Tuesday, November 12, 2013

Get Rid Of The Yale Endowment Model

Investment managers become enamored with faddish theories from time to time.  Theories that promise to outperform the stock market's broad benchmarks always work until they don't work anymore.  It's time to retire one theoretical model that doesn't work anymore - the Yale endowment model from David Swensen.

I can boil this model's argument down to one pithy sentence:  Put one third of a portfolio into the most illiquid, highly leveraged products imaginable, provided those products are based on mathematical formulas that have no relationship to reality.  That worked in the era up until the last housing crisis, when every marginal dollar of debt added to the economy added more than one dollar of additional GDP.  The US economy passed that tipping point and every dollar of additional debt is a burden upon corporate earnings.

The Yale model cannot account for the underperformance of the hedge fund sector over the past decade yet advocates hedge fund investment simply because it is not correlated to equities or bonds.  It also endorses private equity allocations at a time when VC funds are in a long-term trend of underperformance.  Leveraged buyouts are based on the premise that debt-driven restructuring can unlock buried value.  That was fine when average corporate earnings were under their historical norm of 6% of GDP.  Earnings are now almost twice that figure.  They will revert to their mean at some point and companies undergoing a leveraged restructuring will turn in disappointing results to their private equity owners.

The model's logic doesn't even pass a test of internal consistency.  Mr. Swensen's books on portfolio theory argue that more intermediaries between a client and their money provide incrementally less value.  The Yale model implies that hiring more sub-managers for private equity and hedge fund investments adds value, which contradicts any inclination to minimize intermediaries.  Mr. Spock from Star Trek would say that's illogical.  Fictional aliens don't manage money, but if they did I think they'd put a Vulcan nerve pinch on anyone who insisted that ten levels of sub-managers deliver ten times the value of one.

My final beef with the Yale model is its inability to detect fraud.  Remember Bernie Madoff?  He made off with a bunch of cash for his Ponzi scheme because institutions trusted their funds-of-funds managers to perform due diligence on sub-managers like him.  They did no such thing.  Trusting additional layers of money managers increases the possibility that one will be a phony.

The Yale model ignores the effectiveness of the shareholder activist model that used to work well enough for institutional investors.  Maybe CalPERS and other institutions got lazy after the 1990s and decided to contract out their original thinking to sub-managers who did little thinking.  The Yale model gave them all convenient philosophical cover to take their eyes off the ball.  Today's economic climate demands attentive money managers.  They cannot afford to hang onto the Yale model.