David Swensen, the chief investment officer at Yale University, has enjoyed great success. When he arrived in New Haven in 1985, Yale’s endowment was worth just over $1 billion; as of the end of June, the endowment was worth nearly $23 billion. Swensen invested heavily in private equity funds, real estate and hedge funds, a strategy that initially met with some skepticism. Not all U.S. universities followed Swensen's lead, but many of those that didn't hoped to do so someday. Imitators include private foundations, pension funds and even the sovereign wealth funds of oil-rich nations.
With the market's collapse, however, some have begun to question whether the Yale model works as advertised. Yale's endowment is down 25 percent by Swensen's estimate, and for some of those who sought to "be like Yale," the damage may be even worse. Many institutions that followed Yale are experiencing huge losses they never expected. And bonds, which Swensen largely avoids, were one of the few safe harbors in the storm.
ProPublica spoke with Swensen the week he was named to President Obama's Economic Recovery Advisory Board. For more than an hour, Swensen discussed the "new reality" for endowments and the lessons of the financial crisis. He also answered critics who complain that his 2000 book -- Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment -- led universities astray. Here are excerpts from that interview.
How worried are you about the state of university and college endowments these days?
I’m not really worried. I think there’s no question that colleges and universities are going to have to adjust to a new reality. The new reality includes a substantial decline in the resources available from the endowment. The new reality includes at least for the near term more moderate expectations in the rate of growth. I think that as a group colleges and universities are fundamentally sound. But the growth that we’ve enjoyed for nearly three decades has come to an end and we need to adjust.
The first edition of Pioneering Portfolio Management was published nearly a decade ago. How has the endowment world changed since then, and how much of that do you think was attributable to you and your book?
If you look back over the past 20 years, I think the changes in the endowment world have been incredibly profound. A couple of decades ago, endowments were invested almost exclusively in marketable securities and predominantly in U.S. marketable securities. Today, the portfolios are much, much better diversified and much more equity oriented. And both of those are great developments. I know the title Pioneering Portfolio Management sounds a little bit arrogant, but the reason the book has that title is that Yale took the lead moving down this path of creating a better-diversified, more equity-oriented portfolio. So I do think that the university deserves a substantial amount of credit for the improvement in college and university endowments.
I'm sure you've heard that the financial crisis has sparked a debate about the Yale model, that it doesn't work as advertised in the current market. What's your response?
The first thing I’d say is it’s too short a time period over which to judge. If you want to have a fair assessment of any investment strategy, get through the crisis and then look back and see how things performed.
If you look back 10 years from June 30, 2008, Yale’s performance was 16.3 percent per annum. Bonds were 5 percent plus or minus, and stocks were 3 percent plus or minus. So what are you going to do? You’re going to give up that kind of performance to hold a lot of bonds to protect against the financial crisis? Where’s the alternative that performs so much better? 100 percent government bonds? Is that the alternative? Well, then what would have happened if you had held that the decade before? I don’t get it.
They’re not thinking about what happened the 10 years before and they’re not giving us time to get through this crisis and see how it plays out for the Yale model against a more traditional portfolio. That’s one of the really interesting things in these articles that have been critical of the Yale model and sometimes of me personally: Where’s the alternative? What’s the option? Yeah, the model fails. Well, relative to what?
As the financial world began collapsing over the past year, was there a point when you thought, all these schools that tried to copy me are going to be in big trouble?
It’s a tough question. Part of the answer is that a substantial number of college and university endowments are very well managed. I would say that the endowment and foundation community has a higher proportion of high-quality investment management organizations than almost any other category of institutional investor. When I look around, I see a lot of institutions that are dealing with a tough set of circumstances, but dealing with those circumstances quite capably. But there is that group of investors -- and it’s not just institutional investors, it’s individuals as well -- who’ve tried to follow the Yale model, if you will, without committing the resources that are necessary to make high-quality active management decisions. I think those institutions are headed for disappointment.
Have you been able to draw any lessons from this crisis? Were you prepared or was there something that you missed and should have seen?
It’s a very provocative question. One of the criticisms of the Yale model that I’ve seen in the press is that diversification didn’t work. First of all, measuring over a six-month or a nine-month or a 12-month time horizon is measuring over an inappropriately short time horizon. But I think probably the more interesting take on the question is that in times of financial crisis, one of the overriding factors in the market is a flight to quality. And we saw that on October 19, 1987, when stock markets all over the world declined by more than 20 percent. You saw a big rally in Treasury bonds. We saw it again in 1998 around the collapse of (the highly leveraged hedge fund) Long Term Capital Management. You saw an even more pervasive decline in risky assets, and perhaps even a stronger flight to the safety of Treasury bonds. And now today, you’re seeing what you saw in ’87 and ’98, except you’re seeing it even more pervasively and even more intensely than in those two previous crises. When you have this overriding phenomenon of investors selling any type of risk asset to buy the risk-free asset, that overwhelms all the other economic drivers of return. For the period during which we’re in the crisis, the hoped-for benefits of diversification disappear. But once the crisis passes, then the fact that these different asset classes are driven by fundamentally different factors will reassert itself, and you’ll get the benefits of diversification. It would be nice if we could always have the benefit of diversification, but life doesn’t work that way.
