For most timeframes up to 15 years, it was basically a crapshoot as to whether Yale beat the performance of the stock market. And it starts to get a little better at 20 years mostly because of how the periods overlap — look at the above heat maps long enough and you’ll realize that most of the outperformance of those longer averages is attributable to how it avoided the early 2000s market crash. That’s certainly admirable and desirable, but it’s anyone’s guess if it will work the same way the next time markets falter.
Now before you think I’m being a bit harsh on Yale, let’s give them their due and point out that Buffett over-simplifies things as well.
As I mentioned earlier, investing is not simply about averages and the volatility has a major effect on your compound account values. By reducing volatility and overall drawdowns, Yale has indeed posted better overall compound return distributions than the simple stock market alternative. It’s misleading to select only one timeframe to claim superiority and there will be plenty of chances for Buffett to do the same, but Yale is onto something with how risk management can indeed improve portfolio performance. This takes on extra importance with the entire purpose of an endowment to provide consistent sustainable income over time. Just like a retirement portfolio, in fact.
And here you can start to see where it sometimes makes a lot of sense NOT to simply put all of your money in stocks. College endowments manage their finances in a similar way that retirees use perpetual withdrawal rates to provide consistent income even in the worst investing periods without reducing the overall principal of the portfolio. The perpetual rate for the Yale Endowment was actually a little higher than that of the stock market and it also performed a lot better in recent years that are starting to look less desirable for stocks. So in the context of serving its stated function and safely supporting long-term income for the school, the Yale Endowment has done its job just fine and I have no problem with them not just putting the entire balance in a stock index. Responsible investing is about a lot more than comparing simple averages.
Still, I’m not going to let Yale off that easy.
When picking an index portfolio to compare themselves against, the total stock market or Classic 60-40 portfolios that they reference in their report are convenient targets but they sidestep the obvious choice. The Chief Investment Officer of the Yale Endowment is a guy named David Swensen who wrote a terrific book on investing where he recommends a passive index fund asset allocation appropriate for everyday investors that uses some of the same thought processes as the Yale Endowment. It’s called the Swensen Portfolio, and it has an entire section here on Portfolio Charts.
So let’s take a look at a rare opportunity to study how active and passive management compare when they originate from the same portfolio manager.
The Yale portfolio had a higher average return but the Swensen portfolio had the same volatility.
The Swensen portfolio had deeper max drawdowns, but they were also shorter with a lower Ulcer index.
The Yale portfolio had higher returns over many periods, but the Swensen portfolio did much better in the 1970’s.
Both portfolios had very similar baseline returns, while the Yale portfolio had greater upside.
Believe it or not, the Swensen portfolio actually had superior withdrawal rates to the professionally run endowment.
Now I’m not going to go so far as to say Yale would be better off with the passive Swensen portfolio rather than the active variety, as some readers may note that Swensen took over the endowment in 1985 and performance notably picked up once he did. Responsibly managing billions is also a lot more complicated than managing an individual retirement account, so it would be disingenuous to conflate the two situations. But in my opinion the passive Swensen portfolio competes quite well with the active Yale Endowment, and I think there are some important lessons here for normal investors like you and me.
While Buffett has a point that index investing is a lot more competitive with active management than the guys pulling the expensive professional strings want you to believe, I think the idea that a single stock index is the best alternative is blind to the practical benefits of diversification. And while Yale has a point that portfolio design can improve risk-adjusted returns, they overstate how much of that effect is attributable to active management rather than simple intelligent asset allocation.
So rather than getting caught up in the personal back and forth between two investing heavyweights, everyday investors can simply take note that perhaps active management is a great option for some people but it is not at all required to get competitive returns to the experts. Maybe you don’t have access to the same investments that Yale does, but you do have access to a portfolio that their own CIO recommends that is a whole lot easier and cheaper for you to manage yourself with no risk that the manager may retire and no expensive intermediary required.
Don’t get caught up in competing statistics and marketing language. Buffett and Swensen are both brilliant active investors who each recommend passive investing to non-institutional investors, and I suspect they agree more than you might know by only reading the headlines. I personally think the right path is to reap the best of both worlds by learning strategy from the endowments while applying that strategy with low-cost and low-maintenance index funds. With the tools available to investors today, you have a lot more power than you realize.
Don’t take sides. Take action. Your portfolio will thank you later.
(*) Please note that while all of the charts are calculated from data published in public Yale annual reports, the numbers are only approximate based on my best effort to interpret the available information. I encourage enterprising readers to study the reports for themselves, and one should always turn to the primary source for detailed returns numbers. Trust but verify.