As an endowment manager, you ought to have a long enough time horizon that you can say, “OK, this period during which we’re in crisis is a period that we’re going to have to manage through, and get to the point where normality prevails in terms of the interrelationships between the various asset classes in which we’re invested.” The way most universities and colleges are structured allows that.
In Yale’s case, we only mark the portfolio to market once a year, on June 30. That’s the only number that matters. It matters for determining spending. It matters for financial disclosure purposes. That number that we get on June 30 only determines 20 percent of our spending. The other 80 percent comes from an averaging process. Obviously, we’re concerned about what’s happened since June 30th, and it influences our view of where we’re going to end up next June 30, but where we are today and where we were last month and the month before, in some sense, doesn’t even factor into our spending calculations.
I don’t want to come across as sounding oblivious and saying it doesn’t matter because obviously the fact that it’s very likely that we’re going to be down substantially when we count everything next June 30 does matter, and you’ve got to plan for that. But what I am arguing for is putting it in context and trying to behave with a sensible long-term horizon, even in the midst of this chaos.
I think it’s human nature to look at the short term.
I really don’t like it. There’s a horse-race mentality about the one-year numbers. Obviously, you’ve got to disclose them, but anointing winners and losers on the basis of 12 months’ worth of performance is silly in the context of portfolios that are being managed with incredibly long time horizons.
Do consultants exploit that insecurity among elite schools that creates this horse-race mentality, as you put it?
I don’t know that I characterize it as insecurity, but there’s a consulting firm that I know that collects quarterly performance data and then circulates it among a group of colleges and universities. I just think that’s beyond ludicrous. Those numbers carry very little meaning and serve very little purpose. Yale doesn’t participate. We won’t release quarterly numbers.
Does it bother you that consultants exploit your success and offer a short cut to schools that want to be like Yale?
I hate it. I think the consultant-driven process results in a distortion of what I’ve advocated.
Is there an over-reliance on consultants in the endowment world?
If I had to generalize, I would say that institutions have been slow to commit the resources to hire dedicated investment staff. I think that once you get to the $500 million to $1 billion range, you should be moving in that direction. A consultant probably seems like an easier, cheaper alternative, but I think you realize enormous benefits from having dedicated investment staff if you’re going to be pursuing this active investment strategy. It’s hard work. Having a consultant is very easy compared to going out and trying to find two or three high-quality professionals to manage your endowment.
It's striking to hear somebody speak frankly about the investment world, rather than spew platitudes.
When I wrote the first edition, I was much more worried about speaking my mind. Maybe I'm just getting old and cranky. Some of the veneer's come off.
The financial downturn has hit everybody hard, including families that hope to send their children to Yale. What's your answer to those who are looking to large endowments, such as Yale's, to help make college more affordable in the years to come?
One of the things that I care most deeply about is Yale's need-blind admissions, and one of the things I'm incredibly proud of is that the endowment growth that we've experienced over the past couple of decades allowed Yale to have need-blind policies, not only domestically, but globally. If you're qualified and get in, we'll make sure that you can afford it. If we say that, we become as much of a meritocracy as we can be, and that's a great thing.
Liquidity is a big, big problem for many large portfolios invested in alternative assets. How long do you expect the present premium on liquidity to last?
I think that the critical path has to do with fixing the credit markets. Right now, the credit markets are completely broken. You can't talk about a resolution of the crisis, you can't talk about a sustained recovery in the markets, and you can't talk about a recovery in the economy until the credit markets are fixed. Right now, I think we're a ways away from seeing a healing in the credit markets.
There are some institutions out there that are borrowing rather than liquidating positions with large, unrealized losses. Is that increasing the risk in the portfolio? How do you see that?
There are a number of tools that an endowment should have at its disposal to deal with liquidity issues. There are actually lots of ways that portfolios generate liquidity. Some of them are quite pedestrian. You've got dividends from stocks, rents from real estate holdings, logging income from your timber interests, coupons on your fixed-income investments. Those are all sources of liquidity. You also have the ability, if you've structured yourself properly, to generate liquidity by pledging securities positions. In the bond world, you've got the repo market. In the equity world, you've got the security-lending market. You're essentially using those assets as collateral for short-term loans, generally at very favorable terms, without altering the underlying portfolio characteristics. On top of that, you've got the ability to borrow externally. You also have the ability to sell positions, but that's disruptive to the portfolio. So the list of sources of liquidity that I gave you that didn't involve sales of marketable securities or sales of illiquid assets, those are the non-disruptive sources of liquidity. You would far rather use those tools than tools that would alter the characteristics of the portfolio.
How is Yale dealing with liquidity?
Look, we dealt with 1987. We dealt with 1998. We actually dealt with some liquidity issues surrounding the Internet bubble as well, because we'd hedged a lot of positions in these crazily valued Internet stocks. The hedges required a substantial amount of liquidity support. And so we've got the tools available to us, and we've had the experience of using the tools, and we've been able to do what we needed to do without using any of these disruptive sources of liquidity. Our allocation targets don't envision any material use of leverage, and we stayed within our asset allocation ranges throughout the whole period.
As you know, many universities have locked up millions of dollars in capital in private equity funds. The funds can call on this capital at will over a period of several years. How big a problem are these capital calls right now for university endowments?
Right now, they don't appear to be much of a problem at all because the credit markets are broken. You hear a theme? Most of what it is that would be subject to call involves the use of leverage. For example, a leveraged buyout or purchase of real estate would involve leverage. You're seeing the occasional deal, but things have been pretty quiet. I'm not saying that it's not something to worry about. Many are concerned that the pace of capital calls will increase without any corresponding increase in distributions. And there will be this mismatch and we'll end up with a crunch.
Right. But that hasn’t happened yet?
Just looking at what's going on in the industry, I don't see it. Things are very, very quiet.
You touched on the difficulty of valuing private equity, real estate and all other illiquid assets. Yale has to budget for current and future years, so how do you do that when you're not sure of the true value of your portfolio?
One of the things that has clearly happened in the past decade is that the marks that we get from our illiquid asset managers are much more market sensitive. It's something that we pay an enormous amount of attention to. One of the things that we started doing maybe eight years ago was looking at the June 30 valuations of each of the illiquid assets. I'm not talking about each of the partnerships, but each of the holdings of the partnerships. And then when there's a disposition event during the subsequent 12 months, it could be an IPO, could be a merger, could be a bankruptcy, could be an acquisition, then we compare the price at which that company or holding exited to the carrying value. One of the things that I'm reasonably happy about is that in each year in the past eight years, the aggregate of the proceeds from these exit valuations exceeded the June 30 carrying value. So it says that there's some conservatism built into the valuation. But I'd also say that in aggregate, the excess was not an enormous number, wasn't disquietingly large. If it were, that would mean we were under-spending. So it gives you some confidence going forward and making a budget because you feel, if anything, that you have a cushion there to work with, basically. To the extent that's true, there might have been a cushion in the June 30 valuations that helped a little bit to cushion the decline that we obviously experienced in the past six or seven months.
You wrote that the successful investor leans against the wind. All these universities, foundations and even sovereign wealth funds are trying to be like Yale by investing in private equity, hedge funds and real estate. So is it time to lean a different way now?
Yale built its portfolio on two basic principles. First, diversification makes sense. The institutional investment world that I saw in the 1980s was full of undiversified portfolios. Second, equity-oriented portfolios produce higher returns. Those are fundamental investment principles upon which you build a portfolio. They're not principles that go in and out of favor, or principles that you alter to try and take advantage of contrarian opportunities, but within the context of the portfolio that's diversified and equity oriented, you should clearly move your assets toward attractive strategic or tactical opportunities.
A lot of people follow where Yale has been. So where are you headed?
I'd say U.S. Treasuries are incredibly unattractive. That's not hard. Pretty much everything else is very attractive. Distressed credit is a pretty obvious opportunity. The dysfunction in the credit markets is creating some extraordinary opportunities right now.
Where do think things are headed in the endowment world?
I figured out when I revised Pioneering Portfolio Management that the most important distinction isn't between the institutional investor and the individual. It's between those that are set up to make high-quality active management decisions and those that aren't. The investment management world is a strange place in that the right solution is not in the middle. The right solution is at one extreme or the other. One end of the spectrum is being intensively active. The other is being completely passive. If you end up in the middle, which is where almost everybody is, you pay way too much in fees and end up getting subpar returns.
At the active end of the spectrum, you've got institutions like Yale and Harvard and Princeton and Stanford and others, who’ve really built high-quality investment teams that have a shot at making consistently good active management decisions. But there's a vanishingly small number of such investors. Those on the passive end of the spectrum have figured out that they don't know enough to be active. The passive group is not nearly as big as it should be. Almost everybody should be there.
But indexes aren’t much fun.
Yeah, they love the excitement. And they all think that the next guy is making it happen. Because that's what they hear at cocktail parties, so they want to make it happen too. But it's just basic arithmetic. When you pay out a point and a half or two points or two and a half points, and you give away 20 percent of the gains, that gets extracted from you the investor. If you're in an index fund, you're paying tenth of a percent and no percentage of the profits. But the assets that you get when you index are pretty much like the assets that you're invested in with all these fancy fee schemes. So it's just basic arithmetic. It's not complicated.
Seth Hettena is an investigative writer, former AP reporter and author of a book on former Congressman Randy "Duke" Cunningham, Feasting on the Spoils.